Prospect Theory

Prospect theory is modified Utility theory. Utility theory would say that Sunk costs are irrelevent to decision making Prospect theory suggests that disappointment at losses outweighs the pleasure of a gain. Therefore someone will take an expected gain which is lower than a possible (risky) Can be seen using an S shaped value function.

The prospect theory was developed by Daniel Kahneman and Amos Tversky in 1979. Starting from empirical evidence, it describes how individuals evaluate losses and gains. In the original formulation the term prospect referred to a lottery.

The theory is basically divided into two stages, editing and evaluation. In the first, the different choices are ordered following some heuristic so as to let the evaluation phase be more simple. The evaluations around losses and gains are developed starting from a reference point. The value function which passes through this point is s-shaped and, as its asymmetry implies, given the same variation in absolute value, there is a bigger impact of losses than of gains (loss aversion). Some behaviors observed in economics, like the disposition effect or the reversing of risk aversion/risk seeking in case of gains or losses (termed the reflection effect), can be explained referring to the prospect theory.