Prospect Theory: A Literature Review

IUMBERLEY D. EDWARDS

This paper examines the ideas underlying the Kahneman and Tversky (1979) decision-choice model, Pros-
pect Theory, and presetns an extensive chronological review of the literature. The literature review centers on
leading articles that either examine aspects of Prospect Theory itself or use Prospect Theory as a basis for
other areas of research. The paper concludes with a brief look at the potential for using Prospect Theory in
financial research.

I. INTRODUCTION

One of the most intriguing areas of research in finance is that which examines and seeks to
explain how and why individuals make decisions. This research is aimed at predicting accu-
rately decisions that will be made given certain conditions and circumstances. The most com-
monly accepted model of rational choice today is the theory of utility of wealth developed by
Von Neuman and Morgenstern (1953). Questions have arisen recently, however, concerning
the completeness of this theory. These questions have given impetus to competing theories
that attempt to explain individual behavior under conditions of uncertainty. This paper exam-
ines one of these alternative theories: prospect theory.
Prospect theory was formulated first by Kahneman and Tversky (1979) as an alternative
method of explaining choices made by individuals under conditions of risk. It was designed,
in essence, as a substitute for expected utility theory. Kahneman and Tversky realized the fact
that the expected utility theory model did not fully describe the manner in which individuals
make decisions in risky situations and that therefore, there were instances in which a deci-
sion-maker’s choice could not be predicted. For example, they point out that expected utility
theory does not explain the manner in which framing can change the decision of the individ-
ual, nor does it explain why individuals exhibit risk-seeking behavior in some instances and
risk-averse behavior in others.
This paper examines the ideas underlying the development of prospect theory, the
advances that have been made in this field since its development, and the aspects of this the-
ory that need further refinements. Section II is an overview of the ideas leading up to the
development of prospect theory, as well as the ideas that underlie the theory. Section III is a
chronological literature review of the verifications and rejections of prospect theory. Section
IV examines literature in which prospect theory has been used as a building block for other

Kimberley D. Edwards l Louisiana State University, Department of Finance, Baton Rouge, LA 70802; E-mail:
kedward@lsuvm.sncc.lsu.edu.
International Review of Financial Analysis, Vol. 5, No. 1, 1996, pp. 19-38 ISSN: 1057-5219
Coptyright 0 1995 by JAI PRESS Inc., All Rights of reproduction in any form reserved.
20 INTERNATIONAL REVIEW OF FINANCIAL ANALYSIS /Vol. 5(l)

theories. Section V examines future application potential and gives a brief summary.

II. THE DEVELOPMENT OF PROSPECT THEORY

As stated above, prospect theory (PI hereafter) was proposed first by Kahneman and Tversky
(1979) (KT hereafter). KT (1979) argued that the choices that individuals make in risky situ-
ations exhibit several characteristics that are inconsistent with the basic principles of the Von
Neuman-Morgenstem theory of utility (VMUT hereafter). They argued, for example, that
individuals underweight probable outcomes in comparison with outcomes that are certain.
They called this phenomenon the certainty effect. KT also pointed out that the certainty effect
brings about risk-aversion in choices involving certain gains and risk-seeking in choices
involving certain losses (KT, 1979, p. 265).
KT (1979) also found that individuals facing a choice among different prospects disregard
components that are common to all prospects under consideration. They termed this com-
monality the isolation effect. The isolation effect, they argued, will cause the framing of a
prospect to change the choice that the individual decision-maker makes (ibid., p. 271).
A third element of the decision-making process that KT discovered was the reflection
effect, which is the equivalence of choice involving negative prospects and positive prospects
(ibid., p. 268); that is, that choices among negative prospects are a mirror image of choices
among positive prospects.
In order to compensate for these characteristics of individual behavior which are unex-
plained by the VMUT, KT developed a new choice model and called it PT. Whereas in
VMUT, decisions in risky situations are made based on final wealth and probabilities, in PT,
these decisions are made based on values assigned to gains and losses with respect to a refer-
ence point and decision weights (ibid., p. 277). KT found that the decision weights of PT are
lower than the corresponding probabilities of the VMUT except in cases of very low proba-
bilities. KT pointed out that this overweighting of low probabilities may explain why individ-
uals choose to accept insurance and gambling at the same time.
KT (1979) developed a two-phase model for simple prospects with monetary outcomes.’
The first phase of PT is the editing phase and the second is the evaluation phase.

The function of the editing phase is to organize and reformulate the options so as to simplify subsequent eval-
uation and choice. Editing consists of the application of several operations that transform the outcomes and
probabilities associated with the offered prospects (ibid., p. 274).

During the editing phase, four major sequential operations occur: coding, combination,
segregation, and cancellation. Coding involves the setting of a reference point by the deci-
sion-maker by which all gains and/or losses are measured. Combination consists of the
aggregation of probabilities associated with identical outcomes. Segregation involves sepa-
rating the risky components of a prospect from the riskless components of the prospect. Can-
cellation involves discarding the components of choices that are common to all prospects.
In the evaluation phase, the decision-maker evaluates the prospects that are attainable to
him or her after the conclusion of the editing phase. The decision-maker then chooses the
prospect with the highest value. KT denoted the overall value of an edited prospect with a V
which is defined in terms of two scales, rr and v. Accordingly, “the first scale, rr, associates
with each probability p a decision weight n(p), which reflects the impact of p on the overall
Prospect Theory: A Literature Review 21

value of the prospect. . . . The second scale, v, assigns to each outcome x a number v(x), which
reflects the subjective value of that outcome” (ibid., 275). These scales are combined to form
the basic equation of the theory which determines the overall value of a regular prospect: a
prospect that is neither strictly positive nor strictly negative. Following is the equation that
KT used for simple regular prospects with the form (x, p; y, 9) which have at most two non-
zero outcomes:

v(x, p; Y? 9) = NPMX) + NqMyJ (1)

This equation generalizes the VMUT by eliminating the expectation principle.

