Prospect Theory

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Main Premise[edit]

Prospect theory distinguishes two phases in the choice process: framing and valuation. In the framing phase, the decision maker constructs a representation of the acts, contingencies, and outcomes that are relevant to the decision. In the valuation phase, the decision maker assesses the value of each prospect and chooses accordingly. The key elements of prospect theory are 1) a value function that is concave for gains, convex for losses, and steeper for losses than for gains, and 2) a nonlinear transformation of the probability scale, which overweights small probabilities and underweights moderate and high probabilities (Tversky & Kahneman, 1992).

According to cumulative prospect theory (CPT), people tend to overweight extreme but unlikely events, but underweight "average" events. In CPT, cumulative probabilities are transformed, rather than the probabilities. This leads to overweighting of extreme events which occur with small probability, rather than to an overweighting of all small probability events. CPT helps explaining the status quo bias in decision making (Ortoleva, 2010; Sagi, 2006).

Original Paper(s)[edit]

Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica: Journal of the econometric society, 263-291.

Tversky, A., & Kahneman, D. (1992). Advances in prospect theory: Cumulative representation of uncertainty. Journal of Risk and uncertainty, 5(4), 297-323

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