Prospect Theory by Amos Tversky and Daniel Kahneman

Article by: Patty Mulder

Last update: October 20, 2025

Prospect Theory: this article explains the Prospect Theory by Amos Tversky and Daniel Kahneman in a practical way. Next to what is it and the definition, this article also features the Utility Theory, the risks including an example and an additional subchapter on the effect of losses and gains. Enjoy reading!

What is the Prospect Theory?

The definition of Prospect Theory

The Prospect Theory is a behavioural economic theory was that developed in the 1970s by psychologists Daniel Kahneman and Amos Tversky. It states that the preference of taking (uncertain) decisions depends on circumstances.

Together they wrote “Prospect Theory: an analysis of decision under risk”, in which they explain the prospect theory as part of behavioural economics.

This theory describes how people select alternatives where risks are involved, but in which the results are also already known. Prospect theory assumes that losses and gains are valued differently, and thus individuals make decisions based on perceived gains instead of perceived losses. The losses and gains are evaluated using facts that are available (heuristics), which have come to light through methods and/ or systems.

The prospect theory is a descriptive theory and it tries to model real-life choices rather than predict optimal decisions.

One of the criticisms of the prospects theory is that it lacks psychological explanations for the process it talks about.

Utility Theory

The Prospect Theory was developed by Amos Tversky and Daniel Kahneman as an alternative to the expected utility hypothesis. Several scientists had shown that people do not so much look at the net result of a choice, but that they assign weight to choices. This is called the utility theory.

The Prospect Theory deals with the description of preferences in relation to the expected utility that a choice will yield. The utility theory originated dates back to 1738 and was developed by the Swiss mathematician and physicist Daniel Bernoulli. For a long time this theory was the dominant explanation for decisions of which the outcomes are uncertain.

Chances and risks are not absolute, but relative to the situation. The certainty effect plays a role in this; things that are certain outweigh possible chances. Also, many people feel that ‘losses’ outweigh ‘gains’.

Example of Prospect Theory in practice

All these theories discuss risks in detail. However, there is a distinction between risk and uncertainty where risk can be measured and uncertainty cannot be measured.

Bernoulli indicated at the time that chances are assessed differently on the basis of moral expectations. The Prospect Theory, or Loss Aversion Theory is also based on this and the example of a lottery is often cited in several theories.

For example, a ticket that costs 10 Euros will yield either nothing or the grand prize of 10,000 Euros, resulting in a weighted average of 5,000 Euros. This is also called the reference point. A very poor person may want to sell the lottery ticket for less than 5,000 Euros, while a rich person will want to buy it for 5,000 Euros.

He will accept the possibility of a risk. The utility of whether to buy or sell therefore depends on the circumstances in which a person finds himself and explains the risk avoidance behaviour of the poor man and the risk-seeking behaviour of the rich man.

Losses and gains

Kahneman and Tversky, however, did not consider the effect of losses and gains.

Their Prospect Theory shows that the value attached to losses is often greater than the value that is attached to gains. The central idea in their theory is reasoning.

When information is presented in a certain way, people are inclined to make other choices. Gain-framed information makes people more inclined to avoid risks.

In the case of adverse information in terms of ‘losses’, the opposite will happen and risk-seeking behaviour will be demonstrated. When you are aware of the influence of the information, you can prepare yourself for it so that you will not be led by this (unconsciously).

The framing effect is a cognitive bias where people decide on options based on whether the options are presented with positive or negative connotations; e.g. as a loss or as a gain.[1]

Prospect Theory: the decision process

This theory describes the decision processes in two stages; the editing phase and the evaluation phase.

Editing phase

During the initial phase, the outcomes of a decision are ranked according to facts that are available (heuristics).

People determine which outcomes they consider equivalent, set a point of reference and then consider lesser outcomes as losses and greater ones as gains.

Evaluation phase

In the subsequent evaluation stage people start looking for the value (utility) that the outcome will have for them.

They base this value on the potential outcomes and the respective probabilities. Based on this information, they choose the outcomes with the highest value after which they will ultimately make a decision.

Examples of the Prospect Theory

Prospect theory is not only an economic model, but also visible in everyday life and business operations. We rarely make completely rational decisions—emotions, context, and framing influence us more than we think.

