What economic theory, proposed by Kahneman and Tversky, explains how people make decisions under risk by evaluating gains and losses relative to a reference point? Prospect theory.
Daniel Kahneman and Amos Tversky introduced prospect theory in their 1979 paper, “Prospect Theory: An Analysis of Decision under Risk.” It was designed as a descriptive alternative to expected utility theory, which models how ideally rational decision-makers should evaluate risky choices.
The theory says people judge outcomes as gains or losses relative to a reference point, such as current wealth, an expectation, or a previous situation. Its value function is typically concave for gains and convex for losses, while losses usually feel more significant than equivalent gains—a pattern called loss aversion. People also tend to overweight very small probabilities and underweight very large ones.
A common mix-up is expected utility theory, which is a competing framework rather than the answer. Prospect theory was later extended into cumulative prospect theory in 1992, and its ideas became influential in behavioral economics and finance.