Prospect Theory
People often evaluate uncertain outcomes relative to a reference point rather than final wealth alone.
The Mechanism: Prospect theory, developed by Daniel Kahneman and Amos Tversky, models how people evaluate risky choices relative to a reference point. It describes patterns such as sensitivity to losses and changing risk preferences across gains and losses.
The Philosophical Pivot: A person's reaction depends partly on what they believe they are about to lose or gain, not only on the final amount. Expectations and framing can therefore shape how a choice feels.
The Horizon: The theory helped explain departures from classical expected-utility models and influenced behavioral economics. It is a descriptive model with limits, not a universal algorithm that predicts every decision.
Reference points vary across people and can shift with context. Risk-taking under losses may look irrational from outside while reflecting a person's attempt to avoid a worse outcome.
Decision design can reduce avoidable framing effects by presenting comparable options and showing absolute outcomes alongside changes from a baseline.
Understanding the reference point can reveal why two people view the same decision as entirely different stakes.
A choice is felt against the outcome we expected, not only the outcome we receive.
What reference point is making this decision feel like a loss, and who chose that reference point for me?