Re-evaluating prospect theory: A causal mediation approach to reference point, loss aversion, and diminishing sensitivity

Abstract

Prospect theory describes how objective gains and losses translate into subjective value. This theory uses a value function capturing loss aversion: losses feel more impactful than equivalent gains. However, the existing value function faces limitations. It inadequately reflects the role of contextual factors on human behavior and lacks ability to identify the causal mechanism underlying loss aversion. This paper proposes a new value function that addresses these shortcomings. It leverages causal mediation analysis to explicitly specify the relationship between objective and subjective values or among subjective values themselves. This approach enables researchers to examine how various situations (contextual variables) shape loss-averse and gain-seeking tendencies through established mediation techniques. Moreover, it applies to both monetary outcomes and non-monetary outcomes. Using this new framework, this paper re-examines the three core principles of prospect theory: reference point, loss aversion, and diminishing sensitivity. The re-analysis provides deeper insights on these properties from a causal perspective.