Prospect Theory

Prospect theory was proposed by Daniel Kahnemann and Amos Tversky in 1979 as an alternative to expected utility theory, which states that people make decisions which maximize the utility of the outcome. Using sets of surveys, Tversky and Kahnemann demonstrated several tendencies that appeared to run counter to the predictions of utility theory. When making choices, people will tend to show aversion to risk when there is an alternative involving a sure gain, and when a sure loss is involved, people will tend to choose riskier alternatives. Another tendency observed is that people will over-weight low probabilities, and under-weight high probabilities.

Kahneman, D., Tversky, A. (1979) “Prospect Theory: An Analysis of Decision under Risk“, Econometrica, XLVII (1979), 263-291.