Prospect Theory: Loss Aversion in Negotiation

Lessons from Prospect Theory

Prospect theory (Kahneman & Tversky, 1979, 1984) deals with normatively suspect decisions and preference orderings that arise from the way people deal with potential gains versus losses. Its predictions are highly relevant to interpersonal and intergroup negotiation because changes in the status quo that represent a prospective gain to one side may represent a prospective loss to the other side. Furthermore, because “losses loom larger than gains,” parties should be reluctant to make agreements that require them to accept losses in order to achieve gains – especially under circumstances where the relevant losses are perceived as certain while the relevant gains are subject to uncertainty.

To our knowledge, no empirical research has examined loss aversion and unwillingness to trade (Kahneman, Knetsch, & Thaler, 1991) in the context of conflict and negotiation, but the unhappy scenario suggested by prospect theory is a familiar one to observers of interethnic or international conflict. In the Middle East, Northern Ireland, and other troubled parts of the world, longstanding adversaries remain deadlocked in a “hurting stalemate” (Pruitt, Rubin, & Kim, 1994), unwilling to risk a change in the status quo that seemingly would be mutually beneficial. In so doing, they fail to recognize that inaction, far from being a neutral or safe option, incurs not only the costs of deadlock, but also the risk of future deterioration in the situation. Perhaps even more importantly, the parties forfeit potential joint gains that could result from real peace and a truly cooperative relationship.

Although this scenario has not been explored in the laboratory, a study of actual tort case outcomes (Rachlinski, 1994) demonstrates that prospect theory axioms and utility functions can indeed be applied to consequential decisions made by sophisticated individuals engaged in conflict. The study revealed that plaintiffs, who face the prospect of gain – and thus should prefer certain outcomes that guarantee gain – proved to be “risk averse” (i.e., “settled” in cases in which their expected financial outcome would have been better if they had accepted the risks of trial). By contrast, defendants proved to be “loss averse” in that they opted to accept the risks of trial rather than accept a certain loss even when their expected outcome would have been better if they had agreed to the other side’s pretrial settlement offer.

Our contention again is twofold. First, we argue that reluctance to trade concessions, coupled with a willingness to take foolish risks in order to avoid certain losses and refusal to take sensible risks in order to achieve prospective gains, operate not only in the courtroom, but also in labor negotiations, trade disputes, and territorial and self-determination conflicts that rage throughout the world. Second, we argue that the adversaries in question are inclined to defend their own “prudence” even while making harsh attributions about their adversaries’ “intransigence.”