Experiential Prophylaxis: Prospect Theory

15.12.2017

Episode #3 of the course How cognitive biases are messing up your decisions by Abasi Latcham

Consider this: Would you rather receive \$50, or receive \$100 and then lose \$50? Even though both options end up with +\$50, there is something vaguely off-putting about the second option, something you don’t like, something you want to avoid. Prospect theory is an attempt to explain this phenomenon.

What Is It?

Before discussing prospect theory, I need to introduce two concepts: loss aversion and diminishing marginal utility (“utility” means satisfaction from a good). Loss aversion is the notion that most people generally prefer to avoid a loss than receive an equivalent amount. Said another way, the pain of losing X (say, \$50) is greater than the benefit of gaining X (e.g. it’s better to not lose \$50 than to gain \$50). Diminishing marginal utility suggests that the first unit of a good (such as the first dollar gained) gives you the greatest utility, and the utility from each subsequent unit you receive diminishes. This explains why getting \$10,000 is not twice as good as getting \$5,000, or losing \$100 is not twice as bad as losing \$50.

Prospect theory applies loss aversion and diminishing utility to decisions where the outcomes are probabilistic. It suggests that when making a decision with multiple steps, we don’t consider the cumulative impact of each choice (i.e. +\$50) but consider each action in series (i.e. +\$100, -\$50), evaluate the emotional impact of each, and then sum the result. We don’t say, “Gaining \$50 gives me five units of happiness,” we say, “Gaining \$100 gives me nine units of happiness (because of diminishing utility), and losing \$50 takes away six units of happiness (because of loss aversion), so that would leave me with three units of happiness.” Obviously, this is a simplification, but you get the idea. It’s irrational.

Examples

Here are a few examples of prospect theory.

Tax brackets: People exhibit a reluctance to earn more money when it would push them into the next tax bracket, despite the fact they would earn more money overall. Perhaps the loss felt by the extra tax is muting the benefit that would be felt from the extra income.

The disposition effect: This is when people hold on to stocks that have lost value for too long or are too eager to sell stocks that have risen in value. It’s a problem because the desire to sell or buy is based on the purchase, but that shouldn’t be a consideration: If you think the stock will rise, keep it; if you think it will fall, sell it. Prospect theory and loss aversion make the purchase price a false consideration.

Taxi drivers: Studies suggest that New York taxi drivers use “daily income targets” to determine when to stop work each day. This leads to irrational behavior: On the busiest days, this target is reached quicker, which leads to them stopping work earlier, which doesn’t make sense from the point of view of traditional economics. “Prospect theory can explain this irrational behavior: Failing to achieve the daily income target feels like incurring a loss, so drivers put in longer hours to avoid it, and beating the target feels like a win, so once they have done that, there is less incentive to keep working.”

Vigilance

There is a concept called hedonic framing that can be used to counter prospect theory. It’s all about changing how you view the outcomes of the decision (and we will talk more about framing tomorrow). Follow these cues when you face a decision with a series of gains and losses, so you can take control of your tendency to act in accordance with prospect theory:

1. Combine the losses into one big loss (to take advantage of diminishing negative utility).

2. Separate the gains into individual, smaller wins (to prevent diminishing returns from taking away some of your benefits).

3. Merge smaller losses with larger gains (to offset loss aversion).

4. Consider small gains separately from larger losses (you’re happier to get a small gain than to reduce a large loss).

Tomorrow, we will look more at framing—in particular, how it can impact your decisions.

Rethinking thinking

Hedonic Framing

Recommended book

The Undoing Project by Michael Lewis

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