Main Page | See live article | Alphabetical index

Prospect theory

The prospect theory was developed by Daniel Kahneman and Amos Tversky in 1979. Starting from empirical evidence, it describes how individuals evaluate losses and gains. In the original formulation the term prospect referred to a lottery.

The theory is basically divided into two stages, editing and evaluation. In the first, the different choices are ordered following some heuristic so as to let the evaluation phase be more simple. The evaluations around losses and gaines are developed starting from a reference point. The value function which passes trough this point in s-shaped and as it is asymmetric implies, given the same variation in absolute value, a bigger impact of losses than of gains (loss aversion). Some behaviors observed in economics, like the disposition effect or the reversing of risk aversion/risk seeking in case of gains or losses, can be explained referring to the prospect theory.