Prospect Theory: How People Make Decisions Under Risk and Uncertainty.

Prospect Theory: Why We’re All Irrational Idiots (and That’s Okay!)

(A Lecture on How People Make Decisions Under Risk and Uncertainty)

Alright, class, settle down, settle down! Today, we’re diving headfirst into the wonderfully weird world of Prospect Theory. Forget everything you thought you knew about rational decision-making (because, let’s be honest, most of us aren’t rational anyway). We’re talking about the psychological quirks, the biases, and the downright illogical choices we make every single day when faced with uncertainty. Think of this lecture as your guide to understanding why you sometimes choose the objectively worse option, and maybe even how to stop doing it (but probably not).

(👋 Welcome to Irrationality 101!)

(I. The Dismal Science of Decision-Making: A Critique of Expected Utility Theory)

For years, economists clung to the idea that humans were perfectly rational beings. They believed we all calculated expected values with the precision of a supercomputer, always choosing the option that maximized our overall utility. This sacred cow, known as Expected Utility Theory (EUT), suggested we’re all logical Spocks, calmly weighing pros and cons.

(👨‍🚀 Live long and… maximize utility?)

But here’s the thing: life isn’t a Vulcan logic puzzle. We’re emotional creatures, swayed by feelings, fears, and the way things are framed. Imagine offering someone a choice:

• Option A: A guaranteed gain of $50.
• Option B: A 50% chance of winning $100, and a 50% chance of winning nothing.

EUT would predict that most people would be indifferent, as both options have an expected value of $50. However, studies show that most people choose Option A. Why? Because we’re risk-averse when it comes to gains. We prefer the certainty of a smaller reward over the gamble of a potentially larger one.

Now, flip the script:

• Option C: A guaranteed loss of $50.
• Option D: A 50% chance of losing $100, and a 50% chance of losing nothing.

Again, EUT would predict indifference. But in this case, most people choose Option D! Why? Because we become risk-seeking when facing losses. We’re willing to gamble to avoid the certainty of a loss, even if it means potentially losing more.

(🤯 Mind Blown! I’m a walking contradiction!)

This is where Daniel Kahneman and Amos Tversky come in. These two brilliant (and hilarious, I imagine) psychologists noticed this discrepancy between EUT and reality. They challenged the core assumptions of rational choice theory and developed Prospect Theory, a descriptive model of how people actually make decisions under risk. They didn’t just say EUT was wrong; they explained why it was wrong and provided a much more accurate (and depressing) picture of our cognitive biases. Kahneman even won the Nobel Prize in Economics for his work (Tversky sadly passed away before).

(🏆 Nobel Prize for Proving We’re All a Bit Nuts!)

(II. The Building Blocks of Irrationality: Key Concepts of Prospect Theory)

Prospect Theory rests on a few core concepts that explain our irrationality. Let’s break them down:

• Reference Point: We don’t evaluate outcomes in absolute terms. Instead, we assess them relative to a reference point, usually our current state or a previously held expectation. This reference point acts as a neutral baseline. Gains are perceived as deviations above this point, and losses as deviations below it. Think of it like this: finding $100 on the street feels amazing (gain!), while losing $100 feels terrible (loss!). But the absolute value change is the same.

  (📍 Where’s my starting line?)

• Value Function: This is where things get interesting. Prospect Theory proposes that we have a value function that maps outcomes to subjective values. This function is not linear, like EUT assumes. Instead, it has the following key characteristics:

  • Concave for Gains: As mentioned earlier, we’re risk-averse when it comes to gains. The value function is concave in the gain domain, meaning the marginal utility of each additional dollar decreases as the total amount increases. Getting $100 feels great, getting $200 feels good, but getting $1,000,000 feels amazing – the feeling doesn’t increase linearly.

  • Convex for Losses: We’re risk-seeking when it comes to losses. The value function is convex in the loss domain, meaning the marginal disutility of each additional dollar decreases as the total amount increases. Losing $100 feels awful, losing $200 feels terrible, but losing $1,000,000… well, you’re already in the hole, what’s a little more?

  • Steeper for Losses: This is the kicker! The value function is steeper for losses than for gains. This means that the pain of losing $100 is psychologically much greater than the pleasure of gaining $100. This is known as loss aversion.

  (📉 The Pain of Losing Hurts More Than the Joy of Winning!)

  Here’s a visual representation of the value function:

  Value
  ^
  |     /
  |    /  Gains (Risk Averse)
  |   /
  |--/--------------------->
  | / Reference Point
  |/
  |
  |  Losses (Risk Seeking)
  | 
  |  
  v   

• Probability Weighting Function: We don’t perceive probabilities accurately either. We tend to overweight small probabilities and underweight large probabilities. Think about buying a lottery ticket. The odds of winning are astronomically low, yet people flock to buy them. This is because the allure of a potential jackpot looms larger than the reality of the slim chance of winning. Conversely, we often underestimate the probability of common events, like car accidents, leading to inadequate insurance coverage.

  (🎰 Lottery Tickets: Fueling Dreams on Overweighted Probabilities!)

  The probability weighting function looks something like this:

  Weighted
  Probability
  ^
  |     /
  |    /
  |   /
  |--/--------------------->
  | / Perfect Accuracy Line
  |/
  |
  |
  | 
  |  
  v   

  As you can see, small probabilities are weighted more heavily than they should be, and large probabilities are weighted less heavily.

(III. Putting It All Together: The Power of Framing)

Prospect Theory isn’t just about the value function and probability weighting. It’s about how these factors interact to influence our decisions, particularly through the power of framing. Framing refers to how a choice is presented, and it can dramatically alter our preferences.

