On Prospect Theory

Prospect theory turned out to be the most significant work we ever did, and our article is among the most often cited in the social sciences. — Daniel Kahneman

The idea that the future is unpredictable is undermined every day by the ease with which the past is explained. - Daniel Kahneman

Julio, a passionate and skilled bowler, entered the bustling bowling alley on a lively Friday night. The sound of rolling bowling balls and the cheerful chatter of bowlers filled the air. Tonight, Julio was here not just for a casual game of bowling but to put his understanding of prospect theory to the test.

Julio noticed a group of regulars engaged in a friendly competition, with money on the line. He was invited to join, and he eagerly accepted, ready to apply the principles of prospect theory to his bowling strategy.

His opponent, Sarah, was known for her precision in knocking down pins, but she had a tendency to take daring shots. Julio recalled the concepts of prospect theory: people often prefer certain gains over uncertain gains, and they tend to become risk-seeking when facing potential losses.

In the first game, Julio found himself in a favorable position to secure a win with a straightforward spare. The potential gain was evident. Remembering that in prospect theory, individuals often prefer sure gains over uncertain gains, he decided to play it safe, taking the sure win. He knocked down the remaining pins, securing the victory.

In the second game, Julio faced a challenging split spare, a shot that required precision and accuracy. The potential gain from making the split was significant, but the risk of missing was equally high. He recalled that in situations involving potential losses, people tend to become risk-seeking. With determination, he lined up the shot and went for it. The ball curved perfectly, knocking down both pins, securing his second win.

Sarah, observing Julio's strategic approach, decided to apply prospect theory herself. She began to take more conservative shots when facing potential gains and riskier shots when facing potential losses. The bowling alley became a stage for psychological strategy, with Julio and Sarah each trying to outsmart the other using prospect theory principles.

As the evening progressed, Julio and Sarah continued their games, carefully considering their shots based on the potential gains and losses. Other bowlers in the alley couldn't help but notice their thoughtful play.

In the final game, it all came down to a challenging split spare for Julio. He could play it safe and potentially win, or he could take a risk for a more substantial gain. His heart pounded as he remembered that people tend to become risk-seeking when facing potential losses. With unwavering focus, he went for the daring shot, and to his delight, the pins scattered in all directions.

Julio had clinched the game and earned the admiration of fellow bowlers in the alley. Applying prospect theory to his bowling strategy had proven to be a winning approach. He had demonstrated that understanding decision-making biases could give him an edge not only in the game of bowling but also in the game of life.

Prospect Theory

Prospect theory is a behavioral economic theory developed by Daniel Kahneman and Amos Tversky in 1979. It describes how people make decisions involving risk and uncertainty. The theory suggests that individuals do not make decisions based on absolute outcomes, but rather on perceived gains and losses relative to a reference point (usually the status quo or an expected outcome).

Key concepts in prospect theory include:

• Value Function: People tend to be risk-averse when facing gains (willing to take smaller, certain gains over larger, uncertain gains) and risk-seeking when facing losses (willing to take risks to avoid losses).

• Reference Point: The reference point is the baseline from which individuals evaluate outcomes. Gains and losses are assessed relative to this reference point.

• S-Shaped Value Function: The value function is typically represented by an S-shaped curve, indicating that people are more sensitive to changes in probability and outcomes in the domain of losses than in the domain of gains.

• Loss Aversion: People tend to feel the pain of losses more strongly than the pleasure of equivalent gains. This asymmetry influences decision-making.

Prospect theory has had a significant impact on understanding how individuals make decisions involving risk, and it has practical applications in fields like finance, marketing, and public policy.