Prospect Theory is a behavioral economic theory that seeks to explain how people make decisions under conditions of uncertainty or risk. Developed by Daniel Kahneman and Amos Tversky in 1979, it challenges traditional economic models by highlighting the role of psychological factors in decision-making.


  1. Value Function: Prospect Theory proposes that individuals evaluate potential outcomes based on the deviation from a reference point rather than in absolute terms. The value function is an S-shaped curve that describes how people perceive gains and losses relative to the reference point.
  2. Loss Aversion: According to Prospect Theory, individuals are more sensitive to losses than to equivalent gains. Loss aversion is the tendency to weigh potential losses more heavily than potential gains, leading to a risk-averse behavior.
  3. Probability Weighting: People do not assess probabilities objectively; instead, they subjectively weight probabilities based on their psychological perception. Prospect Theory suggests that individuals overestimate low-probability events and underestimate high-probability events.
  4. Disposition Effect: This phenomenon refers to the tendency of individuals to hold onto losing assets while quickly selling profitable ones. It is driven by the desire to avoid the emotional pain associated with realizing losses and to seek the emotional satisfaction of realizing gains.
  5. Status Quo Bias: Prospect Theory proposes that individuals have a preference for maintaining their current state of affairs. They tend to perceive the status quo as the reference point and are resistant to change, leading to a bias in decision-making processes.


Prospect Theory has found applications in various fields, including finance, marketing, and public policy. It helps explain phenomena such as irrational investor behavior, consumer decision-making, and framing effects on public opinion. Understanding Prospect Theory can aid in designing appropriate strategies and interventions to account for the cognitive biases inherent in human decision-making.