Glossary · Behavioral Economics
Prospect Theory
also: cumulative prospect theory · CPT
Definition
Prospect theory, developed by Kahneman and Tversky, describes how people choose under risk: outcomes are evaluated as gains or losses relative to a reference point, losses weigh roughly 2.25× more than equivalent gains, and both gains and losses exhibit diminishing sensitivity.
Prospect theory replaced expected utility theory as the dominant descriptive model of decision-making under risk. Three departures from classical utility: (1) a reference point — outcomes are framed as gains or losses, not absolute wealth levels; (2) loss aversion — the disutility of a loss is steeper than the utility of the equivalent gain, with typical λ ≈ 2.25; (3) diminishing sensitivity — the marginal impact of a gain or loss decreases with magnitude. The value function is concave over gains and convex over losses, producing the characteristic S-curve.
Essays on this concept
- Behavioral Economics
Loss Aversion Asymmetry in Digital Marketplaces: Evidence from A/B Tests Across 14 Million Users
Prospect theory predicts that losses hurt 2.25x more than gains. Our data across 14 million marketplace users shows the real ratio depends on something economists have overlooked.
- Behavioral Economics
The Decoy Effect Reimagined: Dynamic Price Anchoring with Real-Time Behavioral Segmentation
A dominated third option can shift 22% more users to your premium plan. But the static decoy is dead — here's how real-time behavioral data makes asymmetric dominance adaptive.
- Behavioral Economics
The Endowment Effect in SaaS Pricing: Why Free Trials Convert Better Than Freemium
A behavioral economics analysis of why giving users temporary full access converts 2-5x better than permanent limited access. We examine the endowment effect, the IKEA effect, sunk cost psychology, and present an original framework for SaaS pricing architecture.
- Behavioral Economics
Hyperbolic Discounting and Subscription Fatigue: A Quantitative Framework for Churn Prediction
How time-inconsistent preferences explain why subscribers cancel — and a mathematical framework that predicts churn windows before they open.
- Behavioral Economics
Mental Accounting in Multi-Currency E-commerce: How Payment Framing Shifts Willingness to Pay by 23%
Thaler showed that people don't treat money as fungible. In cross-border e-commerce, currency display alone shifts willingness to pay by 23% — and most checkout flows ignore this entirely.
- Digital Economics
The Micro-Economics of API Pricing: Marginal Cost, Value Capture, and Developer Elasticity
An API call costs fractions of a cent to serve but can generate thousands in downstream value. The gap between marginal cost and captured value is where the entire API economy lives — and most companies price this gap wrong.
- Behavioral Economics
Sunk Cost Fallacy in Product Adoption: Why Users Who Customize Retain 4x Longer
Economists call it irrational. Product managers call it retention. The sunk cost fallacy — when properly channeled through customization and effort investment — becomes the most reliable predictor of long-term user engagement.
Related concepts
Authoritative references