If the prospect is either strictly positive or strictly negative, the prospects are separated into
a riskless component and a risky component during the segregation operation of the editing
phase. Thus, if p+q= 1 and either =y>O or x<y<O, then,

W Pi Y. 9) = v(Y)+MP)[W-4_Y)l. (2)
One of the essential features of PT is that the overall value of a prospect is based on
changes in a decision-maker’s wealth reference point rather than on final states of wealth, as
in the case of the VMUT. Figure 1 shows the reference point concept in the situation of esca-
lating commitment.*
One of the most widely used components of FT is the value function. KT proposed that
PT’s value function has three main characteristics:
1. Defined on deviations from the reference point;
2. Generally concave for gains and commonly convex for losses; and
3. Steeper for losses than for gains” (ibid., p. 279) (See Figure 2).
In comparing PT’s value function with VMUT’s utility function, the latter is shallow in the
reference point region and the former is at its steepest at this point.

Figure 1. The Commitment of New Resources to a Failing (Successful) Course of Action

Source: Whyte, Glen. 1986. “Escalating Commitment to a Course of Action: A Reinterpritation.“Accrdemy
r?fManagement Review 1 l(2): 3 17.
22 INTERNATIONAL REVIEW OF FINANCIAL ANALYSIS / Vol. S(1)

VALUE

LOSSES

Figure 2. A Hypothetical Prospect Theory Value Function

Source: Kahneman, Daniel, and Amos Tversky. 1979. “Prospect Theory:
An Analysis of Decision Under Risk.” Econometrica 47(2): 279.

Another important element of PT is the weighting function. KT (1979) describe this func-
tion as:

In Prospect Theory, the value of each outcome is multiplied by a decision weight. Decision weights are
inferred from choices between prospects much as subjective probabilities are inferred from preferences in the
Ramsey-Savage approach. However, decision weights are not probabilities: they do not obey the probability
axioms and they should not be interpreted as measures of degree or belief (ibid., p. 280).

KT also defined the properties of the weighting function ,TC,which relates decision weights
to stated probabilities:

Naturally, 7C is an increasing function of p, with TC(O)=Oand X(1)=1. That is, outcomes contingent on an
impossible event are ignored, and the scale is normalized so that 7C(p) is the ratio of the weight associated
with the probability p to the weight associated with the certain event (ibid., p. 280).

Figures 3 and 4 depict the features of VMUT and PT, respectively, that have been exam-
ined in this section.
The next section of this paper is a review of the literature on PT - both verifications and
refutations - since its inception.

III. VERIFICATIONS AND REJECTIONS OF PROSPECT THEORY

A. Verifications of Prospect Theory

Karmarkar (1979) uses PT to explain observed behavior in the Allais Paradox.3 He points
out that, in PT,
Prospect Theory: A Literature Review 23

Figure 3. The Expected Utility Process

Source: Burton, Scot, and Laurie A. Babin. 1989. “Decision-Framing Helps Make the Sale.”
The Joumul of Consumer Marketing 6(2): 16.

probabilities are modified by a weighting function which can be more general than that used here. How-
ever, the weights enter the decision criterion linearly and are not normalized. Thus for a given gamble, the
weights need not be ‘coherent.’ Furthermore, the weighting function in the Prospect Theory is required to
have certain specific additional properties” (Karmarkar, 1979, p. 69).

He also points out that some other difficulties, such as the subcertainty of weight require-
ments and the question of how and when equivalent payoffs are aggregated, arise when one
uses PT to explain the Allais Paradox.
Schoemaker and Kunreuther (1979) contrast PT with VMUT in an experimental survey of
insurance preferences given to college students and clients of an insurance agency. Their sur-
vey lends support to KT’s (1979) earlier findings that individual decision-makers have lim-
ited ability to process information when making decisions and suggests the preference for a
risk-taking attitude in the domain of losses. They hypothesize that the prevalence of this vari-
ety of risk-taking attitude may be “rooted in people’s limited sensitivity to low probability
24 INTERNATIONAL REVIEW OF FINANCIAL ANALYSIS / Vol. S(1)

Evaluation
Phase

Figure 4. Conceptual Framework of the Decision-Framing Process

Source: Burton, Scot, and Laurie A. Babin. 1989. “Decision-Framing Helps Make the Sale.”
The Journul ofConsumer Marketing 6(2): 18.

events” (Shoemaker and Kunreuther, 1979, p. 616). They suggest that further research is
needed to restructure both expected utility theory and prospect theory in order to take into
account the factors that were examined in their study: “the effects of financial status (income,
wealth, versus other measures), statistical knowledge and cognitive decision style, and most
importantly the impact of context and format effect on choice behavior” (ibid., p. 617).
Prospect Theory: A Literature Review 25

