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Join us on Slack# Prospect Theory: An Analysis of Decision under Risk

When Daniel Kahneman won the Nobel Memorial Prize in 2002, nobody doubted the reason - his article, titled “Prospect Theory: An Analysis of Decision under Risk”, challenged the basis of expected utility theory, an economics model that predicted a choice under uncertainty via probabilities. Kahneman’s research showed that the most rational decision was unlikely to be chosen, with illogical choices being made instead.

In 1979, Daniel Kahneman and his colleague, Amos Tversky, conducted a series of questionnaires at the University of Stockholm and the University of Michigan. In these surveys, participants were asked to choose between choices like monetary prizes, vacations, and jobs. In every one of these scenarios, expected utility theory was violated - instead of choosing scenarios with the biggest probability of profit (as predicted by utility theory), people weighed certain profits much higher than uncertain ones.

He asked participants to choose between two scenarios in both of the following gambles:

Gamble 1:

A. 100% chance of losing $3000

B. 80% chance of losing $4000, and a 20% chance of losing nothing

Gamble 2:

C. 100% chance of winning $3000

D. 80% chance of winning $4000, and a 20% chance of winning nothing

Kahneman & Tversky found that 92% of the participants chose (B), and that 80% chose (C). However, utility theory, given u(0)=0, would have that u($3000) < 0.8u($4000) from Gamble 1 and that u($3000) < 0.8u($4000) from Gamble 2, where u is the utility, or use, for the money. Utility theory anticipates choices (A) and (D), but the data clearly contradicts the prediction, with only 2/25th of people choosing the certain outcome in the loss, and 5/25th choosing the uncertain outcome on the win.

*Losses are weighed steeper than gains (Wikimedia Commons)*

Kahneman found that while people are risk averse over gains, they are risk loving over loss. He labeled this the certainty effect. Simply put, this shows that people weigh certain outcomes much higher than they should when choosing between gains. His resulting theory worked much better than utility theory in predicting choices in questionnaires, and ultimately started a new theory of economics called prospect theory.