Prospect theory is an economic theory which tries to describe the way people will behave when given choices which involve probability.
Prospect theory assumes that individuals make decisions based on expectations of loss or gain from their current relative position.
“An essential feature of Prospect Theory is that carriers of value are changes in wealth or welfare – rather than final outcomes.”
An important element of prospect theory is the idea that individuals are particularly averse to losing what they already have and less concerned to gain.
“Losses loom larger than gains”
Given a choice of equal probability, individuals would choose to preserve their existing wealth, rather than risk the chance to increase wealth.
Prospect theory can explain why people exhibit both risk-seeking and risk-averse behaviour.
Diagram Prospect Theory
Creation of Prospect Theory
The first instance of this theory was proposed by Daniel Kahneman and Amos Tversky in “Prospect Theory: An Analysis of Decision under Risk” (1979)
Features of Prospect Theory
Prospect theory places emphasis on how individuals frame situations and outcomes in their mind. Individuals may use rules of thumbs and the status quo bias.
- Certainty effect: People give greater weighting to certainty than outcomes that are merely probable.
- Reflective effect. In terms of positive gains, people give greater weighting to a small certain gain over a probable larger gain. But, in terms of negative gains, people exhibit risk-seeking behaviour – people preferring a loss that is probable over a small loss that is certain. (This seems to contradict the desire for insurance, but it is for moderate losses, rather than catastrophic losses.)
Model
In the editing phase, people decide which outcomes they consider equivalent, set reference points, simplify and combine probabilities.
In the evaluation phase, people compute utility based on the probability of certain outcomes, then choose alternatives with higher utility.
Prospect Theory differs from Expected Utility theory
- Expected Utility theory assumes individuals will choose the outcome which gives maximum utility given the probability of outcomes.
- Prospect theory allows for the fact that individuals may choose a decision which doesn’t necessarily maximise utility because they place other considerations above utility.
Examples of Prospect Theory in Action
1. Insurance decisions (Loss aversion)
People buy extended warranties for small appliances (e.g., a £40 warranty on a £250 washing machine) even though the expected value is negative.This is because
- The loss of paying for a repair (£200) feels more painful than the equivalent gain of saving the warranty cost.
- People overpay to avoid the possibility of a loss — classic loss aversion.
- Firms exploit this by selling insurance at relatively high cost, hoping to get some customers to pay through loss aversion.
2. Stock market: selling winners, holding losers
Investors tend to:
- Sell winning shares too early (to lock in a gain)
- Hold losing shares too long (to avoid realising a loss)
Prospect theory explanation:
- A realised loss is psychologically painful → investors become risk-seeking in losses.
- Gains feel good but with diminishing sensitivity → investors become risk-averse in gains.
- This is sometimes known as the disposition effect.
3. Price increases vs. price cuts
A business raising the price of bread from £1.00 to £1.10 will face more backlash than goodwill from cutting the price from £1.10 to £1.00.
- Consumers perceive price rises as losses relative to their reference point.
- Price cuts feel less significant due to diminishing sensitivity to gains.
Shrinkflation in a Toblerone – to avoid backlash from rise in price
This explains why firms use shrinkflation instead of outright price increases.
Consumers have asymmetrical responses.
4. Framing of medical risks
A doctor can say:
- “This treatment has a 90% survival rate.” (gain frame)
- “This treatment has a 10% chance of death.” (loss frame)
The behaviour differs even though the information is identical. People avoid the loss frame because losses loom larger.
5. Endowment effect
Somebody who owns a vintage bottle of wine for 20 years
- May demand £2,000 to sell it
- But, they wouldn’t pay even £300 to buy an equivalent bottle brand new
People treat selling the vintage as a loss, hence overvalue it. There is also a psychological attachment to owning it for so long.
Related
Published 29 Mar 2018, Tejvan Pettinger. www.economicshelp.org. Updated 5 Dec 2025.
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