Newman (1980) explains how academicians, practitioners, and policymakers are impacted
by PT. He contends that, wheras VMUT is deductive, or based on an explicit set of axioms,
PT is inductive, or based on observations of behavior [italics added].
He implements a simple accounting information systems example to demonstrate that the
following four claims are true.
1. Expected utility theory and prospect theory predict different values for information
structures.
2. “More” information is not necessarily preferred to “less” information by an agent
who behaves according to PT.
3. If the information evaluator and the decision-maker are separate, the evaluator will
normatively (from an expected utility theory perspective) be made better off if he or
she uses the descriptive model of the decision- maker, whether that model is repre-
sented by expected utility theory or prospect theory (or some competing altema-
tive).
4. If the information evaluator a priori assumes that the decision maker maximizes
expected utility, he or she may systematically select an inappropriate information
system and may never learn the true model of the decision maker (Newman, 1980,
218-19).
He points out, “Prospect theory represents one tractable method of incorporating descrip-
tive theory into analytical models. To the extent that PT proves viable, we have demonstrated
several useful results through a simple numerical example” (ibid., p. 228).
He does not believe, however, that PT is a completely viable theory. He points out that, in
spite of what KT claims, it is not easy to incorporate complex gambles into the model, but
admits that the Allais Paradox could be resolved by PT, but not by VMUT, a point that was
missed by Karmarkar (1979).
Payne, Laughhunn and Crum (1984) use PT and multiattribute utility theory to examine the
multiattribute risky choice behavior of a sample of 128 professional managers from U.S.
firms.
They present the managers with pairs of hypothetical capital budgeting proposals and ask
them to choose between the budget pairs. They find support for the reference point character-
istic of PT. They also find that, as PT predicts, the managers exhibit risk averse behavior for
prospects involving only gains and exhibit risk-seeking behavior for prospects involving only
losses. They also find, however, that decision-makers do not code out common attributes of
the gambles as should occur under the assumptions of PT. Their results, nonetheless, support
the existence of a coding process “for outcomes relative to a target level of return and . a
form of multiattribute risky choice behavior akin to the reflection effect of PT” (Payne,
Laughhunn, and Crum, 1984, p. 1359).
Arkes and Blumer (1985) apply PT to examine the irrational behavior of individuals who
continue with a losing prospect simply because they have already invested money in that
project. They argue that the concept of individuals’ “ throwing good money after bad’ is
appropriately described by PT. They present a total of 10 experiments involving a decision
prospect to a group of college students. Each student is presented with only one experiment,
each containing some sunk cost decision that must be made. The experiments range from
deciding whether to go along with a $10 million investment project to choosing between two
ski trips.
The authors find that two characteristics of PT are important in explaining sunk cost reac-
26 INTERNATIONAL REVIEW OF FINANCIAL ANALYSIS /Vol. 5(l)

tions: the value function, which “represents the relation between objectively defined gains
and losses and the subjective value a person places on such gains and losses” (Arkes and
Blumer, 1985, p. 130- 13 1); and the certainty effect, which implies that a sure gain is overval-
ued and a sure loss is undervalued. The point out, however, that “prospect theory does not
specify the psychological basis for the findings that sure losses are so aversive and sunk costs
are so difficult to ignore” (ibid., p. 132).
Uecker, Schepanski, and Shin (1985) test four models of the “principal’s information eval-
uation behavior in a private, pre-decision, principal-agency setting.” The four models are
VMUT, PT, a linear model, and a multiplicative model. Uecker, et. al. (1985) find that PT
does gain credibility over VMUT because it withstands tests of falsification where VMUT
fails.
They conducted the test using 32 master’s and doctoral candidates in accounting who were
enrolled in an information economics and a managerial accounting theory class. The individ-
uals were encouraged to respond accurately through the incentive of possibly receiving
money for their choices in the four decision sets presented to them. “Three levels of accuracy
(AC), priors (PR), and payoffs (PO), and four levels of effort (EF) were systematically
manipulated in an orthogonal design” (Uecker, Schepanski, and Shin, 198.5, p. 436). Based
on the results, they find that PT better describes the “divergent PR x AC interactions which
were observed” (ibid., p. 443). They observe, however, that although PT is better than
VMUT at describing the decisions made by their subjects, the model that best resisted falsifi-
cation is the multiplicative model.
Gregory (1986) examines the relevance of PT for economic evaluations of potential envi-
ronmental change and analyzes the results to contingent valuation studies of environmental
goods which show that decision-makers demonstrate a consistent difference between willing-
ness to pay and compensation demanded measures of economic loss. She uses PT to support
her argument that “disparities in willingness to pay and compensation demanded measures of
economic value be acknowledged as evidence of real differences in perception and behavior”
(Gregory, 1986, p. 335). She points out that PT predicts that compensation demanded will be
greater than willingness to pay. The rationale behind this reasoning is that PT’s value func-
tion is steeper for losses than for gains. Compensation demanded deals with a potential loss
whereas willingness to pay deals with a gain.
Haka, Friedman, and Jones (1986) use interference theory4 to “test the hypothesis that
exposure to cost and income measures causes fixated responses in a decision making setting
where market value is the appropriate response” (Haka, Friedman, and Jones, 1986, p. 455).
Using number of accounting courses taken as a measure of the amount of exposure to cost
and income, they find that there is no relationship between the exposure to cost and income
and fixation. Although they do not use PT directly to test the hypothesis, they do point out
that a more cognitive approach such as PT may prove more fruitful than their studies.
Tversky and Kahneman (1986) apply the psychophysical principles of evaluation that were
included in their original model to examine the effect of framing and the violation of the prin-
ciple of invariance that underlies the rational theory of choice. They find more evidence that
individuals make decisions based on changes in wealth rather than wealth in the final state.
They point out that PT differs from other choice models “in being unabashedly descriptive
and in making no normative claims” (Kahneman and Tversky, 1986, S272). Their main the-
sis is that normative and descriptive analyses of choice should be viewed as separate enter-
prises. Because the rules of invariance and dominance are “normatively essential but
descriptively invalid, no theory of choice can be both normatively adequate and descriptively
accurate” (ibid., p. S251).
Prospect Theory: A Literature Review 27

Chang, Nichols, and Schultz (1987) examine the usual assumption that individuals are risk-
averse with respect to tax evasion. They present 56 middle-income MBA students with six
tax lottery cases. They conclude that PT better describes taxpayers’ attitudes than does
VMUT. They find that, although taxpayers generally exhibit risk-averse behavior, a large
group will sometimes exhibit risk-seeking behavior. It is this group of risk-seeking individu-
als whose attitudes are consistent with PT. The authors acknowledge the following contribu-
tion of PT to their study:

Depending on the reference point, tax payments may be perceived as a reduced gain or as a loss. This means
that income may not be the only argument in the taxpayer’s utility function. The taxpayer’s utility function
may be different for gains compared to losses. Viewed from a Prospect Theory perspective, we would
hypothesize that if a tax payment is perceived as a reduced gain, the taxpayer’s utility function will assume a
concave shape. In contrast, if a tax payment is perceived as a loss, the taxpayer’s utility function will assume
a convex shape. Finally, from a prospect theory perspective, the taxpayer may not conform to the expected
utility axioms. For example, high probabilities or low probabilities may often be overweighted in the pros-
pect theory view of behavior compared to the Von Nuemann-Morgenstem view of behavior (Chang, Nichols,
and Schulz, 1987, p. 300).

