Prospect theory is a decision-making model under uncertainty that describes how people make choices when the benefits or losses they will receive as a result of their choices and the probability of those benefits or losses are known. ¹ This theory is well known as a representative work in behavioral economics.
Prospect theory is based on three main principles:
1. Loss aversion: People weigh losses more heavily than the same amount of gain. That is, losing $10,000 has a greater impact than gaining $10,000.
2. Diminishing sensitivity: As the absolute value of a gain or loss increases, the feeling of it becomes less noticeable. For example, if someone who already has $10,000 receives another $10,000, the pleasure they feel is less than the pleasure they felt when they first received $10,000.
3. Reference-point dependence: People evaluate gains and losses not in absolute terms, but as changes from a certain reference point (e.g., their current wealth).
These principles help us understand how people evaluate risk and reward. These principles also have applications in many aspects of business, including marketing, product pricing, and contract design.
Prospect theory provides a powerful framework for understanding how people evaluate risk and reward and how they act based on it. Understanding this theory can provide useful insights for designing business strategy, product design, marketing campaigns, and more.² The theory has broad applications not only in business, but also in policy decisions and personal decision-making.
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