Prospect Theory

“Why do smart people make bad financial choices? Could it be that the very foundation of how we think about economics and decision-making is missing a crucial piece of the human puzzle?”

“Prospect Theory is a revolutionary idea in the world of economics. Think of it like a new lens for seeing how people make choices, especially when it comes to money and risk. For a long time, economists believed that people make decisions like super-smart computers, always choosing what’s best for them based on logic. But Prospect Theory showed us that’s not how it really works. People are more like quirky, unpredictable characters. They often prefer avoiding losses more than gaining rewards, even if both options are worth the same. It’s like being more upset about losing $10 than happy about finding $10. This theory opened our eyes to the real, sometimes messy ways we all decide what to do with our money and our lives.

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Throughout history, long before the formalization of behavioral economics, several philosophers hinted at the inherent irrationality in human behavior. Their insights, often expressed in more philosophical terms, laid the groundwork for our understanding of the complexities of human decision-making.

• Socrates (470-399 BC): Famous for his Socratic method, Socrates often exposed the inconsistencies in the thinking of his contemporaries. He believed in the importance of questioning and introspection, suggesting that people frequently act based on flawed understanding or unexamined beliefs.
• Aristotle (384-322 BC): While Aristotle believed in the rational potential of humans, he also acknowledged that people do not always act according to reason. In his Nicomachean Ethics, he discussed how passions and desires could lead to irrational actions, diverging from the ideal of the ‘rational man’.
• Plato (428-348 BC): Plato, a student of Socrates, recognized the conflict between reason and desire. In his famous work ‘The Republic’, he describes the human soul as having different parts – the rational, the spirited, and the appetitive, with irrationality arising when reason does not govern the other parts.
• St. Augustine (354-430 AD): He wrote extensively about the human will and its weaknesses. Augustine believed that humans often know what is right but fail to act accordingly, swayed by their desires and emotions.
• David Hume (1711-1776): A key figure in the Scottish Enlightenment, Hume argued that reason is often the slave of the passions. He believed that emotional responses, rather than rational deliberation, primarily drive human behavior.
• Friedrich Nietzsche (1844-1900): Nietzsche often criticized the notion of human rationality. He suggested that irrational drives and desires deeply influence human actions and that society’s emphasis on rationality overlooks the fundamental aspects of human nature.

These philosophers, each in their own era and style, touched upon the nuances of human behavior that go beyond cold, calculated rationality. Their work presaged modern understandings of behavioral economics, illustrating that the undercurrents of irrationality in human decision-making have been a subject of intrigue and study for millennia.

“Classical economics is like the old-school way of thinking about money and markets. It started way back in the 18th century with big thinkers like Adam Smith, who’s often called the father of economics. These guys believed in the ‘rational actor model.’ It’s a fancy way of saying they thought people made money decisions like perfectly logical robots, always picking the best option for themselves.

This idea was super important. It was like the golden rule for understanding how businesses work, how people buy and sell stuff, and even how whole economies run. Economists used this model to predict everything from stock market trends to how prices change in the supermarket. It was like a map that everyone followed, thinking it would lead them to treasure every time.

So, the rational actor model was a big deal. It shaped how banks lent money, how companies planned their future, and even how governments made laws about taxes and spending. It was all about believing that people, given all the facts, would always make the smartest choice for their wallets.”

“Let’s zoom in on Adam Smith, a superstar of classical economics. Picture him as a rockstar economist of the 18th century. He wrote this famous book, ‘The Wealth of Nations,’ which is like the Bible of economics. Smith had this cool idea called the ‘invisible hand.’ He believed that when people make money decisions for their own good, like a baker baking more bread to earn more, it magically helps everyone else too. It’s like when you’re doing your thing, chasing your own goals, you’re also making the whole economy better without even trying.

Smith thought people were naturally good at figuring out what’s best for them. He saw folks as smart shoppers, always hunting for the best deal or the biggest profit. In his view, it was like everyone had a little calculator in their head, always crunching numbers to make the smartest choice.

Then there’s another key figure, John Stuart Mill. He was like a rockstar’s opening act in the world of classical economics. Mill also thought people were super rational, like mini-economists making decisions that make the most sense for their wallets.

These guys set the stage for how we thought about economics for centuries. They painted a picture of a world where everyone is making decisions like a chess grandmaster, thinking five moves ahead. It was a neat and tidy world – a bit too neat, as we’d find out later with the rise of behavioral economics.”