Budescu and Weiss (1987) test the reflection effect and shape of the value function of PT,
using 22 undergraduate students as subjects. The results of their study firmly support some of
the major assumptions of PT. They find that 82% of the subjects displayed concavity for
gains, convexity for losses, and steeper slopes for losses, and that 77% demonstrated all three
predictions simultaneously. They also find support for the certainty and reflection effects.
They show that 86% of the subjects reflected 78.5% of their preferences. They state, how-
ever, that their results “also reiterate the inability of any model combining outcomes and
probabilities in bilinear fashion to deal with basic cognitive heuristics such as element-wise
processing of prospects” (Budescu and Weiss, 1987, p. 200).
Lowenstein (1988) applies the framing concept of PT to examine the manner in which this
concept is related to intertemporal choice. He conducts three experiments to determine the
effect of immediate and delayed consumption choices. The first experiment involved 66
undergraduate students; the second, 116 MBA students; and the third, 105 high school soph-
omores and juniors. In each experiment, participants were asked to make a decision between
present or future consumption of a good. He finds that “when a temporal shift of consump-
tion is framed as a delay it has greater significance than when framed in terms of speed-up”
(Lowenstein, 1988, p. 212). He points out, therefore, that his research demonstrates the appli-
cability of the reference point concept of PT to intertemporal choice and concludes that the
influence of framing and context effects on intertemporal choice merits further investigation.
Fiegenbaum and Thomas (1988) use COMPUSTAT data of U.S. industrial firms for the
period 1960 to 1979 in an attempt to explain Bowman’s risk-return paradox with PT.” Using
ROE as an accounting-based measure of risk and return, they find that, when firms are suffer-
ing losses or are below targeted ROE levels, the firms tend to demonstrate risk-seeking
behavior (i.e, a convex value function). In contrast, when the firms achieve their targets, they
tend to exhibit risk-averse behavior (i.e, a concave value function). This study’s findings are
therefore in line with what would be expected under PT.
Diamond (1988) draws on PT to examine consumer information processing in high-proba-
bility/low-consequences and low-probability/high-consequences situations. Diamond pre-
sents 161 undergraduate students with information about used cars; including a possible
adverse consequence such as a repair bill and the likelihood of necessary repairs. He notes
28 INTERNATIONAL REVIEW OF FINANCIAL ANALYSIS / Vol. 50)

that those subjects judging low-probability/high-consequence risks were more affected by the
consequence size than the probability, whereas those subjects judging high-probabilityllow-
consequence risks processed information by combining consequence size and probability to
make judgements. His results suggest that promoters of products with a low-probability/high-
consequence risk should be concerned primarily with reducing the perceived magnitude of
the potential loss associated with that product. He observes that, when a consumer considers
severe but unlikely outcomes, he or she may relate the potential loss to other product features
and will not examine this loss possibility in conjunction with its probability.
Qualls and Puto (1989) examine PT’s ability to explain behavior of industrial buyers and
the benefits of using organizational climate as a possible factor in the decision-framing pro-
cess of these buyers. Based on the results of 1,000 questionnaires distributed to randomly
selected fleet managers, they find support for PT’s decision-framing process in that the
industrial buyers regard outcomes above a reference point as gains and outcomes below a ref-
erence point as losses. They also argue that organizational climate variables are a “method of
predicting an industrial buyer’s decision frame from visible or easy to ascertain buyer percep-
tions” (Qualls and Puto, 1989, p. 191).
Bromley (1989) uses “explicit recognition of presumed entitlements” to reinforce PT’s
proposition that decision-makers do not behave as predicted by VMUT. He uses the follow-
ing KT choice problem to examine the entitlements:

A. Do nothing about acid rain and suffer certain losses in habitat valued at 3000; or
B. Install engineering devices that precipitate out acid precursors. If this action is taken
there are two possible outcomes:

1. There is an 80 percent probability that the devices will not work and we will lose
the cost of the devices plus the habitat for a total loss of 4000; or
2. There is a 20 percent probability that the devices will work and net losses after pay-
ing for the devices, will be zero (Bromley, 1989, p. 191).
He concludes that “an entitlement structure that seems to permit individuals to engage in
certain behaviors (pollute, use whatever drugs they can afford, smoke wherever they choose)
will clearly color the way in which the decision problem is cast and evaluated” (ibid., p. 193).
Elliot and Archibald (1989) also support the decision-framing observation of PT. They
examine experiments designed to elicit subjective frames and determine whether these sub-
jective frames yield the same systematically different choices observed in those experiments
using imposed frames. To examine subjective frames, they administer a questionnaire of
reformulated KT-type choice problems to 432 undergraduate students in introductory eco-
nomics courses. The results of their experiments are consistent with PT’s value function and
therefore provide support for the framing argument in situations of subjective frames. They
find that decision-makers independently impose frames on choice problems. They point out
that PT is more capable of providing a basis for predictions of behavior under uncertainty
than is VMUT; and that PT, therefore, when incorporated into positive economic models
could lead to a better prediction of economic behavior of decision-makers.
D’ Aveni (1989) uses data from 57 large bankrupt firms and 57 matched firms to test a new
model of organizational bankruptcy based on agency and prospect theories. His model is
built on the concept of dependability. He hypothesizes that debtors with unprestigious top
managers, low liquidity, and high leverage are signaling that they will be undependable. His
model proposes that “maintaining a minimum level of these assets is a necessary, but not suf-
ficient, condition for bankruptcy” (D’Aveni, 1989, p. 1120). He observes that some unde-
Prospect Theory: A Literature Review 29

