Wednesday, April 6, 2011

Prospect Theory

Once in a blue moon, it is possible to stumble upon a course at a liberal arts university that teaches lessons useful outside the realm of cocktail party conversations and philosophical debates (not that there's anything wrong with either). Below is a brief (and hopefully instructive) summary of one such example from a recent lecture on prospect theory in MGT 562 Behavioral Perspectives on Management.

(Feel free to skip to the end of the post for tips on how to maximize your utility without the background explanation.)

Prospect theory describes how people make choices in situations that involve risk based on subjective evaluations of potential gains and losses. Developed as an alternative model in 1979 by cognitive scientists Daniel Kahneman and Amos Tversky, prospect theory is descriptive rather than normative, i.e., it reflects real-life behavior. This stands in contrast to the traditional expected utility hypothesis, which presupposes the rationality of individuals with well-defined preferences acting optimally to maximize expected utility.

Prospect theory value function
Outcomes termed in gains (concave, risk-averse) and 
losses (convex, risk-seeking) from a reference point

According to prospect theory:
  • Gains and losses relative to a reference point
    • People are risk-seeking in the domain of losses and risk-averse in the domain of gains.
    • People are sensitive to even arbitrary reference points.
    • People spend gains faster than recovered losses.
    • People are highly sensitive to small stakes.
  • Diminishing sensitivity
    • Value function concave for gains, convex for losses.
  • Loss aversion
    • Disadvantages relative to a reference point are given greater weight than advantages relative to a reference point.
    • Negotiators overvalue what they give more than what they get.
    • Price increases often have a greater effect than price decreases.
  • Probability weighting
    • Tendency to overweight very small probabilities and underweight larger probabilities. 

As those of you with exposure to behavioral economics or applied psychology probably know already, prospect theory helps explain phenomena ranging from the framing effect to risk aversion. Prospect theory also accounts for human behavior that appears inconsistent with standard economic rationality, including the equity premium puzzle, status quo bias, gambling situations and the endowment effect. In short, the theory is nothing less than a descriptive model of human decision making that has transformed the study of modern economics and psychology (and it's no wonder that Kahneman received the Nobel Prize in Economics for this work.)

Rather than elaborating further on the nuances of the value function, I'll go ahead and list several actionable lessons that correspond to the principles above:
  • Actively shift contexts when deciding how much you value something because the way we subjectively frame an outcome or transaction affects expected utility.
  • Integrate losses and segregate gains. People show diminishing sensitivity to increased gains and losses, so it makes sense to lump losses, assuming they are unavoidable, to minimize negative value and to segregate gains to maximize positive value (within reason, of course). It really does seem to be the little things in life that matter, at least according to Kahneman and Tversky. (This is also part of the reason that rebates are effective—they can be seen as a separate gain rather than the reduction of a loss.)
  • When possible, give people certainty (and keep in mind that people are relatively insensitive to shifts in uncertain probabilities). Imagine you are compelled to play Russian roulette and can pay some amount to remove one bullet from the gun, which currently holds a total of six bullets. Would you pay more to reduce the number of bullets from four to three or from one to zero? There is a premium for certainty (appropriately termed the certainty effect). 

"But what is happiness except the simple harmony between a man and the life he leads?"
- Albert Camus