Kahneman introduces the difference between the way in which economists and psychologists think about people. Economists think about people as rational, selfish, and unchanging. Psychologists think about people as neither fully rational, nor completely selfish, and as anything but stable. Behavioral economist Richard Thaler designates these ideas of people using the names Econs and Humans.
In this chapter, Kahneman lays the ground work for his introduction to prospect theory. Here he ties in some of his earlier ideas about human fallibility to show how psychologists’ ideas of people are vastly different from economists’ ideas of people.
After discovering this difference in the early 1970s, Tversky proposed to Kahneman that they study decision making to discover what rules govern people’s choices between simple gambles, and between gambles and sure things. The most popular theory that enumerates these rules is called expected utility theory. This theory is not based on psychology but instead on the logic of choice.
Although utility theory provides reasoning for many of people’s choices, because people themselves are not always rational and logical (often relying on intuition), a theory based largely on logic will also be imperfect, as Kahneman shows it to be.
Utility theory focused on the decisions of Econs, but Tversky and Kahneman wanted to investigate the intuitive decisions of Humans. Five years after studying gambles, they completed an essay on what they dubbed “prospect theory.” Prospect theory was closely modeled on utility theory but explained violations of rationality that people committed in choices between gambles. It became the most significant work they ever did.
Prospect theory, on the other hand, takes into account some of the ways in which people ignore logic in favor of their intuitive answers. These intuitions are based on their emotional reactions to the change in wealth that is presented to them.
In 1738, Swiss scientist Daniel Bernoulli investigated the relationship between the psychological value of money (its utility) and the actual amount of money. He argued that a gift of 10 ducats has the same utility to someone who has 100 ducats as a gift of 20 ducats has to someone with 200 ducats.
Utility theory takes into account the relationship between different choices, but it does not take into account the relationship between the choices and the current state of wealth (which is what prospect theory does).
Bernoulli disproved the assumptions of his day, which is that gambles are assessed by their expected value. The expected value of this gamble—80% to win $100 and 20% chance to win $10—is $82. But between this gamble and a guaranteed $80, most people will take the sure thing, even though the expected value of the gamble is more. Bernoulli observed that most people dislike risk and want to avoid the worst outcome. Thus, people’s choices are not based on dollar value, but on the psychological values of outcomes.
Bernoulli, like Kahneman and Tversky, discovered that people dislike risk and are generally risk averse when they want to avoid bad outcomes. But Kahneman and Tversky elaborated on this idea by demonstrating that people dislike losses more than they like gains, because they would rather maintain their current state of wealth.
Bernoulli created a table (shown on page 273) that calculated the utility of different amounts of money, taking into account the fact that people often prefer sure things to gambles. Consider this choice: a gamble in which you have equal chance to win 1 million or 7 million ducats, or a sure 4 million ducats. Using Bernoulli’s table, the expected utility of the first choice is 47, but 60 for the second—which is why most people prefer the second.
Bernouilli’s theory also explains why, in circumstances in which all of the outcomes are positive, people are often risk-averse and will chose sure things. The possibility of losing a sure thing weighs more heavily on people’s minds than the possibility of a larger gain.
Bernoulli’s essay explains why poor people buy insurance and why rich people sell it: the loss of 1 million ducats represents a greater decrease in utility for a poorer person than a richer one, and so poor people are willing to pay a premium in order to transfer the risk to the richer person.
Utility theory is also elaborated on by prospect theory: poor people feel the loss of 1 million ducats more tangibly because it represents a great change in wealth than for a rich person.
But Bernoulli’s theory has a major flaw. It assumes that the utility of one’s wealth is what makes people more or less happy. But it does not take into account their change in wealth. If yesterday Jack had 1 million and Jill had 9 million, and today they both have 4 million, they are not equally happy. Their recent change in wealth is more important to their experience than their state of wealth.
Prospect theory latches on to this major distinction: the reference point of a person when considering a gamble is crucial in evaluating how they feel about the outcomes, and therefore the choices they might make.
Another flaw in Bernoulli’s theory is found in this example: Anthony’s current wealth is 1 million. Betty’s wealth is 4 million. They are both offered a choice between a gamble a sure thing. The gamble: equal chances to end up owning 1 million or 4 million. The sure thing: own 2 million. To Bernoulli, they face the same choice: their expected wealth will be 2.5 million if they take the gamble and 2 million if they prefer the sure thing. This prediction, however, is incorrect. Anthony prefers the sure thing because his wealth will double with certainty. Betty prefers the gamble because she wants to avoid losing half her wealth with certainty and instead will take the risk to try to lose nothing.
This example illustrates one of the major findings of prospect theory, and a large theme in Kahneman’s book. We dislike losses more than gains. Thus, in this example, Anthony will give up the risk in order to certify a gain. Betty, on the other hand, wants to avoid the sure loss. As Kahneman points out, Bernoulli’s theory would make their choices the same, but their reference points are crucial in understanding the decisions they make. For Betty, it is more important to her to maintain her wealth.
Kahneman is fascinated with the idea that the theory survived for so long when there are such obvious counterexamples to be found. He calls it theory-induced blindness: once you have accepted a theory, it is difficult to notice its flaws.
As Kahneman explained in the earlier chapters, it is easier to find evidence to confirm a theory than it is to find examples that disprove it—a bias of System 1.