Prospect Theory (Kahneman & Tversky, 1979) replaces expected utility with a value function defined over changes from a reference point. Key features:
1. Reference dependence — utility is over gains/losses, not final wealth.
2. Loss aversion — losses loom larger than equivalent gains (λ ≈ 2.25 empirically).
3. Diminishing sensitivity — concave for gains (risk-averse), convex for losses (risk-seeking).
The S-shaped value function is v(x) = x^α for gains; v(x) = −λ·(−x)^β for losses.
This explains the reflection effect: people prefer a sure $50 gain over a 50/50 chance at $100, but prefer gambling to a sure $50 loss.