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Behavioural Economics: Prospect Theory

One of the first topics in the Behavioural Economics course that I am teaching is Prospect Theory. Of critical importance to behavioural economists is the fact that people are frequently subject to cognitive illusions (errors in understanding reality based on how information is presented or framed and how our brain processes information) causing errors and biases in decision making. Moreover these events are typically not one-time occurrences: People fail to learn appropriately from their mistakes, which is a product of not abiding by conventional economics behaviour norms. Nobel Laureate Daniel Kahneman and Amos Tversky referred to this as errors and biases approach. Prospect theory was developed as descriptive theory of certain aspects of average decision-making behaviour. Conventional economics can’t describe, explain, or predict choice behaviour. Emotions are a key driver of a person’s behaviour. People have been shown to be loss averse, generally appearing to dislike losing something roughly twice as much as they like gaining it. Such a phenomenon has been shown in a number of experimental studies in a broad range of contexts. Loss aversion can be explained by prospect theory , which states that an individual’s value function (whether for money or otherwise) is concave for gains but convex for losses. In other words, people are more sensitive to losses compared to gains of similar magnitude.

Prospect theoryThis is illustrated in the graph. The reference point in the diagram is the current position of the individual concerned. Gains and losses are evaluated with reference to this neutral reference point. The value function takes an asymmetric S-shape because marginal value (or sensitivity) declines as absolute gains and losses increase in size. A dollar lost more than outweighs a dollar gained. In conventional economics, gains and losses are treated equally – a dollar lost simply cancels out a dollar gained.

Relative Income

Many people pay special attention to reference points when income or wealth increases or decreases. What counts isn’t total income or wealth but the relative changes in income and wealth – this is why the negative and positive dimensions of the value function are drawn from a reference point. In conventional economics, what people are most concerned about is the endpoint or total amount of income or wealth. But from the perspective of prospect theory, many people are happier if their income increase by 10% from a lower level of income than 2% from a much higher level of income. If my income goes up by 10% from $1,000 to $1,100, I’ll be happier than if my income goes up 2% from $10,000 to $10,200. Of course in conventional economics, your emotions don’t introduce concerns about reference points that may override your desire to increase your absolute level of income.

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