Both economists and the average citizen believe that we make decisions in a rational manner. Bernoulli, (1738/1954), presented the expected utility theory which stated that: “decision makers evaluate outcomes by the utility of wealth positions” (Kahneman, 2003, p. 704). In fact, people make decisions for a number of reasons, most of which are not objective. Kahneman & Tversky (2004), in disproving Bernoulli’s theory, have highlighted four aspects of the phenomenon they call prospect theory: 1) when making decisions people assess based on gains vs. losses; 2) humans experience “loss aversion”; 3) the role of framing in making decisions; and that 4) every decision is relative (Schwartz, personal communication, December 6, 2008).
First, prospect theory implies that choices are always made by considering gains and losses rather than final states. The value function shown in Kahneman’s article (2003) is defined based on gains and losses and has four features. I will discuss the first three aspects: a) concave in the domain of gains, favoring risk aversion; b) convex in the domain of losses favoring risk seeking; c) kinked at the reference point and loss averse – steeper for losses than for gains by a factor of about 2-2.5 (Kahneman, Knetsch, & Thaler, 1991; Tversky & Kahneman, 1992 as cited in Kahneman, 2003).
A gain of $100 gives us approximately 10 units of subjective satisfaction. Objectively, a gain of $200 would give us 20 units of satisfaction. But, in fact, as the gain increases the amount of additional satisfaction decreases. Objectively, even though the $200 gain should feel twice as good as the $100 gain it only feels approximately 1.7 times as good. In order to overcome “risk aversion,” one would have to be offered a $240 potential gain to feel as good as the $100 sure thing (Schwartz, 2004). This “law of diminishing utility” explains why we are risk averse in the domain of gains.
People are risk seeking with respect to potential losses when the gamble appears much more attractive than the sure loss. In one experiment participants were offered a $100 sure loss and a fifty-fifty chance to lose $200 or nothing. Prospect theory tells us that losing the first $100 feels worse than losing the second $100. Taking the risk to avoid losing anything feels better than the sure loss. Therefore, in a potential loss situation people are “risk seeking.” This “decreasing marginal disutility of losses” keeps you in a losing situation because each additional loss does not feel as bad (Schwartz, 2004).
In the second aspect of prospect theory, loss aversion results from the subjective feeling that losing $100 feels worse than gaining $100 feels good. In one study, a large group of students were randomly given either a mug or a nice pen roughly of the same value. Then all the participants were given an opportunity to trade gifts. Considering the random distribution, one might predict that about half the people in the group would have gotten the gift they preferred while the other half would be glad to trade. In fact, there were very few trades. Once something is given to you it becomes part of your endowment. Once endowed, by giving it up you entail a loss. And as prospect theory explains since losses are worse then gains are good your endowed mug or pen is worth more to you a potential trade.
Third, prospect theory is concerned with framing and short-term outcomes. It is always in terms of gains and losses rather than how much money people already have. “The carriers of utility are likely to be gains and losses rather than states of wealth and this suggestion is amply supported by the evidence of both experimental and observational studies of choice” (Kahneman, 2003, p. 704). Only when Kahneman’s experiment asked participants to consider their overall wealth before they decided on a bet did the outcomes change (2003).
And finally, every decision is relative. Prospect theory says that people always compare with what they have and where they came from. Preferences are reference dependent. There are four ways we compare our decisions: 1) past experiences; 2) aspirations; 3) possible alternatives; and 4) expectations (Schwartz, personal communication, December 6, 2008).
Prospect theory explains why most people are not objective in their decision making. They are risk adverse with respect to potential gains, risk seeking with respect to potential losses, influenced by framing devices, and have decisions that are reference dependent. Despite Bernoulli’s theory and the 300 years that followed, human are idiosyncratic in their decision making.
References
Kahneman, D. (2003). A Perspective on Judgment and Choice: Mapping bounded reality. American Psychologist, 55, 9: 697-720.
Schwartz, B. (2004). The Paradox of Choice: Why More is Less. Harpers Collins Publishers: New York.