Prospect Theory: Who Designs Your Choices?

In 2002, the Nobel Prize in Economics was awarded to someone who had never spent his life in an economics department. Daniel Kahneman was, by trade, a psychologist. What he proved was not a market equilibrium equation, but rather that the same person transforms into an entirely different being when facing gains versus losses.

For a long time, economics has centered on a fictional human protagonist called ‘Homo Economicus.’ This being is as precise as a calculator, unmoved by emotions, and always maximizes their own utility. The problem is that this character does not exist in reality.

There are people who cannot sell a stock even after it loses half its value, thinking, ‘It will go up someday.’ People who buy lottery tickets despite knowing the odds of winning are lower than being struck by lightning. People for whom the sting of a parking ticket feels far longer-lasting than the joy of finding money on the street. Economics textbooks once labeled these people as ’errors.’ Kahneman and his colleague Amos Tversky saw these not as errors, but as patterns.

These patterns are present in the wallets and screens of everyone reading this. The reason you finally checked out that item you left in your cart yesterday, the reason you delayed canceling a subscription, and the reason you couldn’t cut your losses on a failing stock—all stem from the same circuitry. That circuitry is called Prospect Theory.

The Cartographer of the Mind

Mapmakers do not create mountains or rivers; they simply decide where to draw the lines. Yet, a single line determines whether a village belongs to one country or its neighbor. The land remains the same, but the moment the line is drawn, ownership changes.

The ‘reference point’ described in prospect theory works the same way. The absolute amount of money in your bank account is not what matters. What matters is where the reference line is drawn, as that determines whether the amount is perceived as a gain or a loss. To someone expecting a 1 million won bonus, 500,000 won is a clear loss. Even though the account balance increased, the heart feels a sense of deficit.

This leads to the real question: Who draws that line? Borders on a map have been drawn by treaties and wars—by power. Reference points in the mind do not emerge in a vacuum, either. The ‘original price’ on a tag, the first number thrown out on a negotiation table, the default option in a contract—reference points are usually lines drawn by someone else, and we simply react to them.

The question Kahneman and Tversky posed in their 1979 paper was ultimately this: not how humans should choose, but how they actually choose. It was a shift from normative to observational, and that single transition changed the direction of economics.

Why Loss is Designed to Hurt Twice as Much

There is a graph centered on this reference point. The horizontal axis represents gains and losses, while the vertical axis represents the psychological value a person actually feels. The curve forms an S-shape from the origin. This single curve captures the asymmetry of human psychology.

First, the curve flattens out as it moves further from the origin in both directions. The joy of gaining 10,000 won from zero feels greater than the joy of gaining 1.1 million won from 1 million won. It follows the same principle as the first slice of pizza being the most delicious.

Second, and more importantly, the slope is much steeper on the loss side than on the gain side. Measurements confirmed in countless experiments show this: The pain of losing 100,000 won feels 1.5 to 2.5 times greater than the joy of gaining 100,000 won. This means you need to earn 200,000 won to barely offset the wound of losing 100,000 won.

This asymmetry is not limited to money; human perception itself is built this way. A candle lit in a dark room feels bright, but adding a candle to an already bright room makes little difference. The brain reads the world not by absolute values, but by changes. We apply this ancient circuitry even when counting money.

the consequences of this curve are clear. People are willing to take much riskier actions to avoid loss than they are to pursue gain. The tendency to prefer the status quo and fear change also stems from this. Not losing becomes more urgent than gaining.

The Warped Lens of Probability

It is not just the value of money that is distorted; probability is not perceived as it is, either. Traditional economics calculated 50% as exactly half of 100%, but the human mind does not calculate it that way.

The psychological impact of moving from 0% to 1% is far greater than moving from 50% to 51%. This is because it is the moment a non-existent possibility is born. This is why lottery buyers hold onto the hope of ‘maybe.’

There is a distortion on the other side as well. The move from 99% to 100% is arithmetically a 1 percentage point increase, but psychologically, it is a qualitative leap from ‘uncertain’ to ‘certain.’ This is why people remain anxious even after hearing a 99% survival rate, and why they aren’t satisfied by the term ‘almost certain’ in insurance policies. People are willing to pay a premium to eliminate that final 1%.

The Person Who Buys Insurance While Playing the Lottery

By overlaying the value function and the probability weighting function, we get a table that predicts human risk-taking. In situations with high probability and potential gains, people avoid risk. This is why people accept sure settlements in lawsuits. Conversely, in situations with low probability and potential gains, people embrace risk. This is why lottery tickets are sold.

