Prospect Theory

Prospect Theory is a mathematically-formulated alternative to the theory of expected utility maximization.

Expected Utility theory is based on rational behavior of agents and yet has "systematically mispredicted human behavior in at least certain circumstances." (Schiller, 1997)

For instance, Kahneman and Tversky's (1979) lottery experiment.

Candidates were given the two following choices:

25% chance of winning $3,000 and
20% chance of winning $4,000

65% chose latter

But

100% chance of winning $3,000 and
80% chance of winning $4,000

80% chose former

Prospect Theory similar to Expected Utility Theory in that each possible outcome is weighted. However, they are not weighted with corresponding probabilities determined by a utility function. Instead, the utility of each outcome is determined by what is called a "value function." This value function is based on the idea that "people behave as if they regard extremely improbable events as impossible and extremely probable events as certain." (Shiller 1997, 4). Thus the model assigns a zero probability to extremely improbable events and a one (hundred percent) probablity to extremely probable events.