Prospect Theory

http://www.hss.caltech.edu/~camerer/Ec101/ProspectTheory.pdf

Expected utility theory was widely considered as the normative model of ration choice concerning making decisions under risk, until an alternative model “Prospect Theory” was proposed in 1979 by Daniel Kahneman and Amos Tversky [4]. Prospect theory expands on expected utility theory, overcoming shortcomings that are outlined in the paper that presented prospect theory: “Prospect Theory: An Analysis of Decision under Risk” [4]. One of the sole inadequacies of expected utility theory discussed was that most people will prefer outcomes of higher probability than those with lower probability. This suggests that outcomes with the highest utility may still be less desirable than those with lower utility based on the perceived probability of each outcome; this tendency is called the certainty effect. Under this model a person may be risk-averse or risk-acceptant depending on the amount of possible gain, under expected utility theory a gambler would take the risk with the highest value, but with prospect theory a gambler may decide to be risk-aversive and take a lower value outcome with a higher chance of realization than the highest value outcome with a lower chance of happening.