Prospect theory—a psychologically founded account of decision making under risk and uncertainty—revolutionized how economists and, later, political scientists thought about decision making under uncertainty. Conceptually, prospect theory is based on two central notions: reference dependence, which is the notion that the utility of outcomes is defined over changes in outcomes from a reference point instead of over absolute outcome levels; and likelihood dependence, which is the notion that people distort probabilities non-linearly when making a decision. Likelihood dependence gives rise to the possibility and certainty effects—changes in probabilities are given much more weight if they fall toward the probability endpoints than if they fall into intermediate probability ranges. Reference dependence gives rise to the reflection effect, predicting mirrored risk attitudes for gains and for losses; and to loss aversion, predicting that people display a disproportionate dislike for losses.
Prospect theory has been extensively applied in the literature on political decision making. Two observations stand out. One, some aspects, such as the reflection effect, have received considerably more attention than others, such as loss aversion or likelihood dependence. Two, there is a twin challenge arising from the combination of this selective modelling and ex post rationalization. A step-wise procedure may help making modelling approaches more principled and systematic. This could furthermore help predicting future decision making behaviour—an aspect that has been neglected in favour of fitting past data.
An Experimental Comparison of Risky and Riskless Choice—Limitations of Prospect Theory and Expected Utility Theory