“Fast forward to the 20th century, and things in the world of economics started to get a bit wobbly. It’s like we were all cruising along in a classic car, thinking we knew the way, and suddenly, we’re hitting some unexpected bumps in the road. The rational actor model, our trusty old map, wasn’t fitting the real world as neatly as before.

People started noticing odd things. Like, why do shoppers freak out over a small price increase but don’t bat an eye at spending big on something they don’t need? Or why do investors panic and sell their stocks when prices drop, even though that’s the perfect time to buy? It was like watching someone trying to put together a puzzle but the pieces just don’t fit.

This was the time when economists started scratching their heads. They began to see that people aren’t always these perfectly logical, profit-maximizing robots. Instead, they’re more like regular folks at a buffet, sometimes taking too much, sometimes too little, and often just piling up their plates without a clear plan.

It was a bit of a ‘wait a minute’ moment in economics. Scholars and thinkers started to question the old rules. They began to think maybe, just maybe, there’s more to this whole decision-making thing than cold, hard logic. And that’s where the stage was set for a new chapter in economics – one where our messy, unpredictable human nature gets a starring role.”

3. The Rise of Behavioral Economics (2 minutes)

“Enter two unlikely heroes in the world of economics: Daniel Kahneman and Amos Tversky. These guys weren’t your typical economists. In fact, they were psychologists! Imagine them as the dynamic duo, ready to shake things up.

Kahneman, with his sharp insights into the human mind, and Tversky, a master of understanding how we think and why we err, were like detectives of the mind. They were curious about why people don’t always make the smartest choices, even when it comes to important stuff like money.

They started hanging out, bouncing ideas off each other, and pretty soon, they began uncovering some mind-blowing stuff about decision-making. These guys were like the Sherlock and Watson of psychology, digging into the mysteries of the human brain.

Kahneman and Tversky didn’t just stay in their lab, though. They took their show on the road, challenging the big economic theories of the day. They were asking bold questions like, ‘What if people aren’t as rational as economists think?’ and ‘What if our brains have a few tricks that even we don’t know about?’

Their work was like a breath of fresh air, or maybe a whirlwind, in the somewhat stuffy room of traditional economics. They were about to turn the whole field on its head, showing that when it comes to money, logic isn’t always in the driver’s seat.”

“Daniel Kahneman and Amos Tversky weren’t born with economics textbooks in their hands. Far from it. Kahneman grew up fascinated by the quirks and kinks of the human mind. He was like a detective of psychology, always curious about why we think the way we do. His life, shaped by his experiences as a Jewish child in Nazi-occupied Europe and later in Israel, gave him a unique perspective on human behavior under stress and uncertainty.

Tversky, on the other hand, was the math whiz of the pair. Born in Israel, he had a knack for numbers and a sharp mind that could cut through complex problems like a hot knife through butter. He served in the Israeli military, and his experiences there, seeing decisions made under pressure, got him thinking about judgment and decision-making.

What brought them together was this shared fascination with the mysteries of the human mind. They met in Israel in the 1960s, and it was like a meeting of the minds that was meant to be. Their conversations were a blend of psychology, mathematics, and sheer curiosity.

Their path to challenging traditional economic theories was a bit like a detective story. They noticed that the models economists used didn’t always match how people behaved in real life. Like, why would someone buy lottery tickets, when the odds of winning were so low? Or why do people stick with losing stocks, hoping they’ll bounce back, instead of cutting their losses?

Kahneman and Tversky saw that people’s decisions were often swayed by fears, hopes, and other emotions, not just cold, hard logic. They started to weave together psychology and economics, crafting experiments that revealed the hidden, often irrational, forces driving our choices.

Their journey was like a trek into uncharted territory, combining the rigor of economics with the insights of psychology to uncover the real story behind why we make the choices we do.”

“Kahneman and Tversky turned into sort of mad scientists of economics and psychology, cooking up experiments that would reveal the odd ways our brains work. Their experiments were like cleverly designed traps, catching our irrational behaviors red-handed.

One famous experiment involved asking people to make choices between sure things and gambles. Imagine this: They’d ask if you’d prefer a guaranteed $100 or a 50% chance to win $200. Most people played it safe, taking the sure $100. But then, they flipped the script. They asked if you’d rather lose $100 for sure or have a 50% chance to lose $200. Suddenly, people became risk-takers, preferring to gamble to avoid a sure loss. This showed something wild: we hate losing more than we love winning. It’s like our brains are wired to feel the sting of loss way stronger than the joy of gain.