In situations with high probability and potential losses, people actually take more risks. This is the psychology behind ‘averaging down’ on riskier stocks to recover losses. In situations with low probability and potential losses, people avoid risk again. This is why we pay monthly insurance premiums.

The same person might buy a lottery ticket one day and insurance the next. It may seem like a contradiction, but within this framework, it is not. Depending on how emotions and probability distortions combine, the attitude toward risk simply flips.

Theory Outside the Lab

No matter how plausible a theory is, it is hollow without evidence. Prospect theory has been repeatedly verified beyond the confines of the laboratory.

In one experiment, participants were presented with the same disease control measures in two ways. Most chose the policy described as ‘saving 200 out of 600 people.’ When described as ‘400 out of 600 people will die’—which is mathematically identical—the choices flipped. It wasn’t the numbers that changed, but a single word.

Richard Thaler gave people mugs and asked them to sell them. Those who owned the mugs refused to sell for less than $7 on average, while those without them wouldn't pay more than $3. It was the same mug, but the moment they owned it, its value more than doubled. This is because the act of selling felt like a loss to them. This phenomenon was dubbed the ’endowment effect.’

Different organ donation systems in various countries follow the same principle. In countries where you must sign to become a donor versus countries where you are automatically a donor unless you opt out, the donation rates differ by a massive margin—from single digits to over 90 percent. This is because deviating from the default feels like a loss.

The same pattern repeats in stock investor behavior. They sell winning stocks too quickly and hold onto falling ones for too long. They are quick to grasp the short-term satisfaction of realizing a gain, while postponing the pain of confirming a loss as much as possible. This phenomenon is called the ‘disposition effect.’ Studies of New York taxi drivers showed a similar picture: they clock out early on busy, rainy days, but work longer on slow days. Their daily income target acts as a reference point.

The Angry Psychologist, The Quiet Economics World

This theory was not welcomed from the start. In the 1970s, the economic establishment had already built a sophisticated mathematical system on the model of rational agents. The observations presented by two psychologists threatened to shake that entire foundation, and it was largely ignored rather than accepted.

Kahneman and Tversky were not taken seriously at first precisely because they were not economists. The rebuttal persisted for a long time that these were just ‘anomalies’ confirmed by a few experiments and could not serve as a basis for changing the operating principles of the market. It took nearly 20 years for the theory to be incorporated into the mainstream.

The theory itself had flaws. The initial prospect theory could not explain emotions like regret or disappointment that follow a decision. It was also difficult to predict which criteria a person would use as a reference point in a specific situation. To bridge this gap, Kahneman and Tversky released an improved version in 1992 called ‘Cumulative Prospect Theory.’ Today, when academics say ‘prospect theory,’ they usually refer to this version. The theory didn’t fall from the sky in its finished form; it was continuously refined by absorbing criticism.

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The Hands Drawing the Borders Have Changed

We need to shift our perspective here. The biases discussed so far were all matters within an individual’s head. However, the moment this circuitry was exposed to the world, it ceased to be just an individual problem.

The fact that bias is predictable means it is also designable. That is exactly what happened. Phrases like ‘Price for today only’ or ‘Only 3 items left’ artificially create a loss frame, suggesting you will lose something if you don’t buy now. A one-month free trial is a device to subtly instill the endowment effect while you use the service. It is no coincidence that the cancel button for a subscription is often hidden in a hard-to-find spot. The fact that Europe has begun regulating such interface designs as ‘dark patterns’ is proof that this principle has become a standard tool in product design.

Governments use the same tools. Many policies packaged as ’nudges’ are essentially exercises in changing defaults—that is, changing the reference point. I cannot say that is inherently bad; a nudge that boosts organ donation rates actually saves lives. The problem is that this tool is not used solely for noble purposes.

The gap between those who can design reference points and those who have no choice but to react within them is widening.

Who decides which product an algorithm shows as ’limited quantity,’ which price is marked as a ‘discount,’ or which options are pre-checked? The power is increasingly concentrated in the hands of a few. We have moved from an era where one individual designed one reference point to an era where a few systems design the reference points for hundreds of millions of people simultaneously. And within that, we still believe we are choosing for ourselves.

In 2002, the Nobel Committee awarded the prize not to the person who most elegantly mathematized the market, but to the person who most accurately depicted the human within it. What Kahneman proved was not that humans are irrational, but that this irrationality is surprisingly consistent, and therefore, predictable.

What is predictable can be designed. The price on this screen, the default settings of the app you just opened, the ‘closing soon’ notice you just glanced at. Where did those reference lines come from, and who drew them?