Daniel Kahneman Nobel Lecture

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to a reference point, but Bernoulli’s theory and its successors did not incor-

porate a reference point. We therefore proposed an alternative theory of risk,

in which the carriers of utility are gains and losses – changes of wealth rather

than states of wealth. Prospect theory (Kahneman & Tversky, 1979) embraces

the idea that preferences are reference-dependent, and includes the extra pa-

rameter that is required by this assumption. 

The distinctive predictions of prospect theory follow from the shape of the

value function, which is shown in Figure 6. The value function is defined on

gains and losses and is characterized by four features: (1) it is concave in the

domain of gains, favoring risk aversion; (2) it is convex in the domain of loss-

es, favoring risk seeking; (3) Most important, the function is sharply kinked at

the reference point, and loss-averse – steeper for losses than for gains by a fac-

tor of about 2–2.5 (Kahneman, Knetsch, & Thaler, 1991; Tversky &

Kahneman, 1992). (4) Several studies suggest that the functions in the two

domains are fairly well approximated by power functions with similar expo-

nents, both less than unity (Swalm, 1966; Tversky & Kahneman, 1992).

However, the value function is not expected to describe preferences for loss-

es that are large relative to total assets, where ruin or near-ruin is a possible

outcome. 

Bernoulli’s error – the assumption that the carriers of utility are final states

– is not restricted to decision making under risk. Indeed, the error of refer-

ence-independence is built into the standard representation of indifference

maps. It is puzzling to a psychologist that these maps do not include a repre-

sentation of the decision maker’s current holdings of various goods – the

counterpart of the reference point in prospect theory. The parameter is not

included, of course, because consumer theory assumes that it does not mat-

ter. 

The wealth frame

The idea that the carriers of utility are changes of wealth rather than asset po-

sitions was described as the cornerstone of prospect theory (Kahneman &

Tversky, 1979, p. 273). This statement implied that choices are always made

by considering gains and losses rather than final states, but that proposition

Figure 6.

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must be qualified. The analysis of accessibility and framing that was presented

earlier suggests a more moderate alternative, in which (1) decision problems

can be formulated either in terms of wealth or in terms of changes; (2) the

two formulations may lead to different preferences. For an example, consid-

er Problem 4:

Problem 4

Please estimate your total wealth, call it W

Which of these situations is more attractive:

You own W

or

50% chance that you own W – $100

50% chance that you own W + $150

Informal experiments with problems of this type have consistently yielded a

mild preference for the uncertain state of wealth, and a strong impression

that the stakes mentioned in the question are entirely negligible.

In terms of final states of wealth, Problem 4 is identical to Problem 2.

Furthermore, most respondents will agree, upon reflection, that the differ-

ence between the problems is inconsequential – too slight to justify different

choices. Thus, the discrepant preferences observed in these two problems sat-

isfy the definition of a framing effect. 

The manipulation of accessibility that produces this framing effect is

straightforward. The gamble of Problem 2 is likely to evoke an evaluation of

the emotions associated with the immediate outcomes, and the formulation

will not bring to mind thoughts of overall wealth. In contrast, the formulation

of Problem 4 favors a view of the uncertainty as trivially small in relation to W,

and includes no mention of gains or losses. In this perspective it is hardly sur-

prising that the two problems elicit different representations, and therefore

different preferences.

Over the centuries, Bernoulli’s theory and its successors have been applied

to decision problems in which outcomes are almost always formulated in

terms of gains and losses, without any explicit mention of either current or fi-

nal states of wealth. The assumption implicit in applications of expected util-

ity theory is that outcomes described as gains or losses are first transformed

into final asset states, then evaluated in that representation. In light of the

preceding discussion of framing, the hypothesis of a transformation is highly

implausible, and the different responses observed in Problems 2 and in

Problem 4 provide direct evidence against it. 

The same argument also applies in the other direction. Consider a deci-

sion maker who is only presented with Problem 4. Prospect theory assumed a

preliminary operation of editing, in which prospects are reframed in simpler

terms, prior to evaluation. But Problem 2 is not a simpler version of Problem

4; it includes gains and losses, which are not mentioned in Problem 4. The

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discussion of framing suggests that Problem 4 will be evaluated as it is stated

– in terms of states of wealth. Indeed, some real-world choices are made in

that frame. In particular, financial advisors and decision analysts often insist

on formulating outcomes in terms of assets when they elicit their clients’ pref-

erences. Prospect theory is unlikely to provide an accurate description of de-

cisions made in the wealth frame.

In experimental research as well as in the real world, the overwhelming

majority of decisions are framed as gains and losses. There has been no sys-

tematic study of the choices that people make in the wealth frame, but one of

the important properties of these choices is not in doubt: they will generally

be closer to risk neutrality than when the equivalent outcomes are framed as

gains and losses. The wealth frame favors risk neutrality in two ways. First, this

frame eliminates any mention of losses, and therefore eliminates loss aver-

sion. Second, in analogy with a familiar principle of perception, the outcomes

of small bets will appear less significant when considered in the context of

much larger amounts of wealth. 

If Bernoulli’s formulation is transparently incorrect as a descriptive model

of risky choices, as has been argued here, why has this model been retained

for so long? The answer may well be that the assignment of utility to wealth is

an aspect of rationality, and therefore compatible with the general assump-

tion of rationality in economic theorizing. 

Consider Problem 5.

Problem 5

Two persons get their monthly report from a broker: 

A is told that her wealth went from 4M to 3M 

B is told that her wealth went from 1M to 1.1M

“Who of the two individuals has more reason

to be satisfied with her financial situation?”

“Who is happier today?”

Problem 5 highlights the contrasting interpretations of utility in theories that

define outcomes as states or as changes. In Bernoulli’s analysis only the first

of the two questions is relevant, and only long-term consequences matter.

Prospect theory, in contrast, is concerned with short-term outcomes, and the

value function presumably reflects an anticipation of the valence and intensi-

ty of the emotions that will be experienced at moments of transition from one

state to another (Kahneman, 2000a, b; Mellers, 2000). Which of these con-

cepts of utility is more useful? For descriptive purposes, the more myopic no-

tion is superior, but the prescriptive norms of reasonable decision making fa-

vor the long-term view. The Bernoullian definition of relevant outcomes is a

good fit in a rational-agent model.

It is worth noting that an exclusive concern with the long term may be pre-

scriptively sterile, because the long term is not where life is lived. Utility can-

not be divorced from emotion, and emotion is triggered by changes. A theo-

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