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Prospect Theory in Behavioral Economics



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Somewhere between economics and psychology is the rapidly growing field known as behavioral decision theory, which studies how people make choices in life.  It analyzes empirical evidence of people’s actions and attempts to make sense of how they decide to do the things they do, rather than forming qualitative judgments about how people should act.  The two most prominent pioneers of behavioral economics, Daniel Kahneman and Amos Tversky, collaborated to develop and publish one of its touchstone concepts, known as “Prospect Theory”

From a variety of different perspectives, the theory explains attitudes toward gains, losses, and willingness to take risks.  Kahneman and Tvsersky published their original article in 1979 under the title “Prospect Theory:  An Analysis of Decision Under Risk” in the well-respected journal Econometrica, which at the time was considered the most discerning of academic peer reviews.  It is widely viewed as a transformative model in the union of psychology and economics that would subsequently contribute in profound ways to the growth and academic prestige of such subjects as heuristics and biases, as well as the myriad of topics related to game theory.

Prospect theory has at its core a few rather simple ideas that incisively analyze how people make decisions regarding money.  One of Prospect Theory’s primary underlying themes is the relativity in perceptions people have when evaluating monetary gains and losses.  People notice changes in values much more than they pay attention to the absolute figures at any particular point in time.  For instance, if a person earns annual compensation of $60,000 a year in a given career, then suddenly loses the job and is only able to find new employment for $30,000 annually, it will be far more noticeable than if this person was able to stay at the $60,000 pay level indefinitely.    It is the change in the amount actually received compared to the amount that was expected that effects the person’s evaluation of a gain or loss.  Had the $30,000 a year income been anticipated from the very beginning, the new career would be considered a success, or at least perceived with indifference.  This example illustrates the idea of a reference point, which is the first key concept in understanding Prospect Theory.

The second important idea in Prospect Theory is loss aversion, which involves the level of pain people feel when losing money compared to the thrill they sense when receiving it.  For example, a wealthy multimillionaire worth $100 million who loses half of it on a bad investment may suddenly feel poverty stricken,.  Meanwhile, another person that was really living in poverty and finds out he or she has won the lottery jackpot of $50 million will feel like the wealthiest person on earth.  Both people in his example share the same net worth of $50 million each, it is the divergent perceptions held by these people of a monetary loss or gain that accounts for their differing views.  This idea also contains a degree of relativism in the sense that if the circumstances and numbers are changed slightly, they help explain why gains and losses are not additive functions, but rather subjective in reference to averting losses.  An example of this would be if the multimillionaire stood a fifty percent chance of earning a $10 million profit, against the same odds of losing $50 million.  The gain of only $10 million, while not painful like losing $50 million, will not be nearly as fulfilling for the multimillionaire as it is for the person living in poverty who wins the same amount from the lottery.  In fact, most multimillionaires would be unwilling to enter into an investment where the potential reward is $10 million while risking a $50 million loss.  The quest to avert losses is a powerful predictor of human behavior, as Kahneman and Tversky observed.

The third major concept in Prospect Theory is known as the “certainty effect”. One of the original forces animating Kahneman and Tversky to research their initial inquiries into what later became Prospect Theory was an attempt to solve the riddle known as the Allais Paradox.  This riddle distinguishes between the emphatic ways people act when they understand the absolute certainty of an event as opposed to subtle difference in merely perceiving the likelihood of an event.  The riddle proves that to most people, even a 1 percent risk of failure or a 10 percent probability of success can change behavior.

The riddle resulted from a series of questions from the French economist and Nobel Prize recipient Maurice Allais to the University of Chicago economists Jimmie Savage and Milton Friedman.  Each question posed a choice between two alternatives to find out the preferred decision.  An example of the first question is whether it is preferable to take the absolute certainty of receiving $1 million, or an 89 percent chance of winning the $1 million accompanied with a 10 percent chance of winning $2.5 million and a 1 percent chance of walking away with nothing at all.  Most people would choose to take the $1 million with 100 percent certainty, rather than risk losing all of it by taking the second option.  The next question Allais posed was the choice between an 11 percent chance of winning $1 million, and a 10 percent chance of winning $2.5 million.  The answer to this seems straightforward, as most people would prefer the 10 percent chance of winning $2.5 million since the probabilities are so close, yet the rewards are so much higher with virtually the same risk of receiving nothing either way.  The third, and last, part of Allais’ riddle was a question asking whether it is preferred to have a combined 89 percent chance of winning a mystery prize with an 11 percent chance of winning $1 million; or if it is better to take a combination of an 89 percent chance of winning the mystery prize, a 10 percent chance of winning $2.5 million, and a 1 percent chance of receiving nothing.  The answer should be consistent with the other two, yet for most it is not, due to the role of risk and reward in evaluating the options.  This riddle, and its inconsistent answers, formed the basis of what came to be known in the economics profession as the Allais Paradox.

Through extensive research and statistical analysis of the results, Kahneman and Tversky devised a way of explaining the certainty effect and the Allais Paradox through Prospect Theory.  A simple way to illustrate their findings is by envisioning a two by two matrix that basically resembles a box with four quadrants within it.  The two rows are labeled gain and loss, while the two columns are labeled for likely events and unlikely events.  Proceeding from right-to-left, top-to-bottom, the first box signifies a scenario under which a gain is the likely outcome.  This box is labeled “risk-averse behavior”, as the certainty of a gain overwhelms the decision to take a risk and walk away empty-handed.  The old adages of “a bird in the hand is worth two in the bush”, and “take the money and run” apply to risk-averse behavior that is influenced by the sense of a sure thing.  The next box signifies “risk-seeking behavior”, and falls under gains being the unlikely event.  Risk-seeking behavior comes from a perception that the odds are against a gain anyway, so one might as well shoot for the stars.  It manifests itself in activities like buying lottery tickets or betting on a horse with the longest odds of winning.  The counterpart to this quadrant is the box that lines up below it as a loss being the unlikely event, which is also referred to as a “risk-averse behavior”, and can be found in actions such as people tending to purchase insurance against unlikely losses or improbable events causing a loss.  The final segment of the graph is when a loss is the likely outcome, and this creates the other “risk-seeking behavior” that is symbolic of a “go for broke” mentality when a person perceives that a loss is going to happen anyway and decides to take on greater risk because of a sense there is nothing to lose by adding the additional risk.

Prospect theory changed the relationship between economics and psychology by quantifying human actions related to risk, gains, and losses in ways economists could respect and understand.  In 2002, Daniel Kahneman received the Nobel Prize in Economics for his work developing Prospect Theory.  Tversky passed away in 1996, however Kahneman declared it was a joint award because of the collaborative partnership the two had while researching and publishing Prospect Theory.

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