The Genesis of Prospect Theory

Key Insight

Prospect theory emerged from a critical re-evaluation of existing decision-making experiments, particularly those that attempted to measure the utility of money through tiny, incremental changes in wealth. The initial puzzlement arose from questioning the validity of deriving attitudes to wealth psychophysics from reactions to minute gains or losses, suggesting a disconnect with modern psychophysical theory.

A crucial shift occurred with the realization that outcomes should be defined as gains and losses relative to a reference point, rather than as absolute states of wealth. This idea, though previously proposed by another economist, had not gained significant traction. Embracing this perspective allowed researchers to overcome a prevalent 'theory-induced blindness' that had limited previous investigations.

This change in focus proved to be a significant advancement, making the prior assumptions of utility theory seem not only incorrect but absurd. By analyzing choices in terms of gains and losses, the new theory was able to document and explain systematic violations of rationality axioms that expected utility theory could not. This purely descriptive model aimed to understand how Humans actually make risky choices, without presupposing their rationality.