Prospect theory

Kahneman & Tversky (1979) developed this theory to remedy the descriptive failures of subjectively expected utility (SEU) theories of decision making. Prospect theory attempts to describe decisions under uncertainty, and has also been applied to the field of social psychology. Like SEU-theories, prospect theory assumes that the value V of an option or alternative is calculated as the summed products over specified outcomes x. Each product consists of a utility v(x) and a weight w attached to the objective probability p of obtaining x. Thus the value V of an option is w(p) v(x).

Prospect theory differs from expected utility theory in a number of important respects. First, it differs from expected utility theory in the way it handles the probabilities attached to particular outcomes. Prospect theory treats preferences as a funcion of "decision weights", and it assumes that these weights do not always correspond to probabilities. Specifically, prospect theory postulates that decision weights tend to overweight small probabilities and underweight moderate and high probabilities.

Prospect theory also replaces the notion of "utility" with "value". Whereas utility is usually defined only in terms of net wealth, value is defined in terms of gains and losses (deviations from a reference point). The value function has a different shape for gains and losses. For losses it is convex and relatively steep, for gains it is concave and not quite so steep.

Based on these assumptions some deviations from normative theories can be explained like loss aversion, reflection effect or framing effect.

See also: Allais paradox, reflection effect, framing effect

Literature: Kahneman & Tversky (1979)

Entry by: Susanne Haberstroh

June 17, 1999
Direct questions and comments to: Glossary master