How does your valuing relate with actual value? – Chapter 25

Economics and psychologist have very different views of people. The first think of them as rational and selfish beings. The latter argue that people are neither completely rational nor selfish. Kahneman and Amos studied the attitudes of people to risky options in order the answer the question “What rules govern choices between different simple gambles and between sure things and gambles?”

A simple gamble is for instance “45% chance to win € 500”. Gamble: the consequences of the choice are always uncertain. Choices between simple gambles provide a model that shares main features with more complex decisions. The ‘expected utility theory’ was the basis of the rational-agent model and still is the most important theory in the social sciences.

Consider the following simple decision problem. Which do you prefer? 

1. Toss a coin. Heads: you win € 105. Tails: you win nothing.

2. Get € 50 for sure.

The intuitive choice of most people would be the second option. The study of Kahneman and Amos resulted into the ‘prospect theory’, a descriptive model that was constructed to explain systematic violations of the axioms of rationality in choices between gambles. Their article about the theory is one of the most cited in their field. A few years later they published an essay about framing effects: the significant changes of preferences that are sometimes caused by inconsequential variants in the way a choice problem is worded.

Daniel Bernoulli introduced a theory about the relationship between the psychological desirability or value of money (now: utility) and the actual amount of money. According to Bernoulli, a gift of 10 euros has the same value to someone who already has 100 euros as a gift of 20 euros to someone who already has 200 euros. This is true, as we also define a change in income as an percentage. A 20% raise evokes a similar psychological response for the poor and for the rich, which a numeric amount would not do. Psychological responses to a change in wealth are proportional to the initial amount of wealth: utility is a logarithmic function of wealth. Bernoulli used this knowledge to introduce a new approach to the evaluation of gambles. He argued that the majority of people dislikes risk and wants to avoid the poorest outcome. People will choose the sure thing, even if it is less than expected value. His theory is that the psychological value of gambles is the average of the utilities of the outcomes, each weighted by its probability, and not the weighted average of the possible euros outcomes. The theory explains why poor people buy insurance and wealthy people sell it to them.

300 years later, his theory of risk attitudes and the preference for wealth is still being used in economic analysis. This is quite surprising, as it fairly flawed. This is illustrated by the following example:

• Today Molly and Mike each have a wealth of 6 million
• Yesterday, Molly had 2 million and Mike had 10 million.
• Do they have the same utility? (Or they equally content?)

According to the theory of Bernoulli, they are equally content, but this is obviously not the case: Mike is less content. Bernoulli’s model does not take reference points into account (2 million for Molly and 10 million for Mike). So how is it possible that the theory is still so popular? The explanation is ‘theory-induced blindness’. Once people have accepted a theory and used it in their thinking, it is extremely hard to notice the flaws. The theory gets the benefit of the doubt if your observation does not fit the model, because all the other experts use it. Disbelieving requires effort and System 2 is lazy.