Prospect Theory: An Analysis of Decision Under Risk

Posted: 17 Nov 2009  

Daniel Kahneman

Princeton University

Amos Tversky

affiliation not provided to SSRN

Date Written: 1979

Abstract

Analysis of decision making under risk has been dominated by expected utility theory, which generally accounts for people's actions. Presents a critique of expected utility theory as a descriptive model of decision making under risk, and argues that common forms of utility theory are not adequate, and proposes an alternative theory of choice under risk called prospect theory. In expected utility theory, utilities of outcomes are weighted by their probabilities. Considers results of responses to various hypothetical decision situations under risk and shows results that violate the tenets of expected utility theory. People overweight outcomes considered certain, relative to outcomes that are merely probable, a situation called the "certainty effect." This effect contributes to risk aversion in choices involving sure gains, and to risk seeking in choices involving sure losses. In choices where gains are replaced by losses, the pattern is called the "reflection effect." People discard components shared by all prospects under consideration, a tendency called the "isolation effect." Also shows that in choice situations, preferences may be altered by different representations of probabilities. Develops an alternative theory of individual decision making under risk, called prospect theory, developed for simple prospects with monetary outcomes and stated probabilities, in which value is given to gains and losses (i.e., changes in wealth or welfare) rather than to final assets, and probabilities are replaced by decision weights. The theory has two phases. The editing phase organizes and reformulates the options to simplify later evaluation and choice. The edited prospects are evaluated and the highest value prospect chosen. Discusses and models this theory, and offers directions for extending prospect theory are offered. (TNM)

Keywords: Utility theory, Prospect theory, Choice, Decision making, Management decisions, Risk orientation, Uncertainty

Suggested Citation

Kahneman, Daniel and Tversky, Amos, Prospect Theory: An Analysis of Decision Under Risk (1979). Econometrica, Vol. 47, Issue 2, p. 263 1979. Available at SSRN: https://ssrn.com/abstract=1505880

Daniel Kahneman (Contact Author)

Princeton University ( email )

Department of Psychology 3-2-1 Green Hall
Princeton, NJ 08544
United States
609-258-2280 (Phone)
609-258-2809 (Fax)

Amos Tversky

affiliation not provided to SSRN

No Address Available

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