Prospect Theory

The prospect theory , also called prospect theory , prospect theory , or new expectation theory in German , was presented in 1979 by psychologists Daniel Kahneman and Amos Tversky as a more realistic alternative to expected utility theory. Kahneman received the Nobel Prize in Economics in 2002 for this concept and the research carried out by him and Tversky (Tversky had died in 1996). The theory allows the description of decision making in risky situations. It is based on empirical studies of decision-making behavior in lotteries (gambles), in which the alternatives differ in terms of the probability of occurrence and the winnable monetary value. The prospect theory (originally lottery theory ) is used, for example, in economic decision theory . Today, it is an essential part of behavioral economics (English behavioral economics ).

The Prospect Theory is based on the understanding that individual risk behavior varies depending on the estimated security of an event that occurs. Accordingly, the expected economic utility is not used by many individuals as a basis for decision-making. The individuals behave in a risk averse manner . They prefer secure payments to higher, but insecure, profits in positive events. For example, you would prefer to receive € 50 for sure than € 100 with a 50% probability and € 0 with a 50% probability. In the event of negative events, however, individuals act risk-taking. In this context, according to Prospect Theory, individuals prefer an uncertain, high loss over a certain but lesser loss. This results in an S-shaped value function for the decision maker, which is concave in the positive area and convex in the negative area. In addition, the so-called endowment effect has an impact on behavior, which states that individuals value things that are already in their possession significantly more than things that do not belong to them.

Demarcation

Since around 1940, economic theories have been based predominantly on a rational person who makes his decisions on the basis of information in such a way that costs are minimized and benefits are maximized for him ( Homo oeconomicus ). The Economist uses the metaphor of " Mr. Spock " as an absolutely logical actor. Statistical studies support this observation in some areas, while others cannot be explained.

The Homo Oeconomicus is referred to as a great myth in behavioral economics. The Homo Oeconomicus represents the central assumptions of the classical economy. According to this, he is rational, always maximizes his self-interest, is free of emotions and never makes a mistake in the information acquisition and processing. The Homo Oeconomicus model is unrealistic and incompatible with reality, but this simplified view of man has enabled modern economics to make enormous progress in the elaboration of economic theories and models. The problem is that people with irrational and unpredictable character traits do not allow usable events. The useful thing about models is their simplification of reality and their reduction to a few assumptions. One such simplified model is that of Homo Oeconomicus. If one were to assume that all people are irrational, then any economic theoretical and political model building would be impossible, and any attempt at planned economic policy would then have to be stopped. According to the theory, the human being in classical economics is a perfect, cold calculating machine without emotions.

The Prospect Theory replaces this strictly rational model with a model in which the rationality is modified, among other things, by cognitive distortions (see below). Compared to other models of behavioral economics, it has the advantage that this behavior can be modeled mathematically.

The mathematical model

Value function

Based on empirical evidence, the theory describes how individuals evaluate expected gains or losses. Decision-making processes are divided into two stages: editing ( e.g. processing) and evaluation (evaluation). First, the possible outcomes are ordered heuristically : similarities and reference points are established so that low outcomes are viewed as losses and higher as gains. Then, based on the potential results and their probability of occurrence, values (benefits) are assigned to these points. The alternative with the highest utility is then chosen.

The simplest form of the formula given by Kahneman and Tversky for the evaluation phase is:

${\ displaystyle U = w (p_ {1}) v (x_ {1}) + w (p_ {2}) v (x_ {2}) + \ dots,}$

showing the potential results and their respective probabilities of occurrence. ${\ displaystyle x_ {1}, x_ {2}, \ dots}$ ${\ displaystyle p_ {1}, p_ {2}, \ dots}$

${\ displaystyle v}$ is a so-called value function that assigns a value or benefit to a result. It intersects the reference point (0; 0), is S-shaped and weighted, as its asymmetry suggests, with the same variance in absolute values, losses greater than gains (loss aversion). In contrast to the extended utility theory, only losses and gains are measured, not absolute amounts. The function is called the probability weighting function and expresses that individuals overestimate unlikely outcomes and underestimate medium to highly probable outcomes. ${\ displaystyle w}$

The S-shaped value function has two special features. It is concave in the area of the gains and convex in the area of the losses, and it is steeper in the loss area than in the profit area. If the profit increases from 20 to 40, the valuation increases from v (20) to v (40), if the profit increases from 220 to 240, the valuation increases from v (220) to v (240), whereby the increase in Appreciation in the second case is significantly lower than in the first case. The absolute difference between two wins plays a smaller role, the higher the starting level. In this case, the personal benefit increases from 20 to 40 more than from 220 to 240. This is reflected in the curvature in the profit area. The convex shape in the loss area ensures that the same phenomenon occurs in the loss area. Accordingly, a loss from 50 to 100 is rated as bad, the loss increases from 200,000 to 200,050, but this difference no longer makes much difference. The function is steeper in the loss area than in the profit area, since people weight losses more than gains.

