Barberis (2013) on 30 Years of Prospect Theory

Nicholas C. Barberis, “Thirty Years of Prospect Theory in Economics: A Review and Assessment.” Journal of Economic Perspectives 27(1): 173-96, 2013.

• Prospects are evaluated with decision weights not equal to probabilities, and with valuation tied not to overall wealth, but to gains and losses relative to a reference point. Besides probability weighting and reference dependence, prospect theory also invokes loss aversion and diminishing sensitivity. 

• Diminishing sensitivity with respect to losses is equivalent to risk seeking: the pain of losing $900 is more than 90 percent of the pain of losing $1000. 

• The probability weighting function overweights low probabilities and underweights high probabilities. These weights are not interpreted (within prospect theory) as mistakes. 

• What is the relevant reference point? Koszegi and Rabin (and others) take the reference point to be recent expectations. People then gain when consumption is larger than expected consumption; therefore (perhaps), I do not like to hear praise for a book that I intend to read. 

• The overweighting of low probability, good outcomes, helps to explain the interest in lotteries, and the low average return to some positively skewed financial securities. 

• Prospect theory is carried over to riskless choice via the endowment effect. The endowment effect comes in two forms, exchange asymmetries and willingness-to-pay/willingness-to-accept gaps; both can follow from loss aversion. 

• Some behaviors that looks like contradictions of prospect theory (such as the eroding of the endowment effect among experienced traders) could reflect different reference points.