How I Taught Prospect Theory to My Son

>>How I Taught Prospect Theory to My Son

By Diogo Gonçalves

 

Dear son, today I want to talk to you about how people make decisions. Many choices in our lives have uncertain outcomes. Choosing between two alternatives often involves a risk, such as whether you should spend your birthday money on a new bicycle or on a PlayStation. Each choice is like two sides of a coin: there is a risk of losing something (a loss) and an opportunity of getting something (a gain). If you spend your birthday money on a new bicycle you will lose the opportunity to spend your money on other things and gain the pleasure of having a bicycle and use it to ride through the neighborhood; if you spend your birthday money on a PlayStation you will lose the opportunity to spend your money on other things and gain the pleasure of having a PlayStation to play with your friends. Both alternatives involve gains and losses.

These types of choices are determined by three ways of thinking, which influence the way we evaluate the expected results of our decisions, and consequently, the choices we make.

1) The first one is called Loss Aversion

For us humans, losing something hurts more than gaining it. This happens because we are loss averse. In fact, the science of loss aversion says that losing something makes you feel sad twice as much (let’s give it two frownies 🙁 🙁 ) as you feel happy when you gain something (let’s give that one smiley 🙂 ). Losing your pencil case feels twice as bad ( 🙁 🙁 ) as getting a new pencil case ( 🙂 ). This means that, if you lose your pencil case and find it again the next day, you will feel three times happier (two from canceling the loss and one from the gain) than you felt when you first received it.

2) The second one is called Diminishing Sensitivity

I know you really like chocolate mousse. But when I give you chocolate mousse for dessert, the first spoonful of chocolate mousse tastes much better than the fifth spoonful, the fifth spoonful better than the sixth, and so on… This means that our sensitivity to things becomes smaller and smaller. If I turn on a dim light in your dark room while you are sleeping, it will have a big effect. But the same dim light may be hard to see in your bright room during the day. Similarly, if I cut your $20 allowance by $5, you will feel it more than you would if you had a $30 allowance, but less than you would if you had a $10 allowance, though the difference ($5) is the same in all three cases.

3) The third one is called Reference Point

Imagine you drink a cola with ice after having a warm soup, or after having an ice cream. The cola will seem colder after having the soup than after having the ice cream. This happens because your mouth gets used to a reference point (warmth with the soup and coldness with the ice cream) that determines the way you experience the same cola. When people think about money they also use a reference point, which is usually what you expect, or feel entitled to. Outcomes that are better than the reference point are perceived as gains, the ones that are worse are perceived as losses. So if you are used to receiving $200 from your grandmother for Christmas and she gives you only $150 this year, you will feel like you lost something. But if you had received $100 in the past, this year’s $150 will make you feel like you gained something.

These three principles revolutionized a science called economics, which deals with the way we think about money. More recently, a new kind of economics emerged, which has introduced psychology – the science of the mind – into economics. This field is called behavioral economics. Understanding its ideas can help everyone, including you, make better decisions.

 

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Diogo Gonçalves
Diogo Gonçalves is a Ph.D. candidate in Economic Psychology, Judgment and Decision Making at the Tilburg Institute for Behavioral Economics Research at Tilburg University.
Diogo Gonçalves
Diogo Gonçalves

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By |2018-02-09T11:39:57+00:00July 2nd, 2015|

16 Comments

  1. Eduardo Manrique July 4, 2015 at 5:22 pm - Reply

    I realize that economics misses several supporting theories. At decision making, not only price and quantity and risks (in a distribution of frecuencies), but all those elements which are so well explained by Mr. Goncalves. And not only that. As Mr. Hernando de Soto has ellaborated, economics misses too a property rights constructo. Assuming that in the market every player can uphold in court his legal title on the goods that are supplied is no longer enough.
    A new brave economic science, for global and uncertain times.

    • Diogo Gonçalves July 6, 2015 at 11:57 am - Reply

      Thanks for your comment Eduardo! Those times are definitely arriving!

  2. Sebastian Dengler July 6, 2015 at 8:58 pm - Reply

    Hi Diogo, while I like the tone of the post and think it makes great way to explain (behavioral) economics in a simple and accessible manner, I have some doubts about one of the points made in it. Because I like the effort so much I want to take the time to elaborate shortly so it becomes even better:

    “Losing your pencil case feels twice as bad ( 🙁 🙁 ) as getting a new pencil case ( 🙂 ). This means that, if you lose your pencil case and find it again the next day, you will feel three times happier (two from canceling the loss and one from the gain) than you felt when you first received it.”

    In general, I am pretty sure that you should not write “three times happier” as this is a statement about the absolute level of happiness whereas everything else in this paragraph speaks about changes in happiness.

