Prospect Theory (Loss Aversion)

What this diagram shows

Prospect Theory demonstrates that people feel losses more intensely than equivalent gains - a psychological bias called loss aversion. The diagram shows a kinked curve where the negative side (losses) is steeper than the positive side (gains), meaning a £100 loss feels worse than a £100 gain feels good. This matters for understanding market failures because people's irrational behaviour can lead to suboptimal outcomes, particularly in environmental economics where future costs are undervalued. It helps explain why governments need intervention to correct these behavioural biases.

Key points

• The curve is kinked at the origin (reference point) showing how people evaluate gains and losses differently
• Loss aversion means the loss curve is approximately twice as steep as the gain curve
• People are risk-averse in gains (prefer certainty) but risk-seeking in losses (gamble to avoid definite loss)
• This creates market failures as people systematically undervalue future environmental costs
• Explains why carbon taxes are unpopular but carbon credits/subsidies are more acceptable - framing matters

Exam board notes

OCR places more emphasis on behavioural economics applications, while AQA focuses more on the policy implications. Edexcel and CIE treat prospect theory as supporting evidence for market failure rather than a central concept.