ABSTRACT
In the previous chapter on heuristics and bias, we explored some of the limits on rationality explaining some of the heuristics and biases seen in everyday decision-making. This literature is discursive and intuitive in style and so vulnerable to a criticism that it lacks objective rigour. In response, Kahneman and Tverksy (1979) developed these insights to construct their own alternative to expected utility theory (EUT) – the standard approach to risky choices embedded within the standard economic model of risk. Kahneman and Tversky argue that behavioural paradoxes cannot easily be explained by EUT but these can be reconciled using their prospect theory. But what is prospect theory? Prospect theory is a framework which captures how people choose between different risky “prospects” – defined as sets of risky alternatives. Prospect theory can reconcile behavioural inconsistencies without abandoning rigorous analysis.
