Prospect Theory


Developed by Daniel Kahneman and Amos Tversky in 1979, prospect theory centers around the premise that losses loom larger than gains.

In the diagram above, the slope of the graph is steeper in the “losses” region than in the “gains” region. What this suggests is that the disutility (or value) derived from a certain loss – say x – is greater than the utility derived from a gain equivalent to x. This is to say that psychologically, losing $10 brings us more unhappiness than gaining $10 brings us pleasure.

A second observation is that the steepness of the slope decreases as the curve moves further from the origin. This suggests that winning $1 million dollars will make you very happy, but winning $2 million dollars won’t make you twice as happy. In economics, we know this as the law of diminishing marginal utility.

A third observation is that the vertical axis is labeled the Reference Point. This reference point is arbitrary, and as we are about to find out, affects how we make decisions. Which option would you choose: (A) I give you $50, or (B) I flip a coin, and give you $100 if it comes up heads and nothing if it comes up tails? Professor David tried this out in lecture and found that most (me included) would go for option A. We are “risk averse” when deciding among potential gains.

Now suppose I ask this question: Would you rather (A) give me $50, or (B) flip a coin and give me $100 if it comes up heads and nothing if it comes up tails? David tried this out too, and found that most (me included) would now choose option B. This is a little strange: if we dislike risks, shouldn’t we choose certainty in both problems? Kahneman and Tversky point out that we are “risk seeking” when it comes to losses, simply because losses produce a feeling of negativity much more intense than the feelings of elation produced by a gain. In other words, losses hurt so much that we prefer taking risks to avoid losing anything at all. What does this mean for us when we make decisions?

How we make decisions is largely influenced by how the problem or question at hand is being framed. A question framed as a gain affects us differently than one framed as a loss. A study presented two questions:

Imagine that you are a physician working in a village, and six hundred people have come down with a life-threatening disease. Two possible treatments exist. If you choose treatment A, you will save exactly two hundred people. If you choose treatment B, there is a one-third chance that you will save six hundred people, and a two-thirds chance that you will save no one. Which do you choose, A or B?

The vast majority of respondents chose treatment A, i.e. they prefer saving a definite number of lives to the risk that they will save no one. Now consider:

You are a physician working in a village, and six hundred people have come down with a life-threatening disease. Two possible treatments exist. If you choose treatment C, exactly four hundred people will die. If you choose treatment D, there is a one-third chance that no one will die, and a two-thirds chance that everyone will die. Which do you choose, C or D?

Now the overwhelming majority of respondents chose treatment D. They would rather risk losing everyone than settle for the death of four hundred.

What’s going on here? The two questions are clearly the same – just phrased differently – why the difference in response? Prospect theory explains this: when the choice is framed as a gain, we are “risk averse”; when the choice is framed as a loss, we are “risk seeking”. Our perception is heavily influenced by the framing effect, and our ability to make decisions rationally can be impaired by a simple tweak in the presentation of a choice.

American psychologist Barry Schwartz writes:

People often talk jokingly about how “creative” accountants can make a corporate balance sheet look as good or as bad as they want it to look. Well, we are all creative accountants when it comes to keeping our own psychological balance sheet.

Creatively yours,

Tim

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