pendable firms are capable of delaying bankruptcy through the use of strategies that help
create hope that they can become dependable in the future. He states that these strategies
work, according to PT, because creditors wish to avoid recognizing significant losses and
therefore take on more risk than they would otherwise. This situation is similar to that dis-
cused in other papers that study the “throwing good money afer bad” phenomenon.
Fiegenbaum (1990) studies COMPUSTAT data from 85 industries, comprising approxi-
mately 3,300 firms, to examine risk-return relationships within the framework of PT. He
looks at these relationships in order to better understand firms’ competitive behavior. He
finds that target level is important in evaluating risky choices, and that firms above their tar-
get level show risk-averse attitudes whereas firms below their target level exhibit risk-seek-
ing attitudes. He finds additional support for PT in the fact that the below-target risk-return
association is generally steeper than the above-target risk-return association.
Meyer and Assuncao (1990) examine an individual’s ability to make rational sequential
purchase quantity decisions under imperfect knowledge concerning future prices of a prod-
uct. Their subjects are 35 second-year MBA students, each of whom completes nine buying
games. The authors then apply PT to explain the biases revealed by their subjects. They
assume that individuals approach each buying decision in the following manner:

with a belief about how large a “typical” expenditure would be given a decision to purchase. This expec-
tation would be influenced by both the size of previous outlays on trials in which a purchase was made, as
well as beliefs about future prices and future buying quantities. This expected expenditure level defines a
psychological “break even” point for expenditures, such that outlays below were seen as having increasing
marginal disutility (an analogy to “gains” in the Kahneman and Tversky (1979) formulation), while those
above decreasing marginal disutility (an analogy to “losses”) (Meyer and Assuncao. 1990, p. 36).

They go on to point out that a PT expenditure function can be used to explain subjects’ ten-
dencies to underbuy during inflation and overbuy during deflation (ibid., p. 37).
Kameda and Davis (1990) examine the function of PT’s reference point in group decision-
making. They present 401 male undergraduate students with three gambling decisions: (1) a
“positive prospect” (i.e., no possibility of loss); (2) a regular prospect with possibilities of
both gain and loss; and (3) a scenario in which six poker chips are used to choose among six
bets with equal expected values. The subjects are assigned to work either by themselves or as
members of a three-person team. The authors find that, consistent with the proposed shape of
PT’s value function, “subjects in the loss condition generally preferred riskier alternatives
than subjects in the even condition” (Kameda and Davis, 1990, p. 70). They do find, how-
ever, an inconsistency with PT in that 68% of their subjects wished to play a symmetric bet
(in violation of the prediction of PT that suggests that the value function is steeper for losses
than for gains). They find that the inclusion of a loss person in a group does not affect the
choice that the group makes because the loss member is overridden by the majority of non-
loss members.
Garland and Newport (199 1) reexamine the effect of sunk costs on individuals in the pro-
cess of making a decision. They conduct two experiments - one involving 88 undergraduate
students in introductory management classes, and the second involving 36 MBA students in
graduate-level organizational behavior classes. Both groups are given the same question-
naire, the only difference being that the MBA students are allowed to take the questionnaire
home and respond to it at their leisure, whereas the undergraduate students are required to
complete the questionnaire during a specified class period. Both experiments reveal that the
relative, instead of the absolute, magnitude of sunk costs has a significant impact on the like-
30 INTERNATIONAL REVIEW OF FINANCIAL ANALYSIS /Vol. 5(l)

lihood of individuals committing additional funds to some course of action. This finding is
consistent with the predictions of PT in that it supports the idea that underlying the decision-
making process associated with sunk costs, is a “topical organization of mental accounts”
where the existing investments are compared with a preset reference state.
Jegers (1991) uses Fiegenbaum and Thomas’s (1988) risk-return findings and replicates
their study using accounting data from 110 three-digit Belgain NACE manufacturing indus-
tries. His findings confirm Fiegenbaum and Thomas’s (1988) earlier findings that firms with
returns above a target level exhibit risk-averse behavior, and firms with returns below that
target level exhibit risk-seeking behavior.
Kanto, Rosenqvist, and Suvas (1992) study the risk-aversion of bettors using data from a
Tampere racetrack. They find that the data do not support the notion that bettors are either
risk-averse or risk-neutral. Their findings are consistent with PT’s prediction of overweight-
ing low probabilities, and are similar to the results of North American studies that show that
bettors tend to favor the longshot.
Bhattacharjee, Cicchetti, and Rankin (1993) scrutinize the traditional explanations for
underinvestment in conservation and present a PT-based analysis of the conservation behav-
ior of individuals. They suggest four guidelines of PT that they feel are relevant to the study
of conservation theory:
1. Design arrangements that give the consumer a sure thing.
2. Use framing to promote conservation.
3. Segregate gains and force segregation of losses
4. Reduce out-of-pocket costs. Ameliorate the effect of sunk costs. (Bhattacharjee,
Cicchetti, and Rankin, 1993, pp. 73-4).
They also present some suggestions for marketing individuals that can be used as guide-
lines for conservation investments sponsored by electric utilities. They find that the most lim-
iting factors on conservation investments include factors outside household control, factors
from the idiosyncrasies of consumer behavior, and socioeconomic relationships. They
emphasize that the individual’s decision process creates a different set of barriers than these
limiting factors. They use PT as a framework for statistically examining and testing apparent
shortcomings, and argue that, if these individuals carry out nonroutine transactions such as
those suggested by PT, “an improved design of conservation programs may help close the
gap between the current conservation level and the efficient level” (ibid., p. 74).
Shefrin and Statman (1993) examine the effect of the framing of identical cash flows. They
use a combination of PT, hedonic framing, behavioral life cycle theory, and cognitive errors
in the development of their model. Their model suggests that, contrary to popular belief, indi-
vidual investor’s decisions are affected by the framing of identical cash flows. For example,
whereas VMUT suggests that individuals will be indifferent among investments with identi-
cal cash flow, the framing feature of PT is used to show that, instead, investors can prefer one
identical cash-flow financial product over another because of the way in which the cash flows
are framed.
White (1993) extends the escalating commitment problem of earlier research experiments
is extended to the group decision setting. He asks 324 senior undergraduate and graduate stu-
dents to make decisions concerning scenarios in order to test the following three hypotheses:

