267
See also: Economic man 52–53 ■ Free market economics 54–61 ■ Economic bubbles 98–99 ■
Risk and uncertainty 162–63 ■ Irrational decision making 194–95 ■ Paradoxes in decision making 248–49
Early studies of these quirks of
behavior were made in 1979 by two
Israeli-American psychologists,
Amos Tversky and Daniel
Kahneman. They looked at the
psychology involved in decision
making and backed up their
hypotheses with empirical
examples. Their key paper,
Prospect Theory: An Analysis
of Decision under Risk, outlined a
theory that marked the start of
a new branch of study known
as behavioral economics. This
aimed to make economists’
theories about decision making
more psychologically realistic.
Dealing with risk
Tversky and Kahneman found
that people commonly violate
economists’ standard assumptions
about behavior, particularly when
consequences are uncertain. Far
from acting with rational self-
interest, people were found to be
affected by the way a decision is
presented and responded in ways
that violate standard theory.
Economists had long understood
that people are often “risk-averse.”
For example, if given a choice
between definitely receiving $1,000
or having a 50 percent chance of
receiving $2,500, people are more
likely to choose the guaranteed
$1,000—despite the fact that the
average expectation of the second,
uncertain, option is higher, at
$1,250. The psychologists
constructed the opposite situation,
giving the same people the choice
of either definitely losing $1,000, or
having a 50 percent chance of no
loss and a 50 percent chance of
losing $2,500. In this situation,
people who chose the safe option
in the previous example now
chose the riskier alternative of
the gamble between no loss and
a large loss. This is known as
risk-seeking behavior.
The standard economic
approach to decision making
under uncertainty assumed that
any one individual was risk-averse,
risk-loving, or didn’t mind either
way. These risk preferences wouldCONTEMPORARY ECONOMICS
When faced with making a
decision where outcomes
are uncertain...They are affected more
by whether they stand to
gain or lose, and how the
question is framed.... people do not calculate
gains and losses through
mathematical probability.People are not
100 percent rational.apply whether the individual was
facing risks that involved gains
or losses. However, Tversky and
Kahneman found that individuals
are risk-averse when facing gains
but risk-loving when facing losses:
the nature of individual preference
seems to change. Their work
showed that people are “loss
averse,” and so are willing to take
risks to avoid losses, where they
would not be willing to take risks
to gain something. For example,
the loss in utility from losing $10
appears to be greater than the gain
in utility from gaining $10.
These quirks in behavior
show that the way that choices
are presented influences people’s
decisions, even if the ultimate
outcomes are the same. For
example, consider a situation
where a disease is projected
to kill 600 people. Two programs
exist to counter the disease: A,
which saves 200; and B, which
offers a one-third chance that
600 people will be saved versus a
two-thirds chance that no one will
be saved. When the problem is
explained to them in this way, the
majority of people show themselves
to be risk-averse—they opt for the ❯❯A government wishing to persuade
people to be vaccinated should stress
the increased probability of death if
they are not vaccinated. People hate
losing more than they love winning.