Attempted explanation: cognitive distortions

The theory argues that cognitive distortions ( biases ) that occur frequently influence behavior under uncertainty. In particular, people should be more motivated by losses than by profits and therefore invest more energy in avoiding losses than in making profits.

The theory is based on the experimental work of Kahneman and Tversky. Kahneman was awarded the Nobel Prize in Economics in 2002, by which time Tversky had died. In their psychological experiments they uncovered the following distortions of perception and causes:

According to the Prospect Theory, an absolute profit or an absolute price increase from 20 to 40 is valued higher than an absolute increase from 220 to 240. This also includes the business accounting of earlier expenditures that are not relevant to the decision, the so-called sunk costs . For example, if you invest a lot of money in the repair of a used car, you no longer want to take advantage of cheaper car offers. The financial illusion is also part of economic irrationality. You change stores because of a price disadvantage of five euros when buying sneakers. However, if the price disadvantage is the same, you do not change stores when it comes to buying a television.

Presumptuousness bias

English overconfidence / over-confidentiality bias

Overestimating one's own abilities and courage
Overestimating one's own influence on the future. Even fantastic ideas about future events are held to be effective (e.g. wearing the club t-shirt before important games, superstition)
Misjudgment of the skills of competitors
Overestimating one's own knowledge and understanding

(also called the overconfidence effect )

Anchor heuristic

english anchoring effect

A statement (opinion) once made becomes a self-fulfilling prophecy . This is true even if a statement comes from a source that is no better informed than you are.

Stubbornness

Once a position has been taken, people do not like to give up.

Proximity distortion

The knowledge of a certain problem distorts the perception in the direction of the known; other options are ignored.

Status quo distortion

english status quo bias

People take greater risks to maintain the status quo than to change the situation.

win and loss

People fear loss more than they welcome gain (see also disposition effect ). This goes so far that tangible benefits are not perceived in order to avoid the more distant chance of failure.

Wrong priorities

People spend a disproportionate amount of time on small and disproportionately little on big decisions.

Inappropriate regret

Regret of a loss is worthless, but time is spent on it.

illusion

Wrong decisions are often glossed over (stubbornness, dissonance resolution ).

manipulation

A decision for a thing - with the same result - is easier if it is presented with fear of loss, and is more difficult when there is hope for profit (profit and loss scenarios).

Priming

after John A. Bargh

Decisions are influenced by past, stored and mostly unconscious experiences and expectations ( semantic priming ).

Premonitions

Decisions are influenced by the ability to anticipate the future ( situation awareness ).

criticism

The prospect theory describes human decisions under uncertainty. If one understands expected utility theory as a normative theory, it should be understood as a theory that tries to tell individuals how to make a decision in certain situations. This starting point can be equated with instructions for optimizing decisions. With this approach, the prospect theory would elude many points of criticism. But if you understand it as a descriptive theory; d. H. as a pure description of human action - i.e. as a positive theory, one should be able to observe the behavior described in reality. This is exactly where the problem begins, since the behavior actually observed suggests that the expectation-utility theory only inadequately describes human behavior.

In this context, Kahneman explained in 2003 that the expected utility theory should serve as a secondary explanation of certain economic phenomena and primarily make a contribution to psychological research. Primarily, by including affective variables, one should move away from the model of the rationally acting decision-maker in order to be able to include irrational behavior in the economic analysis. Consumer behavior research can show how emotions arise in the end consumer and how they can ultimately be generated and affect action or behavior.

The Allais paradox is an example that speaks against expected utility theory. In this example, two different decision-making situations are presented. First, the individuals choose between the first choice:

A : (1,000,000, W (1)) or B : (5,000,000, W (0.1); 1,000,000, W (0.89); 0, (0.01))

then the individuals choose between the second choice:

C : (1,000,000, W (0.11); 0, W (0.89)) or D : (5,000,000, W (0.1); 0, W (0.9))

Explanation: First the amount that can be won is in the brackets, the term W expresses the probability with which one wins the amount, followed by the semicolon, which expresses the second amount with the second probability. The Prospect Theory expects a consistent choice in both decision-making situations. In this example, this means: Individuals who choose alternative A in the first situation should also choose C in the second situation. Conversely, the people who chose B in the first choice should choose D in the second choice. In reality, it turns out that individuals choose A in the first situation and, contrary to expectations, choose D in the second case. This phenomenon can be explained by the fact that the way in which one decides in certain situations has an influence on the preferences themselves. Thus the assumption of the prospect theory that the method of preference finding has no influence on the preference is called into question.

Another point of criticism of the expected utility theory is the experiment on framing . This shows that the way a decision problem is represented has an influence on the choice. This can be described using the term “75% fat-free” or “with 25% fat” (which is theoretically the same). According to the expected utility theory, there is no change based on the description. In reality, however, individuals include these descriptions in their purchase decision.