Hl: Escalating commitment to a failing project will occur in individual and group
decision making regardless of personal responsibility for past related sunk invest-
ments.
Prospect Theory: A Literature Review 31

H2: Escalating commitment will occur more often in group decisions than in individ-
ual decisions taken in response to the same commitment dilemma.

H3: Group decisions will manifest a higher degree of escalation than individual deci-
sions taken in response to the same commitment dilemma (ibid., p.437).

He concludes that a PT-based explanation for the escalating commitment phenomenon is

well founded. Although he also finds support for the self-justification approach, he points out
that motives for self-justification do not appear to be a necessary condition for escalation to
occur.
Hardie, Johnson, and Fader (1993) use PT’s value function to argue that “consumer choice
is influenced by the position of brands relative to multiattribute reference points, and that
consumers weigh losses from a reference point more than equivalent sized gains” (Hardie,
Johnson, and Fader, 1993, p. 378). They make it clear that the traditional analysis of brand
choice does not address reference dependence and loss aversion. They explain that the 1991
version of PT can be used in situations involving multiple attributes (ibid., p. 379).
Drake and Freedman (1993) examine the framing of discounts into either the amount of
money off or the percentage off the base price that can be saved. They ask 160 visitors to the
Ontario Science Center in Toronto to read one of four scenarios describing the purchase of a
product and the possibility of saving money through some type of discount. Their findings
suggest that individuals are more likely to expend extra time and effort if the sale involves
either a large percentage of savings or a large amount of savings. Although this finding does
contrast with PT’s suggestion that only the percentage off should affect the individual’s deci-
sion, they point out that, as long as it is recognized that individuals frame their decisions at
several levels, their results are not inconsistent with PT.
Salminen (1994) uses PT’s value function to develop an “interactive method for solving
discrete, multiple-criteria decision problems.” His method is based on the use of pairwise
judgments of the decision-maker to identify the best decision alternative of those presented to
him or her. He assumes that the choice of the decision-maker can be described with linear PT,
and argues that this model is valid only for convex preferences because piecewise linear mar-
ginal value functions are assumed to approximate the S- shaped value functions of PT.
Hirst, Joyce, and Schadewald (1994) focus on the processes that underlie mental account-
ing. They use a PT framework to investigate the role that temporal contiguity and causal rea-
soning play in mental accounting for consumer-borrowing decisions. They conduct four
experiments involving 131 MBA students. The results of these experiments are consistent
with those found by Thaler’s (1985) extension of PT. These results indicate that consumers
prefer to finance a product with a loan that corresponds to the expected life of the product
rather than to face a situation in which they would still be paying for the product after its use-
ful life.
Schaubroeck and Davis (1994) revisit the escalating commitment problem by conducting
two experiments to test the effect of risky alternative investment opportunities on decision
behavior in an escalation context. They suggest that, consistent with PT, individuals will
respond differently to risks concerning perceived gains than they will to risks concerning per-
ceived losses. They find that “salient information concerning relative risk dominate the effect
of prior performance information when alternative investments are considered” (Schaubro-
eck and Davis, 1994, p. 59).
Benartzi and Thaler (1995) use two behavioral concepts to explain why stocks outperform
bonds:
32 INTERNATIONAL REVIEW OF FINANCIAL ANALYSIS / Vol. 5(l)

1. Investors are assumed to be “loss averse,” meaning that they are distinctly more
sensitive to losses than to gains.
2. Even long-term investors are assumed to evaluate their portfolios frequently
(Benartzi and Thaler, 1995, p. 73).
They find that the size of the equity premium is consistent with those estimated according
to PT when investors evaluate their portfolios annually.
Mayer (1995) examines consumer rationality versus PT in electricity conservation. His
findings support the notion of “the efficacy of Prospect Theory over utility maximization for
consumer investment in electricity saving equipment” (Mayer, 1995, p. 109).
Leclerc, Schmitt, and Dube (1995) use PT to examine whether consumers treat time like
money when making decisions. They find that, in deterministic situations, the decisions peo-
ple make involving time losses are consistent with the convex loss function of PT.
Sebora and Cornwall (1995) reexamine the VMUT versus PT debate. They find that the
results indicate that, “. . . when making strategic decisions, the choices made by decision mak-
ers tend to reflect the risk, simplifications, and preference reversal characteristics of prospect
theory” (Sebora and Cornwall, 1995, p. 41).

