Prospect theory, developed by Daniel Kahneman and Amos Tversky (1979), is the most influential descriptive model of decision making under risk. It replaced expected utility theory's assumption of rational, utility-maximizing agents with a psychologically realistic account of how people actually evaluate risky prospects. The theory earned Kahneman the 2002 Nobel Prize in Economics (Tversky had died in 1996).
Key Structures
- Ventromedial prefrontal cortex — A prefrontal region involved in value-based decision making, emotion regulation, and the representation of reward outcomes.
- Amygdala — An almond-shaped structure in the medial temporal lobe that processes emotional significance, particularly threat and fear, and modulates emotional memory formation.
- Striatum — The input structure of the basal ganglia, comprising the caudate and putamen, critical for reward learning and habit formation.
- Insula — A cortical region deep within the lateral sulcus involved in interoception, emotional awareness, and taste processing.
- Amos Tversky — The brilliant cognitive psychologist whose collaboration with Daniel Kahneman produced prospect theory and the heuristics and biases research program — transforming the study of human judgment.
- Decision Making — The cognitive processes involved in selecting a course of action from among multiple alternatives, integrating information about options, outcomes, and preferences.
- Expected Utility Theory — The normative theory that rational decisions should maximize expected utility — the probability-weighted sum of the values of all possible outcomes.
- Daniel Kahneman — The Nobel Prize-winning psychologist whose research on cognitive biases and dual-process thinking transformed our understanding of human judgment, decision-making, and rationality.
- Loss Aversion — The robust finding that losses loom larger than equivalent gains — people typically feel the pain of losing something about twice as strongly as the pleasure of gaining it.
Key Functions
Describe how people evaluate gains and losses relative to a reference point, with losses weighted more heavily than equivalent gains (loss aversion) and diminishing sensitivity.
Key Components
Prospect theory has two key components. The value function describes how outcomes are evaluated: relative to a reference point (gains and losses, not absolute wealth), with diminishing sensitivity (the difference between $10 and $20 feels larger than between $110 and $120), and with loss aversion (a loss of $100 hurts roughly twice as much as a gain of $100 feels good — the loss aversion coefficient is approximately 2). The probability weighting function describes how probabilities are transformed: small probabilities are overweighted (explaining why people buy lottery tickets and insurance) and moderate-to-high probabilities are underweighted.
v(x) = −λ(−x)^β for losses (β ≈ 0.88, λ ≈ 2.25)
Reference dependence + Diminishing sensitivity + Loss aversion
Prospect theory predicts a distinctive fourfold pattern: risk aversion for moderate-to-high probability gains (preferring a sure $900 over a 90% chance of $1000), risk seeking for moderate-to-high probability losses (preferring a 90% chance of losing $1000 over a sure loss of $900), risk seeking for low-probability gains (lottery tickets), and risk aversion for low-probability losses (insurance). This pattern, well-supported empirically, cannot be explained by expected utility theory.
Disorders
- Altered loss aversion in amygdala damage
- Risk-seeking in mania
- Excessive loss aversion in anxiety