Neoclassical economists spent two centuries assuming that humans calculate money like rational, emotionless computing robots; Daniel Kahneman and Amos Tversky proved that the human brain feels the pain of losing 100. Awarded the 2002 Nobel Prize in Economics, Prospect Theory shattered rational-choice theory and founded Behavioral Economics, revolutionizing financial markets, consumer design, and government policy worldwide.
In standard economic textbooks, "Homo Economicus" was a mythical creature: a completely rational human who calculates probabilities perfectly and feels the exact same emotional weight whether winning or losing ten dollars. For two centuries, economic policies were built on this unrealistic robotic assumption.
Israeli psychologists Daniel Kahneman and Amos Tversky proved that human psychology has an asymmetric S-shaped curve: losses loom twice as large as gains. Losing a thousand dollars stings twice as hard as the happiness of gaining a thousand dollars, causing people to make irrational bets, hold onto losing stocks too long, and overpay for extended insurance warranties.
Prospect Theory became the most cited paper in economics history, earning Kahneman the 2002 Nobel Prize. By predicting stock market panic bubbles, by designing automatic retirement savings nudges for workers, and by founding behavioral economics, Kahneman and Tversky humanized the science of money.
Prospect Theory: An Analysis of Decision under Risk
This paper presents a critique of expected utility theory as a descriptive model of decision making under risk, and develops an alternative model, called prospect theory. Choices among risky prospects exhibit several pervasive effects that are inconsistent with the basic tenets of utility theory. In particular, people underweight outcomes that are merely probable in comparison with outcomes that are obtained with certainty. This tendency, called the certainty effect, contributes to risk aversion in choices involving sure gains and to risk seeking in choices involving sure losses. In addition, people generally discard components that are shared by all prospects under consideration. This tendency, called the isolation effect, leads to inconsistent preferences when the same choice is presented in different forms. An alternative theory of choice is developed, in which value is assigned to gains and losses rather than to final assets and in which probabilities are replaced by decision weights. The value function is normally concave for gains, commonly convex for losses, and is generally steeper for losses than for gains. Decision weights are generally lower than the corresponding probabilities, except in the range of low prob-abilities. Overweighting of low probabilities may contribute to the attractiveness of both insurance and gambling. 1.
Philosophy taught that human reason was an immaculate engine of pure logic and objective truth; Amos Tversky and Daniel Kahneman proved that our daily decisions are run by quick mental shortcuts that systematically trick our brains into predictable cognitive illusions. Published in Science in 1974, "Judgment under Uncertainty" mapped the universal cognitive biases governing the human mind, revolutionizing behavioral psychology, courtroom legal jury decisions, and medical diagnostics.
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