A descriptive model of decision-making under risk showing that people evaluate outcomes relative to a reference point, are loss-averse, and weight probabilities non-linearly.
Prospect theory replaced the rational-actor model of expected utility theory with a psychologically realistic account of choice. Its core insights are: (1) loss aversion—losses loom larger than equivalent gains; (2) reference dependence—outcomes are evaluated relative to a reference point rather than in absolute terms; (3) probability weighting—small probabilities are overweighted while moderate to high probabilities are underweighted. This framework earned Kahneman the Nobel Prize and explains phenomena from the endowment effect to why people simultaneously buy lottery tickets and insurance.
A doctor can frame surgery as having a '90% survival rate' or a '10% mortality rate.' Though identical, patients are more likely to choose surgery with the first framing (survival is a gain from the reference point of death) than the second (death is a loss from the reference point of life).
Prospect theory tells us how we should make decisions—actually, it's descriptive (how people do decide) not prescriptive (how they should decide).
What are the three core insights of Prospect Theory that distinguish it from expected utility theory?
True or False: Prospect Theory provides a prescriptive model—it tells us how we should make decisions to maximize utility.
The slow, deliberate, effortful mode of thinking that allocates attention to complex computations, self-control, and conscious reasoning.
Mental ModelThe fast, automatic, intuitive mode of thinking that operates effortlessly and generates impressions, intuitions, and feelings without conscious control.
Mental ModelJudging the frequency or probability of events by how easily examples come to mind, leading to overestimation of vivid or recent events.
Mental ModelJudging probability by how much something resembles a typical case while ignoring base rates, sample size, and statistical principles.
Mental ModelThe tendency to rely too heavily on an initial piece of information (the anchor) when making subsequent judgments, even when the anchor is arbitrary or irrelevant.
Mental ModelThe principle that losses loom psychologically larger than equivalent gains, with losing something feeling roughly twice as bad as gaining the same thing feels good.
PrincipleSystem 1's tendency to construct the most coherent story possible from currently available information without considering what's missing or questions not asked.
PrincipleThe systematic tendency to underestimate how long tasks will take, how much they'll cost, and what risks they face, due to focusing on the specific plan rather than similar projects.
PrincipleA descriptive model of decision-making under risk showing that people evaluate outcomes relative to a reference point, are loss-averse, and weight probabilities non-linearly.
A doctor can frame surgery as having a '90% survival rate' or a '10% mortality rate.' Though identical, patients are more likely to choose surgery with the first framing (survival is a gain from the reference point of death) than the second (death is a loss from the reference point of life).
Prospect theory tells us how we should make decisions—actually, it's descriptive (how people do decide) not prescriptive (how they should decide).
Prospect Theory is explored in depth in "Thinking, Fast and Slow" by Daniel Kahneman. Distilo provides a deep AI-powered analysis with key insights, audio narration, and practical frameworks.