What is Prospect Theory?

Anticipating People's Reactions to Risk and Uncertainty

What is Prospect Theory?

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How much pain would you choose to accept for an uncertain gain?

Saul is aware that the receptionist is staring at him hard. Could it be because he's been noisily drumming his fingers for the last 10 minutes? He quickly stops and exhales deeply to calm himself – which earns him another glare.

Saul is a senior executive in a large and long-established packaging firm. The problem is, he's not sure how much longer the description “large” is going to apply, because competition is increasingly tough. So he is about to propose a radical reshaping and re-prioritizing of the business that will involve both cuts and investment.

He's thought long and hard about how to win the board's approval. He's come armed with facts, charts and projections, and he's practiced his presentation until it's perfect. But he's uncertain of one important factor – how much risk are the company directors prepared to live with? Will they see his plan as the best option for growth or too much of a gamble?

In this article, we'll look at Prospect Theory, and how it might help you to predict and prepare for people's reactions to risk and change.

Understanding Prospect Theory

Prospect Theory is a behavioral economics model that was developed by Daniel Kahneman and Amos Tversky. It uses sophisticated math to describe and explain how people decide between alternatives. But, even at a basic level, it can provide a useful insight into how they might react to what they perceive as loss and gain.

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