Another experiment involved how we perceive gains and losses. They found that if you win $100, you’re happy, but if you win another $100, you’re not twice as happy. The thrill sort of wears off. But with losses, it’s a different story. Losing $100 hurts, but losing another $100 hurts just as much, maybe even more. Our brains don’t get used to losses like they do with wins.

These experiments and many others showed that our decision-making is full of quirks. We’re not the cool, calculated decision-makers economics thought we were. Instead, we’re more like emotional creatures, with a bunch of biases and blind spots. Kahneman and Tversky called this ‘systematic irrationality’ – it’s like our brains are following a hidden, wonky rulebook that even we don’t fully understand.

Their findings were like puzzle pieces falling into place, showing a picture of human behavior that was much more complex and, honestly, a lot more interesting than the old models of perfect rationality.”

4. Prospect Theory Explained (3 minutes)

“Prospect Theory is like the secret recipe behind why we make the choices we do, especially when it comes to risky decisions. Here are its key ingredients, served up in plain language:

• Loss Aversion: This is the big one. It’s like we have a built-in alarm system that hates losing. People usually prefer avoiding losses more than acquiring equivalent gains. Think of it like this: losing $50 feels a lot worse than finding $50 feels good. Our brains are wired to be more upset about a loss than happy about a win of the same size.
• Reference Points: Our decisions depend a lot on where we’re standing. Kahneman and Tversky showed that we don’t just think about gains or losses in the abstract. We compare them to our current situation, or a ‘reference point.’ It’s like if you’re used to a certain salary, a small raise feels different than if you were earning less to start with.
• Diminishing Sensitivity: This part is about how we feel changes in value. It’s like when you first eat a piece of chocolate, it tastes great. But each extra piece feels less and less exciting. The same goes for money. Winning $100 feels awesome if you have $0, but if you already have $1,000, another $100 doesn’t hit the same way. And similarly, the more you lose, the less painful additional losses feel.
• Overweighting of Small Probabilities: We often overestimate the chances of unlikely events. This is why lotteries are so popular. The chance of winning is tiny, but our brains pump it up like it’s a sure thing. It’s like seeing a tiny spider and reacting as if it’s a giant tarantula.

Put these ingredients together, and you’ve got Prospect Theory in a nutshell. It’s a theory that shows our choices are less about the actual gains or losses and more about how we perceive those gains or losses. It’s like looking through a pair of glasses that slightly distort how we see the world of risks and rewards.”

“Let’s make these concepts from Prospect Theory super relatable with some everyday examples:

• Loss Aversion: Imagine you’re at a store, and there’s a sale on your favorite chocolate. Normally it’s $5, but today it’s $4. You’re happy about the $1 saved. Now, picture another day, you find out the same chocolate has gone up from $5 to $6. That extra $1 feels like a big deal, much worse than saving $1 felt good. This is loss aversion – we’re more sensitive to losing something than gaining the same amount.
• Reference Dependence: Think about your internet speed at home. If you’ve always had slow internet and it gets a slight boost, you’re thrilled. But if you’re used to super-fast internet and it slows down just a bit, it feels unbearable. Your current situation – slow or fast internet – is your reference point. How you perceive the change in speed depends on what you’re used to.
• Diminishing Sensitivity: Let’s say you find $20 on the street. You’re super excited. Now, imagine you find another $20 the next day. You’re happy, but the thrill is a bit less than the first time. If this keeps happening, by the fifth or sixth time, finding $20 is still nice, but it doesn’t give you the same rush. Each additional $20 has less impact on your happiness. This diminishing sensitivity means that as gains (or losses) grow, each additional unit has a smaller emotional impact.”

These examples show how Prospect Theory plays out in real life, influencing the way we feel about gains, losses, and changes in our circumstances.

“Prospect Theory and traditional utility theory are like two different maps for navigating the world of decision-making. Let’s compare and contrast them using our everyday examples:

• Loss Aversion (Prospect Theory) vs. Symmetrical View of Gains and Losses (Utility Theory):
  • In Prospect Theory: Remember the chocolate price example? Losing $1 feels worse than gaining $1 feels good. This is loss aversion.
  • In Utility Theory: It would say that gaining or losing $1 should have the same emotional impact. It sees gains and losses symmetrically – losing $1 should upset you as much as finding $1 makes you happy.
• Reference Dependence (Prospect Theory) vs. Absolute Value (Utility Theory):
  • In Prospect Theory: Think about the internet speed scenario. Your happiness or frustration depends on what you’re used to (your reference point).
  • In Utility Theory: It would look at the change in internet speed in absolute terms, without considering your starting point. A 10 Mbps increase is the same whether you’re going from 20 to 30 Mbps or from 100 to 110 Mbps.
• Diminishing Sensitivity (Prospect Theory) vs. Constant Marginal Utility (Utility Theory):
  • In Prospect Theory: Like finding $20 repeatedly, each additional $20 excites you less and less. This is diminishing sensitivity.
  • In Utility Theory: It assumes that each additional $20 should give you the same level of happiness or utility. If one $20 makes you happy, the second should make you just as happy, and so on.

