Since the Swiss mathematician Daniel Bernoulli developed in 1738 what is now called the utility theory, it has been the mainstream approach in economics for explaining how people make their choices. It supposes that the relationship between the psychological value or desirability of money (“utility”) and the actual value of money is based on rational calculation. The theory has hold up until today, although its foundation begins to show serious cracks, thanks to the work of Daniel Kahneman, Amos Tversky and others. It will need a thorough study to explain why utility theory could stand so long (and it still stands), but that’s another problem than what I want to treat here. Now I want to discuss what’s wrong with it. In doing so I base myself on the so-called prospect theory developed by Kahneman and Tversky and described by Kahneman in his book Thinking, Fast and Slow (see my last blog; all data here are from this book).
Last week I showed already that man is not a rational being but that he or she is often guided by emotions, feelings and intuitions. Actually I think that it’s often better so and that what is rational is not always what is right. Here I want to develop the theme yet a bit more.
Someone offers you a gamble on the toss of a coin. If the coin shows tails, you lose € 100,-, and if it shows heads you win € 150,-. Would you accept it? The expected value of the gamble is positive, for you can gain more than you can lose. Therefore a rational person in the sense of the utility theory would accept it and that’s also what your System 2 tells you to do. However, probably you’ll decline, since your System 1 doesn’t like it. Most people stick to what they have and are afraid to lose it. The psychological cost of losing is bigger than the psychological benefit of gaining. This brought Kahneman to rule one – as I call it – of the prospect theory: Losses loom larger than corresponding gains, or people are loss averse. Of course, if the possible gain is high enough, you’ll accept the gamble. According to Kahneman the gain must be about € 200,- or more in the example. However, in some cases you’ll never accept the gamble, for instance if it is about losing everything you have or gaining € 10 mln.
Now (1) you are given € 1000,- in addition to what you have plus you are asked to choose one of these options: 50% chance to win € 1000,- or getting € 500,- for sure. Or (2) you are given € 2000,- in addition to what you have plus you are asked to choose one of these options: 50% chance to lose € 1000,- or lose € 500,- for sure.
According to utility theory there is no difference between (1) and (2): Either you’ll be richer by € 1500,- or you accept a gamble with equal chances to be richer by € 1000,- or € 2000,-. Nevertheless, most people prefer the sure thing in case 1 and the gamble in case 2. This leads to rule two of the prospect theory: The reference point from which options are valued determines your preferences.
This is not pure theory but it works also in practice. For example, you got a job in another town and you are going to move and must sell your house. For a rational agent the price to ask for the house should be determined by the current market price for such houses. Nevertheless, you’ll ask more if the current market price is lower than what you paid for your house ten years ago. Moreover, you are less willing to lower your asking price in this case than in case what you paid ten years ago was below the current price: Your reference point determines what you ask and you are loss averse. Or another instance – a personal one: During several years car dealers put cards under the windscreen wipers of my old car proposing to buy it for a good price. From the point of utility theory it would have been rational to sell my car, but I didn’t, for I stick to what I have.
Traders behave more in agreement with the utility theory than casual sellers and buyers. In fact this is another argument against the utility theory, for it illustrates that its applicability is dependent on people’s attitudes towards value and money. Also experiments carried out in the USA and the UK gave different results (Kahneman gives an example). But who had ever thought that what is rational for me is also rational for you?Source: Especially chapters 25-27 in Kahneman's book (see last week).