Prospect theory, developed by Kahneman and Tversky in 1979, offers a psychologically realistic alternative to expected utility theory. Rather than evaluating outcomes in terms of final wealth, people judge outcomes relative to a reference point — typically the status quo or an expectation level — and code deviations as gains or losses. The theory's value function is S-shaped: concave in the domain of gains (reflecting risk aversion) and convex in the domain of losses (reflecting risk seeking). Critically, the function is steeper for losses than for gains, capturing the central finding that losses loom larger than equivalent gains.
This asymmetry is quantified by loss aversion, the empirical regularity that losses hurt roughly twice as much as gains of the same magnitude please. The typical loss-aversion coefficient found in experiments is approximately \( \lambda \approx 2.25 \), meaning a loss is psychologically weighted about 2.25 times more than an equivalent gain. Loss aversion also drives the reflection effect: people are risk-averse when facing potential gains but switch to risk-seeking when facing potential losses, exactly the reverse of standard expected-utility predictions. Closely related is the certainty effect — the disproportionate preference for sure outcomes over merely probable ones — which violates expected utility theory and is illustrated by the Allais Paradox, where people choose certainty in some gambles but gamble in structurally identical ones.
Loss aversion shapes a wide range of real-world behaviors. Investors subject to it tend to hold losing stocks too long, hoping to break even, while selling winning stocks too early to lock in gains — a pattern known as the disposition effect. Studies of taxi drivers reveal analogous dynamics in labor supply: drivers often set daily income targets and quit early on high-demand days while working longer on slow days, behavior that contradicts rational models of supply. Prospect theory even explains why people buy insurance at actuarially unfavorable prices: the heavy psychological weight of avoiding a potential loss outweighs the modest disutility of paying the certain premium.