Prospect theory is a behavioral economics theory developed by Daniel Kahneman and Amos Tversky, which describes how people make decisions involving risk and uncertainty. It posits that individuals assess potential losses and gains asymmetrically, notably exhibiting loss aversion, where the pain of losing is felt more acutely than the pleasure of an equivalent gain. Rather than making decisions based on a rational calculation of expected outcomes, individuals evaluate options in relation to a reference point, leading to choices that deviate from traditional utility theory.
In real-world scenarios, prospect theory can be illustrated by individuals preferring a guaranteed gain of $450 over a 50% chance to win $1000, despite the higher expected utility of the gamble. On the flip side, when it comes to losses, people may choose a risky 50% chance to lose $1100 instead of a sure loss of $500, driven by the desire to avoid losses even when the expected utility is lower.
To mitigate the effects of prospect theory on decision making, individuals can consciously evaluate potential outcomes using a rational framework, considering both gains and losses impartially without bias toward loss aversion or framing effects.