Psychology › Thinking, memory & biases › Behavioral economics
Prospect theory
1979· Theory or model
Well replicatedStrong, repeated evidence.
Kahneman and Tversky's 1979 model of how people actually choose under risk, judging outcomes as gains and losses from a reference point.
See it on the Psychology map →What it says
Published in Econometrica, it offered four ideas in place of the textbook model of maximizing total wealth. People judge changes from a reference point, often the purchase price or status quo. Losses hurt about twice as much as equal gains please. Sensitivity shrinks with size: $100 versus $200 feels bigger than $1,100 versus $1,200. And people overweight small probabilities, which helps explain both lottery tickets and insurance. A 1992 'cumulative' version refined the math.
Why it matters
It explains why investors hold losers, why people buy both insurance and lottery tickets, and why framing a choice as a loss changes decisions.
Think of it like
Like a seller who judges an offer against what they paid, not against today's market.
The evidence
Well replicated. A 2020 study repeating the original 1979 survey questions with about 4,000 people in 19 countries reproduced most results. It is one of the most cited papers in economics.
Open questions
Economists still debate where the reference point comes from, the purchase price, expectations or the status quo, and how quickly it shifts.
Connections (4)
▸Framing effects are explained by Prospect theoryWell replicated
The connection
Prospect theory says people judge outcomes as gains or losses from a reference point, playing safe with gains and gambling to avoid losses. Framing moves the reference point: 'saves 200' sounds like a gain, '400 will die' like a loss, so the same choice flips.
Who showed it and when
Tversky and Kahneman, 'The Framing of Decisions and the Psychology of Choice', Science, 1981, two years after prospect theory.
The evidence
The framing paper explicitly derives its predictions from prospect theory's value curve, and the predicted flip replicates widely.
Open questions
Other explanations, such as people reading 'saves 200' as 'at least 200', can account for some framing effects without prospect theory.
▸Daniel Kahneman and Amos Tversky developed Prospect theoryWell replicated
The connection
From about 1974 the pair spent five years testing choices between gambles on students and colleagues, writing and rewriting together. They chose the deliberately meaningless name 'prospect theory' so it would stand out, and published in the economics journal Econometrica so it would reach economists directly.
Who showed it and when
Hebrew University of Jerusalem and Stanford, 1974–1979; Econometrica, March 1979; the cumulative version followed in 1992.
The evidence
The 1979 paper itself, Kahneman's Nobel autobiography on how it was written, and the 2002 Nobel announcement naming prospect theory.
Open questions
Whether its parts, especially the overweighting of small probabilities, belong in standard economic models remains debated among economists.
▸Prospect theory is the founding theory of Behavioral economicsWell replicated
The connection
Prospect theory gave economists a precise alternative to expected-utility theory, the standard model of rational choice, in their own mathematical language and journal. Thaler used it to explain the endowment effect and mental accounting; later work applied it to stock returns, insurance and how hard people work.
Who showed it and when
Econometrica, 1979; taken up by Thaler from 1980, and by finance economists such as Shlomo Benartzi in the 1990s.
The evidence
It is among the most cited papers ever published in Econometrica, and founders of the field, Thaler included, credit it as their starting point.
Open questions
Some argue behavioral economics has several roots, including Herbert Simon and George Katona, so calling one paper 'founding' oversimplifies.
▸Loss aversion is the heart of Prospect theoryWell replicated
The connection
In prospect theory's value curve, the line is steeper for losses than for gains, about twice as steep in typical estimates. That one asymmetry drives many of the theory's predictions: refusing fair bets, sticking with the status quo, and the gap between buying and selling prices.
Who showed it and when
Kahneman and Tversky, 1979; their 1992 cumulative prospect theory paper estimated the ratio at about 2.25.
The evidence
Coin-flip acceptance studies and a 2024 meta-analysis of hundreds of estimates put the ratio near 2.
Open questions
Some researchers argue the asymmetry depends on stakes and context, and that other parts of the theory, like probability weighting, matter as much.