B. Rejections of Prospect Theory

Hershey and Schoemaker (1980) examine PT’s reflection effect hypothesis at both across-
subject and within-subject levels and, in so doing, raise questions that challenge the generality
of the reflection effect. They use data from three separate experiments involving a total of 28
questions. They present each question in both gain and loss formulations; i.e., “In each case
the choice was between a probabilistic gain (or loss) and a sure gain (or loss) of equal
expected value” (Hershey and Shoemaker, 1980, p. 405). They then examine the results in
across-subject and within-subject situations. They find no strong or systematic across-subject
reflectivity. In the within-subject situations, they find weak reflectivity, but observe, neverthe-
less, that the lawfulness of reflectivity remains in question. They suggest that there be a “revi-
sion in the shapes of the value and/or probability weighting functions” of PT (ibid., p. 417).
Martinez-Vazquex, Harwood, and Larkins (1992) use MBA students as subjects to exam-
ine three hypotheses concerning the reasons why individuals who find that not enough taxes
have been withheld from their salary or wages might decide to evade taxes altogether. These
three hypotheses represent PT’s reflection effect, the liquidity position of taxpayers, and fis-
cal illusion. They find that neither the tax withholding position nor the element of surprise
affects the attitudes of the subjects toward tax compliance, and conclude therefore that they
cannot support PT’s reflection hypothesis.
The escalating commitment is once again examined by Brockner (1992). He studies alter-
natives to the self-justification explanation for continuing with a failing course of action, one
of the alternatives being PT. While other studies referenced above have pointed to the sup-
port of PT in relation to the escalating commitment problem, Brockner (1992) suggests that
the David and Bobko (1986) study seems to support self- justification more than PT, because
David and Bobko found that individuals were more likely to continue with a failing course of
action if they were the one who instigated the action than if someone else began the course of
action.
Casey (1994) examines PT’s integration and segregation factors through individual’s max-
imum buying prices for lotteries. Using 114 graduate students in microeconomics classes as
subjects, he finds that buyers are “strongly influenced by loss aversion and that the conven-
Prospect Theory: A Literature Review 33

tional assumption that the buying price for a risky alternative is a reduction in the altema-
tive’s payoff to describe behavior” (Casey, 1994, p. 730). He also finds that buyers “undergo
a segregation encoding process in which the buying price is encoded separately from the
bet’s payoffs and treated as a sure loss” (ibid.). He concludes that the maximum buying price
versus choice comparison favors PT’s segregation model slightly, but that the comparison
does not uphold the segregation model’s prediction of strategic equivalence.

Iv. PROSPECT THEORY AS A BASIS FOR OTHER MODELS

Loomes and Sugden (1982) offer a theory that they argue is simpler and intuitively more
appealing than PT. They contend that decision-makers anticipate feelings of regret or rejoic-
ing brought about by their decision and therefore develop a model that they feel better takes
into account those feelings. Their modified utility function is as follows:

where cti and Ckj represent the situation in which an individual chooses an action i over action
k when the jth state of the world occurs and R(.) is the regret-rejoice function of their theory
“which assigns a real-valued index to every possible increment or decrement of choiceless
utility” (Loomes and Sugden, 1982, p. 809). They argue that this model explains and predicts
individual decision making under risk better than does PT. They state, “Simultaneous gam-
bling and insurance, the reflection effect, and the mixture of risk attitudes may all be accom-
modated by conventional expected utility theory, although only at the cost of certain fairly
arbitrary assumptions and some rather unsatisfactory implications” (ibid., p. 806). They
argue that their model not only explains the reflection effect and the simultaneous gambling
and insurance, but also predicts the certainty effect, the Allais Paradox, and the isolation
effect better than is possible with PT. They do point out, however, that their regret theory
model does not explain the framing characteristic wheras FT does. Their regret theory is more
to salvage VMUT than to serve as an alternative to PT. They admit, however, that, although
regret theory is less complicated than FT, it does not explain all that PT explains.
Thaler (1985) develops a new model of consumer behavior that is an integration of cogni-
tive psychology and microeconomics. His model uses PT’s value function as a basis, and
begins with a mental coding of combinations of gains and losses. The model is applied to a
problem of decision making under risk to evaluate purchasing decisions of consumers. He
argues that consumers often do not behave “in accordance with the normative prescriptions
of economic theory.” He refers to earlier findings that show that consumers often allow their
decisions to be affected by sunk costs and also underweight pardoned costs as compared with
out-of-pocket costs. He also argues that PT’s value function is “psychologically richer” than
VMUT, because it incorporates the behavioral principles of:
1. The function v(.) is defined over perceived gains and losses relative to some natural
reference point, rather than wealth or consumption as in the standard theory.
2. The value function is assumed to be concave for gains and convex for losses. This
feature captures the basic psychophysics of quantity.
3. The loss function is steeper than the gain function (Thaler, 1985, p. 201).
His theory has three distinct areas: the coding of gains and losses, the evaluation of pur-
chases (transaction utility), and budgetary rules. On that portion of his questionnaire regard-
34 INTERNATIONAL REVIEW OF FINANCIAL ANALYSIS / Vol. 5(l)

ing the losses, he presents subjects with questions such as “[IQ two events are going to
happen to you, would you rather they occurred on the same day or two weeks apart?” He
finds that previous gains and losses affect later choices in a manner that complicates any
interpretation of the loss function. The transaction utility section of his questionnaire
involves the pricing of sports events’ tickets, and the budgetary rules section involves only
small sample of households.
Harrell and Stahl (1986) propose that some characteristics of PT be integrated into expect-
ancy theory6 in order to better describe the way that individuals process additive information
to come to decisions involving “motivation rather than the multiplicative information pro-
cessing implied by the expectancy force model” (Harrell and Stahl, 1986, p. 431). The char-
acteristics that they propose be integrated into expectancy theory are as follows:
1. Individuals initially perform an editing activity during which they eliminate some
alternatives and frame acts, outcomes, and contingencies, and
2. Individuals subsequently perform an evaluation activity during which they evaluate
the remaining alternatives (ibid., p. 431).
They use information from five diverse groups of subject to examine the hypothesis that if
the expectancy of success increases, the result will be a declining marginal increase in moti-
vation. Their results are consistent with this hypothesis. They also show the existence of the
concave portion of PT’s value function (ibid., p. 431).
Hogarth and Einhom (1990) propose a decision model for assessing decision weights.7
Their model assumes that individuals decide on a stated probability and then adjust this by
mental simulation of other possible values:

The amount of mental simulation is affected by the absolute size of payoffs, the extent to which the anchor
deviates from the extremes of 0 and 1. and the level of perceived ambiguity concerning the relevant probabil-
ity. The net effect of the adjustment reflects the relative weight given in imagination to values above as
opposed to below the anchor [decided probability]. This, in turn, is taken to be a function of both individual
and situational variables, and in particular, the sign and size of payoffs. Cognitive and motivational factors
therefore both play important roles in determining decision weights (Hogarth and Einhorn. 1990, p. 780).

Their experiment involves 96 graduate and undergraduate students. The subjects are pre-
sented with three decision/choice experiments. The results indicate that an optimal model for
assessing decision weights should consist of PT’s value function and the authors’ own ven-
ture theory.
Mowen and Mowen (1991) study the manner in which time influences a decision-maker’s
valuation process. They develop their own time and outcome valuation (TOV) model. This
model suggests that time has an impact on an individual’s valuation of losses and gains. The
assumption of the relative weights on losses and gains in their model is indirectly derived
from PT.
Shafir, Osherson, and Smith (1993) propose a new choice model, advantage model of
choice, as an alternative to PT. Based on this model, individual decision makers evaluate lot-
teries in choice problems by comparing them separately on the dimension of both gains and
losses. They concede that in its present form, their advantage model of choice is inferior to
both PT and VMUT because their model applies only to certain kinds of choice problems and
both PT and VMUT have a wider range of applicability (Shafer, Osherson, and Smith, 1993,
p. 372).
Paese (1995) tests the effect of positive versus negative frames on the riskiness of actual
Prospect Theory: A Literature Review 35

time allocation decision. He conducts two experiments. The first, involving an unattractive
task, is administered to 111 undergraduate students; and the second, involving an attractive
exercise, is administered to 98 undergraduates. In both these experiments, framing effects in
line with PT are observed. Paese does point out however, that the framing effects are small to
moderate in magnitude.

V. SUGGESTIONS FOR FUTURE WORK AND SUMMARY

As the previous section suggests, there has not been a lot of independent research in the area
of PT. Most of the papers reviewed here consist of experiments in the same areas of research
(i.e., escalating commitment, sunk costs, race-track betting, etc.). Because of the lack of recent
investigation into the extension and further development of this theory, it seems that there are
many opportunities available to the researcher wishing to expand this theory. Regularly,
authors suggest the expansion of their experiments as a possible outlet for future work, but
possibly it is necessary to expand this research into an area that might foster the use of Pf in
the finance classroom. Professor Vernon Smith, founder of the Economic Science Laboratory
at the University of Arizona, has been very instrumental in doing just that by pushing forward
the studies of “behavioral finance.” As it is described by Galant (1995), “behavioral finance
strives to go beyond folk investing wisdom to detect distinct modes of market behavior.”
As a new field, PT has yet to be fully explored. Several papers presented here have used
this “new” idea to explore the fields of finance, marketing, management, and economics. Of
course, any field that deals with individuals in decision-making scenarios is a prospect for
application. The above papers have examined PT as a basis for other theories as well as ana-
lyzed the individual aspects of PT itself. Intuitively, it seems that PT is much more descrip-
tive than expected utility theory. As can be seen in the experiments conducted for the above
research papers, PT is capable of explaining decisions that expected utility theory is incapa-
ble of explaining. The problem is, however, that there has not been enough conclusive evi-
dence in support of PT’s predictive powers. It seems evident, therefore, that there is much left
to cover before the research on PT is considered complete.

NOTES

1. But they pointed out that this simple model can be extended to more complex choices.
2. Escalating commitment is the situation where a losing investment is continued, or, as
the old saying goes, the situation of throwing good money after bad.
3. The Allais Paradox is a situation in which the substitution, or independence, axiom, of
the three behavioral axioms necessary and sufficient for a binary relation to have an expected
utility representation is violated. The substitution axiom states that for all p,q,r E P, a choice
set, and a E (0, I], p > q implies up + (1 - a)r > up + (1 - a) r (Huang and Litzenberger, 1988,
pp. 7-15).
4. “Interference theory is an outgrowth of the ‘transfer of training’ hypothesis - the
idea that what is learned in one task may be carried over (sometimes inappropriately) to
another task” (Haka, Friedman, and Jones, 1986, p. 455).
5. “Bowman (1980) discovered that within most industries, risk and return were nega-
tively correlated. He described that research outcome as a paradox for strategic management,
36 INTERNATIONAL REVIEW OF FINANCIAL ANALYSIS /Vol. 5(l)

since the findings ran counter to the conventional wisdom that argues for a positive associa-
tion. He also argues that firms’ risk attitudes may influence risk-return profiles and that more
troubles firms may take greater risks (Bowman, 1982, 1984)” (Fiegenbaum and Thomas,
1988, p. 85).
6. In the force model posited by expectancy theory (Vroom, 1964), the level of motiva-
tional force acting on a person is determined by multiplying the model’s valence and expect-
ancy variables. Logically, this implies that increases in expectancy result in proportionate
increases in motivation” (Harrell and Stahl, 1986, p. 424).
7. “The key notion [of Venture Theory] is that decision weights used to discount values
of outcomes for uncertainty are the end result of a process that involves first anchoring on an
estimate of probability and then adjusting this by imagining other possible values for the
weights” (Hogarth and Einhom, 1990, p. 782).

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