Marketing and consumer behavior

Companies consciously use loss aversion in their campaigns. Think of offers with texts such as “Only valid for 2 more days” or “Don’t miss this discount.” The fear of losing something (the discount, the benefit) is stronger than the desire to gain something. Amazon and Bestbuy.com often use “temporary deals” or “last chance” messages to activate that psychological response to loss.

Investments and investing

Investors often hold on to losing stocks for too long, hoping that they will rise again. This phenomenon is called the disposition effect — people avoid the feeling of loss, even if it would be better to do so from a rational point of view. An investor would rather sell a stock at a profit to “celebrate” that success than sell a loss-making stock to acknowledge the loss.

Healthcare and behavior

Loss aversion is also used in health campaigns. Messages such as “Smoking costs you 10 years of your life” often have more impact than “Quitting smoking extends your life by 10 years.” Negative framing (loss) motivates more strongly than positive framing (gain), exactly as Prospect Theory predicts.

How to apply Prospect Theory in organizations

The insights from Prospect Theory are extremely valuable for managers, HR professionals, and marketers. They help to better understand why people make certain choices and how you can influence behavior without manipulation—but rather through empathetic design of policy, communication, and decision-making.

In HR and organizational change

Employees often react more strongly to potential losses than to promised benefits. In organizational change, this can lead to resistance (“What am I losing?”) rather than motivation (“What’s in it for me?”). Communicate changes in terms of certainty, preservation, and protection of values. For example: “Your job will remain the same, but you will have new opportunities.”

In marketing and sales

Use framing in offers and communication: emphasize what customers will miss out on if they don’t take action, but remain credible. For example, “Don’t miss out on this exclusive early-bird discount” works better than “Take advantage of our discount.”

In leadership and motivation

Managers can use the loss principle to make goals more tangible. When employees see what is at stake (e.g., losing a lead, customer satisfaction, or market share), their motivation to take action increases.

In risk management and decision-making

Organizations sometimes take too little risk for fear of loss, which slows down innovation. Prospect Theory makes it clear that “risk-averse behavior” is not always rational. Encourage teams to base decisions on data and scenarios in which controlled risks actually deliver value.

It’s Your Turn

What do you think? Is the Prospect Theory applicable in your personal or professional environment? Do you recognize the practical explanation or do you have more suggestions? What are your success factors for good decision making?

Share your experience and knowledge in the comments box below.

Recommended literature and books on the Prospect Theory

Barberis, N. C. (2013). Thirty years of prospect theory in economics: A review and assessment. Journal of Economic Perspectives, 27(1), 173-196. https://doi.org/10.1257/jep.27.1.173. → Provides a good retrospective look at how Prospect Theory has developed in economics and what the implications are — useful for further study.
Cabedo-Peris, J., et al. (2022). Decision making in addictive behaviours based on prospect theory. Frontiers in Psychology. → Applies the theory to another domain—addiction—showing how universal the principles (loss aversion, reference point) are.
Kahneman, D. (2013). Thinking, fast and slow. New York: Farrar, Straus and Giroux → This book provides an accessible overview of how decisions are influenced by intuition and reflection; it includes an extensive discussion of loss aversion and framing from the perspective of Prospect Theory.
Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47(2), 263-291. https://doi.org/10.2307/1914185. → This is the original publication in which Prospect Theory was developed — essential reading for anyone who wants to understand the core of the theory.
Kahneman, D., & Tversky, A. (1992). Advances in prospect theory: Cumulative representation of uncertainty. Journal of Risk and uncertainty, 5(4), 297-323.
Saliya, A. Y. (2020). A literature review of the prospect theory. Proceedings of the 5th International Scientific Research Congress (IBAD-2020). → Geeft een bredere literatuuroverzicht van Prospect Theory en de toepassingen ervan buiten economische modellen.
Wakker, P. P. (2010). Prospect theory: For risk and ambiguity. Cambridge university press.

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Original publication date: 09/07/2017 | Last update: 10/24/2025

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Article by:

Patty Mulder

Patty Mulder is an Dutch expert on Management Skills, Personal Effectiveness and Business Communication. She is also a Content writer, Business Coach and Company Trainer and lives in the Netherlands (Europe).
Note: all her articles are written in Dutch and we translated her articles to English!