Category: ECONOMICS AND FINANCE

While preparing economic models, one common assumption made by economists is that of rationality,i.e., people are rational decision makers. By making this assumption, we establish that people make decisions by taking into account the various alternatives present before them, doing a cost-benefit analysis and arriving at decisions that maximize their utility.
However, this general conception changed in 1979 when psychologists Daniel Kahneman and Amos Tversky entered the scene. They proposed a theory which suggested that people are not efficient decision makers and that they often make errors in weighing the costs and benefits of the different alternatives. This theory came to be known as the “Prospect Theory”. It describes how people compare options and make choices (which are, many a times, influenced by their own biases). According to the theory, people make errors because they are misguided by their biases, particularly, when it comes to potential losses.

Kahneman and Tversky conducted an experiment to give us a convincing demonstration of this theory. In this experiment, they created two scenarios with two options each for their participants –

Scene 1

A)  100% chance of winning $3000.

B) 80% chance of winning $4000 and 20% chance of gaining nothing.

Scene 2

A) 100% chance of losing $3000.

B) 80% chance of losing $4000 and 20% chance of losing nothing.

According to our traditional economics, the participants, being ‘rational’ should have opted for option B in scene 1 (where the benefits are more ,$4000) while going with option A in scene 2 (where costs are less ,$3000). However the case was different. In scene 1, participants decided to opt for option A, being very cautious about their assured gain of $3000 and in the process even forgoing a potential gain of additional $1000 from option B. However, in scene 2, the same cautious participants decided to gamble with their luck and opted for option B. In this case they were ready to undertake the risk of losing $4000 since there was a 20% chance of losing nothing.

This simple experiment artfully exposed three flaws in human rationality-

A) If given a choice, people would prefer avoiding fixed economic losses for acquiring gains even though the chances of losing are minuscule.

B) While making decisions, people often disregard the common elements of different alternatives and focus only on what differs. This is done in an attempt to simplify the decision-making process by reducing our cognitive load (although it may lead to miscalculations/wrong decision making). This is also known as the isolation effect. In the above experiment, note, that the face values are the same, so the participant’s gain or loss is equal in numeric value. Hence, logically, the satisfaction derived from a gain of $3000 should be equal to the dissatisfaction from a loss of $3000 (in absolute terms). However this is not the case as mentioned next.

C) Losses are (psychologically) more painful than gains (even when the absolute value is same). As a result, people would go to a greater extent (e.g. taking more risks) to avoid losses than to receive gain. People refused to opt for a gain of winning $4000 as it accompanied a 20% chance of winning nothing. However they gladly accepted the option of undertaking a risk of $4000 loss since there was 20% of avoiding any loss.

Prospect theory helps us to understand a few puzzling decisions that are taking place around. For instance, it helps to explain why people take out insurance policies. The basic idea is that you pay a regular, fixed premium to an insurance company in hopes that if, one day, something goes wrong, you have a plan B to fall back upon. In this case, the insured has no way of predicting the future so he is willing to gamble and pay a fixed amount. Just like the participants of Kahneman and Tversky’s, the insured are taking a risk when faced by the chances for suffering financial losses: they are willing to pay a small and definite amount so that in case of an unexpected event, they are protected from an indefinite financial burden. This highlights the people’s aversion to losses; the fear of loss forces people to take risks in hopes of reducing their chances of facing losses.

It even helps to explain the thought processing that goes into making investing decisions. The traditional (rational) economic person would invest in companies by seeing the rate of return it yields. Hee/she would invest in companies which yield higher profits as opposed to the ones which yield moderate profit. In this case, the person has ignored an important element of time period to make his decision making simple. The person does not take into consideration whether the company has been consistent in its profits or not. A few years of high profits of a company does not correlate with its credibility; it might be just a short-run phenomenon. On the other hand, a company making moderate yet consistent profits is more trustworthy and credibility.

At the end, it’s safe to say that prospect theory is indeed an important theory of behavioural economics, which is an emerging school of thought. Prospect theory finds its application in diverse areas such as managerial decision-making, consumer behaviour, investing and marketing only to name a few.

By Arushi Sharma