Prospect Theory

Source: Laboratory of Jonathan Flombaum—Johns Hopkins University

What’s the value of a dollar? Currencies store value to facilitate trade. Implied in any economic transaction is the value of a unit of currency. But what is the subjective value of a dollar? For a long time, economists assumed the answer to this question to be, specifically, that a dollar has a value determined by the market and that the subjective value of a dollar is always that, more or less.

Beginning in the early 1970s, experimental psychologists Daniel Kahneman and Amos Tversky upended this assumption, showing that the subjective value of currency depends on a number of factors, most notably, whether losses or gains are being discussed, and the overall size of a transaction. To pump intuition, consider the fact that, to most people, it would seem reasonable to drive an extra half-mile in order to save $2 on a gallon of gas. But very few people would do the same to save $2 on the cost of a new car. So $2 is sometimes, but not always worth an extra half-mile drive. Value is context-dependent.

The theory devised by Kahneman and Tversky to describe how people psychologically value currency (and goods and services, generally) is called Prospect Theory. In 2002, Kahneman was awarded the Nobel Prize in Economics for Prospect Theory, along with related research using the methods and theories of experimental psychology to understand economic decision-making (Tversky passed away in 1996.).

Many of the primary implications of Prospect Theory were obtained through survey experiments. The surveys consisted of choices between gambles; for example, subjects might be asked whether they would prefer to receive $5 or risk receiving nothing with a 50% chance of winning $10.

This video will demonstrate procedures for designing the type of survey questions used in research on Prospect Theory.