original version of prospect theory is described in Kahneman and Tversky
(1979). While this paper contains all of the theory’s essential insights, the specific
model it proposed has some limitations: it can be applied to gambles with at most
two nonzero outcomes, and it predicts that people will sometimes choose domi-
nated gambles. In 1992, Kahneman and Tversky published a modified version of
their theory known as “cumulative prospect theory” which resolves these problems.
This version is the one typically used in economic analysis, and it is the version
I briefly review here.
Consider a gamble