Interactive modelBehavioral Economicsintermediate

Prospect Theory Value Function

Kahneman & Tversky's value function: reference points, diminishing sensitivity, and risk attitudes that flip.

Current equations

v(x): v(x) = 3·x^0.6 if x≥0; −6·(−x)^0.6 if x<0Risk-neutral: v(x) = 0.8·x

You don't feel wealth, you feel CHANGES. Gains satisfy less and less as they grow; equal-sized losses hurt about twice as much. That kink at zero is loss aversion, the most consequential asymmetry in decision-making.

Source: Kahneman & Tversky (1979)

Shift the curves

Loss aversion (λ): how much more losses hurt0

Kahneman & Tversky measured λ ≈ 2.25: losing $50 hurts about twice as much as winning $50 feels good.

The Prospect Theory Value Function model, in writing

Definition

How people actually choose under risk: outcomes are valued as gains and losses from a reference point, losses hurt roughly twice as much as equal gains feel good, and small probabilities are overweighted.

Value function v(x): concave for gains, convex and steeper for losses (λ ≈ 2.25)

The intuition

Loss aversion explains why people refuse small favourable bets, hold losing shares too long, and buy both insurance and lottery tickets. The kink at the reference point means FRAMING matters: the same outcome feels different described as a loss avoided versus a gain forgone, which standard expected-utility theory says should be impossible.

Exam tip

Name the three ingredients (reference dependence, loss aversion, probability weighting) and attach one behavioural anomaly to each. Kahneman and Tversky (1979) is the citation.

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