In summary, traditional utility theory views decision-making as a logical, consistent process based on the absolute value of gains and losses. Prospect Theory, on the other hand, reveals that our decision-making is often illogical, influenced by how we perceive gains and losses relative to our current situation and past experiences. It shows that we’re not just emotionless calculators – we’re humans with all our quirks and biases.”

5. Implications and Applications (2 minutes)

Prospect Theory has been like a whirlwind through the fields of economics and finance, flipping tables and opening curtains. Here’s how it’s changed things:

• In the old days, finance gurus believed markets were super rational. Everyone was making perfectly logical choices, right? Wrong. Prospect Theory showed that investors often make decisions based on fear of losses or overexcitement about potential gains. This explains why stock markets can swing wildly. People aren’t just looking at numbers; they’re riding a rollercoaster of emotions.
• Marketers and retailers caught on quickly. They realized that pricing, discounts, and sales strategies could play into our fear of loss or our skewed perception of value. Ever seen a ‘limited time offer’ and felt the urge to buy now or regret it forever? That’s loss aversion at work, a key concept from Prospect Theory.
• This is a whole new branch of finance that grew out of Prospect Theory. It looks at how psychology impacts financial decision-making. It’s like a detective figuring out why people make seemingly irrational financial choices, and it’s all thanks to Kahneman and Tversky’s insights.
• Governments and policymakers started scratching their heads too. They realized that for policies to be effective, they needed to consider how real people behave, not just how economic models say they should. This means designing taxes, retirement plans, and even health policies in a way that aligns with how people actually think and make decisions.
• Understanding how people perceive risk and loss has been a game changer for insurance companies. They now get why someone might overpay for insurance to avoid a small chance of a big loss – it’s all about loss aversion and fear of disaster.

In short, Prospect Theory has shaken up the old, rational models and replaced them with a more human, more real understanding of economics and finance. It’s like we’ve gone from believing everyone’s a Spock from Star Trek, all logic and no emotion, to realizing we’re more like Homer Simpson, sometimes wise, often not, but always very human.”

“Prospect Theory’s impact was so huge that it even led to a Nobel Prize. In 2002, Daniel Kahneman, one half of our dynamic duo, was awarded the Nobel Prize in Economic Sciences. This wasn’t just any award. It was like the Oscars for brainy economists, a big deal in a world where being smart and right gets you the gold.

This Nobel Prize was a massive nod to the importance of Kahneman and Tversky’s work (sadly, Amos Tversky had already passed away by then and Nobel Prizes aren’t awarded posthumously). It was an acknowledgment from the highest level that, hey, these psychology guys really were onto something big.

The award was like a seal of approval on Prospect Theory, confirming that understanding the quirky, sometimes irrational ways people make decisions is crucial in economics. It was a testament to how their ideas had transformed thinking in not just economics, but also in finance, business, policy-making, and beyond.

Kahneman’s Nobel Prize was a milestone moment, marking the official arrival of behavioral economics on the world stage. It was a celebration of the idea that to get economics right, you need to get the human mind right – with all its flaws and wonders.”

“As we wrap up this journey through the twists and turns of Prospect Theory, here’s a final thought to chew on: What if understanding our own quirky, often irrational tendencies could be the key to making better decisions?

It’s a bit like having a map that shows where the potholes and detours are in your own thinking. By being aware of how loss aversion, reference dependence, and diminishing sensitivity shape our choices, we might navigate life’s financial decisions with a bit more wisdom.

Imagine you’re about to make a big purchase or a major investment. Knowing that your brain might overreact to the fear of loss or get overly excited by a small chance of a big win could help you pause, take a breath, and maybe choose a path that’s a bit more reasoned.

So, perhaps the real treasure that Kahneman and Tversky uncovered isn’t just a theory, but a mirror – showing us not just how we do make decisions, but how we might make them better. What do you think – could understanding our own irrationality be the first step towards making smarter choices?”