    Moreover, I am not sure whether it is indeed “correct” to say that you actually get the 🙂 from gaining the previously lost pencil case additionally to cancelling the two 🙁 from the loss. Either your reference point has already adjusted (“having no pencil case”); then you should only gain one 🙂 as the result of gaining a new pencil case. Or your reference point has not yet adjusted (“having the pencil case”); then you should only gain the effect from cancelling out the two :-(.

    Or is my logic somewhere flawed?

    • Diogo Gonçalves July 6, 2015 at 9:45 pm - Reply

      Hi Sebastian, dear colleague, thanks for the point!

      You are actually right: or the reference point adjusts or it doesn’t, so the change in happiness can never be 3x, but only 1x or 2x. Interestingly, I also thought about the issue you point to when I was writing the example, but choose to sacrifice it, in order to be able to use the metaphor. Nevertheless it’s good that you point it, so we can discuss it and increase our understanding of prospect theory.

      Thanks for the comment, and please keep that same curiosity and critical thinking, the most important asset, I believe, for people who want to do science.

      Best, Diogo

  3. Karl Masons July 7, 2015 at 4:04 pm - Reply

    I think you’re both right: Diogo is right in his prediction that finding the pencil case again would lead to more happiness than getting it the first time around, because this time it occurred after a loss. Sebastian is right for doubting whether it would lead to as much as three 🙂 🙂 🙂 :
    Behavioral economic theory on (hedonic) adaptation (and indeed Diogo’s second point about diminishing sensitivity) would predict that gaining the same pencil case a second time would not be associated with the same level of happiness anymore, as it has worn off. However, it seems to me that making up for a loss (finding it again) should lead to more happiness than when it was received the first time around. Economists of the behavioral persuasion would probably think of this in terms of specific values and perceived/psychological costs, while psychologists might think of it in terms of the relief felt when the object is found again. I’m not sure about prospect theory more specifically — I realize that I’m stepping outside of its boundaries here.

  4. michael webster July 9, 2015 at 3:35 am - Reply

    You write: ” In fact, the science of loss aversion says that losing something makes you feel sad twice as much (let’s give it two frownies 🙁 🙁 ) as you feel happy when you gain something (let’s give that one smiley 🙂 ). ”

    Hmm, and what units do the frownies stand for?

  5. Karl Masons July 9, 2015 at 8:00 am - Reply

    Michael: Two frownies = two emoticon units of negative valence, one smiley = one emoticon unit of positive valence. I think Diogo used emoticons to make the units as clear as possible.

    • michael webster July 9, 2015 at 9:17 pm - Reply

      Karl and Diego;

      One of the most important developments in preference theory is the idea that utility functions are not generally not measuring units, units of anything.

      We have no natural zero point in preference theory, unless say heat measurements which have 0 degrees Kelvin as the ideal 0. All thermometers then are simply affine translations of the Kelvin scale.

      We don’t like that in preference theory. So the entire talk of “units” is misleading. (And more technically, meaningless.)

  6. Diogo Gonçalves July 10, 2015 at 11:54 am - Reply

    Michael,

    Thanks for your comment. In Prospect Theory, it was very clear that losses loom 2 times larger than gains. How that that reconcile with the absence of “units” or a quantitative measure in preference theory?

    • michael webster July 10, 2015 at 12:20 pm - Reply

      Diogo, do you know what a representation theorem is?

      I am asking because I want to know what level I should begin my explanation at.

  7. Diogo Gonçalves July 10, 2015 at 3:11 pm - Reply

    Michael, teach me like if I was your son 🙂

  8. Karl Masons July 11, 2015 at 11:41 am - Reply

    Michael, can you explain the connection between levels of measurement and the point you are trying to make? Maybe it would be easiest if you just suggested an alternative/better way of explaining it to a child.

  9. Fay Porter August 21, 2015 at 9:34 pm - Reply

    — Though I do not wish to downplay the academic tenor of the articles and subsequent comments, I would just like to add how much I appreciated running across this article today. To be able to convey economic theory effectively to anyone under the age of ten and have them appreciate the implications of critical reasoning and choice processing is a tremendous win for all involved. Also, I wonder if there is a way to acknowledge relative emotionally-assigned weight to an item in this situation. If, for instance, the pencil case discussed was a favorite possession, would it not be possible to achieve greater than three emojis of positive valance due to the sentimentalism attached upon the recognition and return of the item?

    • Diogo Goncalves August 26, 2015 at 3:23 pm - Reply

      Good point Fay..I think Kahneman speaks to that when he distinguishes objects for use (i.e., with emotional value) from objects for trade, with no personal attachment.

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