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Term

Prospect Theory - Selection Logic

A theory of decision under risk that explains loss aversion and framing effects.

Aliases: Prospect theory

Definition

Prospect Theory: A theory of decision under risk that explains loss aversion and framing effects.

1. Mechanism (why it happens)

Prospect theory models reference-dependent valuation: outcomes are perceived as gains/losses relative to a reference point; losses are weighted more heavily; probabilities are subjectively weighted. This yields systematic violations of expected utility.[^1]

2. Classic experiments / evidence

2.1 Foundational demonstrations (Kahneman & Tversky, 1979)

  • Design: A set of choice problems under risk comparing predictions of expected utility vs observed choices.[^1]
  • Manipulation: Outcome framing and probability structures across equivalent expected values.[^1]
  • Key finding: Observed preferences show loss aversion, reference dependence, and framing effects.[^1]
  • Notes/limitations: Introduces the prospect theory value function and weighting function.

2.2 Cumulative prospect theory extension (Tversky & Kahneman, 1992)

  • Design: Refinement for risky prospects with cumulative probability weighting.[^2]
  • Manipulation: Model extension to handle more general lotteries.[^2]
  • Key finding: Provides better descriptive fit across a wider range of gambles.[^2]
  • Notes/limitations: Often used in applied behavioral economics and consumer modeling.

3. Consumer decision patterns

  • Strong reactions to “loss frames–in marketing.
  • Reference prices drive perceived gains/losses.
  • Asymmetric sensitivity around the reference point affects upgrades/downgrades.

4. How marketing leverages it

Marketers create reference points (MSRP, “regular price”, then frame offers as gains and non-purchase as loss. This drives urgency and reduces deliberation.[^3]

5. Mitigation (Selection Logic)

  1. State your reference point explicitly (budget, must-have needs).
  2. Reframe to absolute terms and compare alternatives.
  3. Use M2 weighting discipline and M5 validation.

References

  1. Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47(2), 263–91.[source]
  2. Tversky, A., & Kahneman, D. (1992). Advances in prospect theory: Cumulative representation of uncertainty. Journal of Risk and Uncertainty, 5(4), 297–23.[source]
  3. Kahneman, D. (2011). Thinking, Fast and Slow. Farrar, Straus and Giroux.[source]

Further Reading