Prospect theory, first described in a 1979 paper by Daniel Kahneman and Amos Tversky, is widely viewed as the best available description of how people evaluate risk in experimental settings. While the theory contains many remarkable insights, it has proven challenging to apply these insights in economic settings, and it is only recently that there has been real progress in doing so. In this paper, after first reviewing prospect theory and the difficulties inherent in applying it, I discuss some of this recent work. It is too early to declare this research effort an unqualified success. But the rapid progress of the last decade makes me optimistic that at least some of the insights of prospect theory will eventually find a permanent and significant place in mainstream economic analysis. [A good video explaining prospect theory is here].That is Nicholas Barberis in a new working paper (November 2012), "Thirty Years of Prospect Theory in Economics: A Review and Assessment.
Even prospect theory’s most ardent fan would concede that economic analysis based on this theory is unlikely to replace the analysis that we currently present in our introductory textbooks. It makes sense to teach students the fundamental concepts of economics using a traditional utility function, not least because this is simpler than using prospect theory. Indeed, while Mankiw’s best-selling undergraduate economics textbook devotes part of a chapter to behavioral economics, it makes no specific mention of prospect theory anywhere in its 900 pages. However, as prospect theory becomes more established in economics, a reasonable vision for future textbooks is that, once they complete the traditional coverage of some topic – of consumer behavior, say, or of consumption-savings decisions, industrial organization, or labor supply – they will follow this with a section or chapter that asks: Can we make more sense of the data using models that are based on psychologically more realistic assumptions? I expect prospect theory to figure prominently in some of these, as yet unwritten, chapters.