Final answer:
Prospect Theory, formulated by Daniel Kahneman and Amos Tversky, is a foundational concept in behavioral economics that explains how people decide between options involving risks and uncertainty. It highlights the human tendency to value losses and gains differently, with a stronger emphasis on loss aversion.
Step-by-step explanation:
The Prospect Theory developed by Daniel Kahneman and Amos Tversky is a behavioral economic theory that describes the way people choose between probabilistic alternatives that involve risk, where the probabilities of outcomes are known. The theory posits that people make decisions based on the potential value of losses and gains rather than the final outcome, and that people evaluate these losses and gains using certain heuristics. The theory is best known for identifying that people tend to place more weight on losses than on gains, a phenomenon known as loss aversion. Moreover, Prospect Theory illustrates that the decision-making process is divided into two phases: an editing phase, where prospects are organized and simplified, and an evaluation phase, where prospects are assessed and the decision is made. The theory challenges traditional economic theory, that assumes rational decision-making, by showing that people often act irrationally when making choices under uncertainty.