Consider this classic example:

Imagine a disease outbreak is expected to kill 600 people. Two programs to combat the disease have been proposed:

• Frame 1 (Positive Framing):

  • Program A: 200 people will be saved.
  • Program B: There is a 1/3 probability that 600 people will be saved, and a 2/3 probability that no people will be saved.

  Most people choose Program A. They prefer the certainty of saving 200 lives over the risk of saving more or none.

• Frame 2 (Negative Framing):

  • Program C: 400 people will die.
  • Program D: There is a 1/3 probability that nobody will die, and a 2/3 probability that 600 people will die.

  Most people choose Program D! Even though Programs C and D are mathematically identical to Programs A and B, respectively, the way they’re framed changes our perception. In the negative frame, we become risk-seeking to avoid the certain loss of 400 lives.

(🎭 Framing: The Art of Manipulating Your Mind!)

This highlights the crucial role of the reference point. In the positive frame, the reference point is "no one is saved," so saving lives is a gain. In the negative frame, the reference point is "everyone dies," so preventing deaths is a gain.

(IV. Key Biases Explained by Prospect Theory: Your Irrationality Cheat Sheet)

Prospect Theory helps explain a host of common biases that plague our decision-making:

• Loss Aversion: We’ve already talked about this one, but it’s worth emphasizing. The pain of a loss is roughly twice as strong as the pleasure of an equivalent gain. This explains why we’re so reluctant to sell losing investments (the sunk cost fallacy) or why we haggle fiercely over small amounts.

  (😭 Holding on to Losers: The Sunk Cost Fallacy in Action!)

• The Endowment Effect: We tend to value things we own more highly than things we don’t own, even if there’s no objective reason to do so. Imagine you’re given a coffee mug. You’re then asked how much you’d be willing to sell it for. People typically demand a much higher price than they would have been willing to pay for the same mug if they didn’t already own it.

  (☕️ My Precious Mug! I’ll Never Sell It (Unless You Pay Me A Fortune)!)

• The Status Quo Bias: We prefer things to stay the same. We’re more likely to stick with our current choices, even if there are better alternatives available. This is partly driven by loss aversion. Switching to a new option involves the potential for losses (e.g., the hassle of learning something new), while staying with the status quo feels like avoiding a loss.

  (😴 Comfort Zone: The Enemy of Progress!)

• The Peak-End Rule: We judge experiences based on their peak intensity (the most intense moment) and their ending, rather than the average level of pleasure or pain throughout the experience. This explains why a painful medical procedure that ends on a slightly less painful note might be remembered more favorably than a less painful procedure that ends abruptly.

  (🎢 Rollercoaster of Emotions: It’s All About the Peak and the End!)

• Mental Accounting: We tend to compartmentalize our money into different "mental accounts," and we treat money differently depending on which account it’s in. For example, we might be more willing to spend "found money" (like a tax refund) on frivolous purchases than we would be to spend money from our regular income.

  (💸 Mental Piggy Banks: Where We Stash Our Irrationality!)

(V. Implications and Applications: Prospect Theory in the Real World)

Prospect Theory isn’t just an academic exercise. It has profound implications for a wide range of fields:

• Finance: Understanding loss aversion can help investors avoid panic selling during market downturns. Recognizing the endowment effect can prevent us from overvaluing our existing portfolios.

  (📈 Investing with Your Head (and Not Your Gut)!)

• Marketing: Framing products as avoiding a loss (e.g., "Protect your family with our security system") can be more effective than framing them as providing a gain (e.g., "Enhance your home with our security system").

  (📣 Selling Fear: The Marketer’s Secret Weapon!)

• Negotiation: Understanding your opponent’s reference point and framing your offers accordingly can give you a significant advantage.

  (🤝 Mastering the Art of the Deal (by Understanding Irrationality)!)

• Healthcare: Presenting medical treatments in terms of survival rates (positive framing) rather than mortality rates (negative framing) can encourage patients to undergo necessary procedures.

  (🩺 Doctors: Framing the Odds in Your Favor!)

• Public Policy: Designing policies that minimize perceived losses and maximize perceived gains can increase public support and compliance.

  (🏛️ Nudging Us Towards a Better Society (by Understanding Our Biases)!)

(VI. Limitations and Criticisms: Even Irrationality Has Its Limits)

While Prospect Theory is a powerful tool, it’s not without its limitations:

• Context Dependence: The specific parameters of the value function and probability weighting function can vary depending on the context and individual differences.

• Emotional Influences: Prospect Theory doesn’t fully account for the role of emotions beyond risk aversion. Factors like regret, disappointment, and envy can also influence our decisions.

• Cognitive Effort: Calculating the subjective values and weighted probabilities required by Prospect Theory can be cognitively demanding. In many situations, we may rely on simpler heuristics and rules of thumb.

• Descriptive, Not Prescriptive: Prospect Theory describes how people actually make decisions, but it doesn’t necessarily tell us how we should make decisions.

(🚧 Caveats and Considerations: Prospect Theory Isn’t a Perfect Science!)

(VII. Conclusion: Embracing Our Irrationality (and Maybe Making Slightly Better Choices)

Prospect Theory is a humbling reminder that we’re not the perfectly rational beings we like to believe we are. Our decisions are shaped by emotions, biases, and the way information is presented to us. By understanding these quirks, we can become more aware of our own irrational tendencies and make slightly better choices (emphasis on "slightly").

(🤓 Knowledge is Power (Even if It’s the Power to Understand Your Own Stupidity!)

So, go forth and embrace your irrationality! Just try not to lose too much money on lottery tickets or panic sell your stocks during the next market crash. And remember, even if you do, you’re not alone. We’re all in this irrational mess together!

(🎉 Class Dismissed! Go Be Irrational… Responsibly!)