Prospect theory

Topic: Schools of Economic Thought and Economic Laws · NCERT: Beyond NCERT

Meaning

Prospect theory says that people judge a result as a gain or a loss measured from a reference point, such as their current salary or the price they paid. They do not judge it by their final total wealth. They also feel losses more strongly than gains of the same size. Daniel Kahneman and Amos Tversky proposed it in 1979, and Kahneman won the Nobel in 2002 for this work.

• Why it matters: it explains choices that standard theory cannot. Examples are refusing a bet that pays more than it costs on average, or holding a losing share too long. It is also the base for policy "nudges", such as presenting a fine as a loss.
• Core formula (loss aversion): Pain of a loss of ₹X ≈ λ × Pleasure of a gain of ₹X, where λ (lambda) ≈ 2. λ is called the loss-aversion coefficient.

Explanation

1. How it differs from expected utility theory

• Expected utility theory is the standard textbook model. It assumes a fully rational person.
• Only final wealth matters.

• So a ₹1,000 gain and a ₹1,000 loss are just opposite moves of the same size.

• Prospect theory looks at how real people behave.

• The reference point (the starting line a person compares against) decides whether a result feels like a gain or a loss.
• The same final wealth can feel good or bad depending on where the person started.
• Example: two people each end the year with ₹10 lakh. One started with ₹8 lakh and feels a gain. The other started with ₹12 lakh and feels a loss.

2. The three building blocks

• Reference dependence: outcomes are coded as gains or losses from a reference point, not as total wealth.
• Loss aversion: losses weigh about 2 times as much as equal gains.
• Diminishing sensitivity: each extra rupee matters less as the amount grows, whether it is a gain or a loss.

• Going from a ₹0 to a ₹100 gain feels bigger than going from a ₹1,000 to a ₹1,100 gain.

• Shape of the "value curve" (standard textbook result):

• It bends downward (concave) for gains, so people are risk-averse in gains and prefer a sure gain.
• It bends upward (convex) for losses, so people are risk-seeking in losses and gamble to avoid a sure loss.
• It is steeper for losses than for gains, which is loss aversion.

3. Worked example: the coin toss

Heads, you win ₹150. Tails, you lose ₹100.

• Expected value (rational view): 0.5 × 150 − 0.5 × 100 = +₹25. A fully rational person accepts the bet.
• Felt value (prospect theory, λ = 2): 0.5 × 150 − 0.5 × (2 × 100) = 75 − 100 = −₹25. A loss-averse person refuses.
• Break-even: a loss-averse person accepts only when the win is more than ₹200, twice the possible loss.

4. Effects that come from prospect theory

• Endowment effect: people value something more just because they own it.
• Example: a farmer will not sell inherited land at the market price, yet would never buy the same land at that price.

• Why: selling feels like a loss, and losses hurt about twice as much.

• Framing effect: the same facts, presented in a different way, lead to different choices.

• Example: patients accept surgery far more readily when told "90% survival" than when told "10% mortality".

• Why: "survival" sets up a gain frame and "mortality" sets up a loss frame.

• Investor behaviour (the disposition effect):

• An investor sells a winning share early to lock in the gain, because they are risk-averse in gains.
• They hold a losing share too long, hoping to get back to the purchase price (the reference point), because they are risk-seeking in losses.

In India

• SEBI data on retail traders:
• 93% of individual traders made losses in equity F&O (futures and options, contracts whose value comes from a share or an index) between FY22 and FY24.
• Their total losses were more than ₹1.8 lakh crore over those three years [1][2].

• Loss aversion helps explain why many keep trading to "win back" losses. It works together with overconfidence and the sunk cost fallacy.

• Economic Survey 2018-19 (the chapter on "Nudge"):

• It proposed moving from "Give it up" for the LPG subsidy to "Think about the Subsidy". This reframes the subsidy so that better-off households choose to give it up [3][6].

• This is the framing effect used as policy.

• Framing a penalty as a loss: "you will lose your ₹500 deposit" works better than "you will earn ₹500". This idea can be applied to deposits, rebates or compliance schemes.

• Nobel link: the 2002 Nobel to Kahneman is seen as the prize for behavioural economics, which means using psychology in economic theory [5].

Don't confuse with

• Expected utility theory: only final wealth matters, and gains and losses of equal size have equal weight. Prospect theory uses a reference point and weighs losses about 2× more.
• Bounded rationality (Herbert Simon, Nobel 1978): people have limited information, time and brainpower, so they satisfice (pick the first "good enough" option). Prospect theory is about how people value gains and losses, not about how hard they search.
• Mental accounting (Richard Thaler, Nobel 2017): people treat money differently depending on its source or use, which breaks the idea that money is fungible (every rupee can be swapped for any other). It builds on prospect theory but is Thaler's anomaly, not a core part of Kahneman–Tversky's 1979 theory.
• Hyperbolic discounting: this is about time. The discount rate falls as the delay grows. Prospect theory is about gains versus losses, not time.

Prelims Hooks

• Prospect theory: Kahneman–Tversky, 1979. Kahneman's Nobel: 2002. Their earlier heuristics-and-biases paper: 1974 [4].
• Loss aversion: losses weigh about 2× equal gains (λ ≈ 2). At λ = 2, a 50-50 bet that risks ₹100 is accepted only if the win is more than ₹200.
• Endowment effect and loss aversion come from prospect theory, not from Thaler's list of anomalies.
• Framing trap: "90% survival" and "10% mortality" carry the same facts but lead to different choices.
• Reference point, not final wealth: a statement saying "prospect theory evaluates outcomes by final wealth" is wrong. That is expected utility theory.
• The Economic Survey 2018-19 proposed "Give it up" → "Think about the Subsidy" for LPG [3][6].

Mains Points

• Low-cost policy design (GS-II/GS-III):
• Framing a penalty as a loss, and reframing subsidy give-ups as "Think about the Subsidy", can change behaviour at almost no cost [3][6].

• Limit: nudges cannot replace mandates where the harm is serious [6]. Critics also call nudges paternalism, meaning the state deciding what is good for people.

• Retail investor protection (GS-III):

• Loss aversion leads investors to hold losing positions and chase losses. Along with overconfidence and herding, it helps explain why 93% of individual F&O traders lost money between FY22 and FY24, with losses above ₹1.8 lakh crore [1].

• This supports SEBI action on risk disclosure and entry barriers, along with financial literacy.

• Challenge to the rational-agent model:

• Prospect theory shows that errors are systematic, not random, so they do not cancel out across people.
• Such errors can move savings, tax compliance and asset prices. This is why behavioural finance challenges the efficient-market hypothesis (the idea that share prices already reflect all available information).

Related concepts

• Behavioural economics
• Bounded rationality
• Satisficing
• Heuristics
• Anchoring
• Availability heuristic
• Confirmation bias
• Overconfidence bias
• Loss aversion
• Endowment effect

Read more

• Behavioural economics: bounded rationality, heuristics and biases