Prospect Theory

____________________________________________________________________________

anomaly: Anomalies are exceptions to standard expectations about events or behavior. In economics, the term anomaly increasingly refers to behavior not in accord with conventional economic theory. For example, people who habitually set their clocks or watches ahead a few minutes are exhibiting anomalous behavior, because economic analysis assumes that rational people never intentionally try to fool themselves.

prospect theory: Prospect theory is a collection of explanations for observed exceptions to standard economic assumptions: (a) that people’s preferences are orderly and conform to a general law of diminishing returns (strictly concave preferences, for those of a mathematical bent), and (b) that human behavior is “rational” in that choices can reasonably be expected to accomplish the decisionmaker’s goals.

________________________________________________________________________________________________________________________________________________

Prospect theory originated in the works of cognitive psychologists who dispute that decisions always conform to the conventional economic concept of “rational.” Standard economic theory [SET] is known as expected utility theory [EUT]. Economists conventionally assume that people behave in certain predictable ways: 1. Humans are self-interested and they seek pleasure and avoid pain. 2. Human beings make decisions that are consistent and rational. 3. Human beings are forward-looking and time consistent –choices at any moment are assumed consistent with choices people expect to make at future points in time. 4. Human beings tend to be somewhat risk averse. 5. Human beings must optimize because choices are bounded by limited resources. Behavioral economists describe human decisions as constrained by “bounded rationality, bounded self interest, and bounded willpower.”	Gains, Losses, and Utility
People may avoid losses because losses of hierarchical class, status, and power are especially hard to take psychologically. People tend to experience greater regret after making errors of commission than after experiencing errors of omission. This helps explain why the value function consistent with prospect theory, as shown in the top graph, generates the tendency for loss aversion shown in the bottom graph.	Following in the footsteps of Nobel Laureate Maurice Allais, Daniel Kahneman [Nobel 2002] and Amos Tversky found that most people are risk averse when considering potential gains, but risk loving (loss averse) when faced with a prospect of losses.
Example: Consider a choice of A or B, where A yields a 3/4 chance at +$6,000 and 1/4 chance at zero, while B yields a sure +$4,000. In surveys, the majority (roughly 80%) of respondents select B [the sure +$4000] instead of A [which has an expected value of +$4500]. This pattern reflects risk aversive behavior. Now change the expected gains into expected losses, and keep the same expected values. Suppose C now yields a certain loss of $4,000, while D entails a 75% chance of losing $18,000, and a 25% chance of losing nothing. Although the expectation of loss with choice D is – $4,500, roughly two-thirds of respondents choose option D as preferable to option A, with its certain loss of $4,000. The choice of option D reflects risk-seeking behavior. The lesson from this part of prospect theory may be that many people are far more willing to engage in risky behavior to avoid potential losses than they are willing to take risks to improve their positions. This pattern of paired choices is inconsistent with some standard economic assumptions about our preference functions.

Anomalies: Prospect theorists categorize inconsistencies with the assumption of rationality into problems of:

(a) framing – people sometimes make different choices when the same problem is presented in different ways. Example: If the grocery store cashier rings up “on sale” microwave dinners at $2 each regardless of whether the price is stated as “$2 each” or “2/$4” and if people buy more microwave dinners in even numbered lots (2, 4, 6, 8, …) when the price is stated as “2/$4,” then framing affects consumer decisions.

(b) nonlinear preferences – people may make choices that seem inconsistent with assumptions about preference functions. Consider transitivity. If A is preferred to B and B is preferred to C, then when people choose C over A, they are not behaving in accord with economic rationality.

(c) risk aversion and risk seeking – some individuals will simultaneously and knowingly take unfair bets to avoid risk (e.g., by buying life insurance) and unfair bets that increase risk (e.g., playing slot machines at casinos).

(d) source – the mechanism may matter even if the probable outcomes of activities are identical. People may pay more for a good because of the way it is packaged than they will an item that they know to be identical but packaged differently, even if they intend to immediately discard the packaging.

(e) loss aversion – potential losses loom greater than relatively equal potential gains. The observed asymmetry in these differences is far too large to be explained solely by income effects.

Other anomalies? Many prosperous people mow their own lawns to save roughly $25, or clean their own homes to save $80, but they would never consider mowing their neighbors’ lawns or cleaning their neighbors’ houses for comparable amounts. Why will most people not buy another ticket to an event if they lose a ticket they have already purchased? Why will fans frequently fail to scalp tickets to an event even if they are offered more than they would be willing to pay a scalper if they did not already have tickets? Why do so many financial investors hold onto a stock that has plummeted far more frequently than they keep a stock that has risen sharply, or that has maintained a steady price? [This list could be extended significantly with other examples of behavior inconsonant with standard economic theory.]

________________________________________________________________________________________________________________________________________________

Author: Ralph Byrns

Economics instructors and students are hereby granted provisional permission to use these materials for educational purposes only. Commercial use of any of these materials is forbidden. Withdrawal of this permission may be announced at this site without notice, and these materials may not be used thereafter without written permission.