Others

The Prospect Theory is based u. a. on fundamental considerations of the individual utility function of Daniel Bernoulli , whose weak points and errors Kahneman and Tversky revealed and supplemented in the context of their work with simple thought experiments. In Kahneman's book " Fast Thinking, Slow Thinking ", he wrote:

"One could easily imagine that Bernoulli himself would have constructed similar examples and developed a complex theory to account for them; for some reason he did not. One could also imagine that contemporary colleagues contradicted him or later scientists after him objected to reading his essay, but neither did so. " (P. 340)

literature

D. Kahneman, A. Tversky: Prospect theory: An analysis of decision under risk . In: Econometrica , Volume 47, 1979, No. 2, pp. 263-291.
A. Tversky, D. Kahneman: Advances in prospect theory: cumulative representation of uncertainty. In: D. Kahneman, A. Tversky (eds.): Choices, values and frames. Cambridge University Press, Cambridge 2000, pp. 44-66.
D. Kahneman: Thinking, fast and slow. Allen Lane, London 2011, ISBN 978-1-84614-606-0 , therein Chapter 26 Prospect Theory , pp. 278-288.

Web links

Commons : Prospect theory - collection of images, videos and audio files

Prospectus theory . Gabler Economic Lexicon

Individual evidence

↑ ^a ^b ^c www.economist.com
↑ W. Kroeber-Riel / A. Gröppel-Klein: Consumer behavior . 10th edition. Franz Vahlen, Munich 2013, ISBN 978-3-8006-4618-0 , pp. 21 .
↑ ^a ^b ^c ^d ^e Irrationality Rethinking thinking on Economist.com of December 16, 1999.
^ Economist: Behaviorists at the gates; May 8, 2003.
^ H. Beck: Behavioral Economics . 1st edition. Springer Fachmedien, Wiesbaden 2014, ISBN 978-3-658-03367-5 , p. 1-2 .
^ H. Beck: Behavioral Economics . 1st edition. Springer Fachmedien, Wiesbaden 2014, ISBN 978-3-658-03367-5 , p. 131-132 .
^ The Economist. 24.-30. May 2003.
^ V. Trommsdorff: Consumer behavior . 7th edition. W. Kohlhammer, Stuttgart 2009, ISBN 978-3-17-020155-2 , pp. 259 .
↑ Christian Becker-Carus ; Mike Wendt: General Psychology. An introduction. 2nd Edition. Springer Verlag, Berlin, Heidelberg 2017, ISBN 978-3-662-53006-1 , p. 13 f.
^ H. Beck: Behavioral Economics . 1st edition. Springer Fachmedien, Wiesbaden 2014, ISBN 978-3-658-03367-5 , p. 101-102 .
↑ EC Hirschmann, BB Stern: The Role of Emotions . In: EJ Arnould, LM Scott (Eds.): NA - Advances in Consumer Research . No. 26 , p. 4-11 .
^ H. Beck: Behavioral Economics . 1st edition. Springer Fachmedien, Wiesbaden 2014, ISBN 978-3-658-03367-5 , p. 107 .
^ H. Beck: Behavioral Economics . 1st edition. Springer Fachmedien, Wiesbaden 2014, ISBN 978-3-658-03367-5 , p. 110 .

[Economist.com-1] www.economist.com

[2] W. Kroeber-Riel / A. Gröppel-Klein: Consumer behavior . 10th edition. Franz Vahlen, Munich 2013, ISBN 978-3-8006-4618-0 , pp. 21 .

[Economist99-3] Irrationality Rethinking thinking on Economist.com of December 16, 1999.

[Economist03-4] Economist: Behaviorists at the gates; May 8, 2003.

[5] H. Beck: Behavioral Economics . 1st edition. Springer Fachmedien, Wiesbaden 2014, ISBN 978-3-658-03367-5 , p. 1-2 .

[6] H. Beck: Behavioral Economics . 1st edition. Springer Fachmedien, Wiesbaden 2014, ISBN 978-3-658-03367-5 , p. 131-132 .

[7] The Economist. 24.-30. May 2003.

[8] V. Trommsdorff: Consumer behavior . 7th edition. W. Kohlhammer, Stuttgart 2009, ISBN 978-3-17-020155-2 , pp. 259 .

[9] Christian Becker-Carus ; Mike Wendt: General Psychology. An introduction. 2nd Edition. Springer Verlag, Berlin, Heidelberg 2017, ISBN 978-3-662-53006-1 , p. 13 f.

[10] H. Beck: Behavioral Economics . 1st edition. Springer Fachmedien, Wiesbaden 2014, ISBN 978-3-658-03367-5 , p. 101-102 .

[11] EC Hirschmann, BB Stern: The Role of Emotions . In: EJ Arnould, LM Scott (Eds.): NA - Advances in Consumer Research . No. 26 , p. 4-11 .

[12] H. Beck: Behavioral Economics . 1st edition. Springer Fachmedien, Wiesbaden 2014, ISBN 978-3-658-03367-5 , p. 107 .

[13] H. Beck: Behavioral Economics . 1st edition. Springer Fachmedien, Wiesbaden 2014, ISBN 978-3-658-03367-5 , p. 110 .