While much of economics in the 1900s was dominated by the assumption of rational behaviour (this is known as expected utility theory), in 1979, Daniel Kahneman and Amos Tversky published a ground-breaking paper in the Econometrica journal that presented an alternative theory of behaviour known as prospect theory.
Similarly to expected utility theory, prospect theory is centred around human behaviour resulting from actions, risks and outcomes. It has four main concepts; certainty, loss aversion, relative positioning, and small probabilities.
This concept enumerates the following. If someone is presented with a set of options, they will tend to pick the option that has the most certainty, even if the potential return is lower. This is opposed to expected utility theory, which states that the option with the highest potential return (in other words, the expected utility) will be chosen regardless of the certainty.
For example, if John was presented with a choice between an option A with a 50% chance at winning 100 rupees and an option B with a 25% chance of winning 300 rupees, expected utility theory postulates that since the payoff of option B (75) is greater than the payoff of option A (50), John would always pick option B. But in reality, according to Kahneman and Tversky’s research, people tend to go toward option A rather than B as it seems more “certain” to them*.
2. Loss Aversion
When people are presented with an option with gains and losses, they tend to focus more on and attach more value to the losses. To illustrate this, if Bob earned 500 rupees from his business but lost 250 rupees, even though he made a net profit of 250 rupees, he would focus inordinately on the 250 rupees he lost. This loss aversion also occurs in the case of bets; for example, if Yash was presented with a coin flip in which he would gain 1000 rupees if he won but would lose 500 rupees if he lost, even though expected utility theory states that he would take the bet, in reality most people avoid taking this bet. Loss aversion becomes increasingly pronounced with larger sums of money.
3. Relative positioning
This phenomenon occurs because people tend to give more importance to relative gains or losses as opposed to final, absolute values. For example, if Rahul and Rohit are workers in the same office and Rahul gets a 5% raise, while Rohit gets a 10% raise, Rahul would feel bad; while if Rahul still gets a 5% raise and Rohit gets no raise at all, Rahul would feel better, despite the ultimate increase in his income being the same in both cases. This is called relative positioning.
4. Small probabilities
Finally, the last main phenomenon explained under prospect theory is that of small probabilities. This is a very simple concept that states that people tend to pay less attention to small probabilities (they discount small probabilities). Because of this oversight of small probabilities, people tend to pick higher-risk options because they have higher probabilities.
Prospect theory was a revolutionary idea in behavioural economics, spawning many ideas such as nudges and boosts that form important parts of today’s economics thinking. There are many criticism of this theory as well, however. I will hope to cover both these aspects in later articles.
1. Kahneman, Daniel, and Amos Tversky. “Prospect Theory: An Analysis of Decision under Risk.” Econometrica 47, no. 2 (1979): 263–91. Accessed July 10, 2021. doi:10.2307/1914185.
2. “Prospect Theory — Overview, Phases, And Features”. 2021. Corporate Finance Institute. Accessed July 13. https://corporatefinanceinstitute.com/resources/knowledge/other/prospect-theory/.
3. A Quick Read On Prospect Theory And Loss Aversion — Slidemodel. 2019. Image. https://cdn2.slidemodel.com/wp-content/uploads/loss-aversion.png.
* The numbers used here differ from those in the actual study by Kahneman; all numbers used here are only for illustration purposes