Prospect theory

Prospect theory is a theory in cognitive psychology that describes the way people choose between probabilistic alternatives that involve risk, where the probabilities of outcomes are known. The theory states that people make decisions based on the potential value of losses and gains rather than the final outcome, and that people evaluate these losses and gains using some heuristics. The model is descriptive: it tries to model real-life choices, rather than optimal decisions, as normative models do. Prospect theory is a theory in cognitive psychology that describes the way people choose between probabilistic alternatives that involve risk, where the probabilities of outcomes are known. The theory states that people make decisions based on the potential value of losses and gains rather than the final outcome, and that people evaluate these losses and gains using some heuristics. The model is descriptive: it tries to model real-life choices, rather than optimal decisions, as normative models do. The theory was created in 1979 and developed in 1992 by Daniel Kahneman and Amos Tversky as a psychologically more accurate description of decision making, compared to the expected utility theory. In the original formulation, the term prospect referred to a lottery. The paper 'Prospect Theory: An Analysis of Decision under Risk' (1979) has been called a 'seminal paper in behavioral economics'. The theory describes the decision processes in two stages: