Sunday, 28 July 2013

Why is prospect theory ignored

I have finally got around to reading Daniel Kahneman's book Thinking Fast and Slow. It is a fantastic read. It brilliantly sets out how Kahneman and Tversky revolutionized the way we think about human judgement and decision making. But, here's the question I was left asking myself - why has the work of Kahneman and Tversky had so little impact in economics? That question might sound bizarre given that Kahneman won the Nobel Prize for Economics (Tversky had died). As far as I can see, however, the insights provided by Kahneman and Tversky have largely been ignored. So, what's gone wrong?
        In his book Kahneman points to prospect theory as one idea economists have endorsed. True enough, their paper on prospect theory is one of the most cited papers in economics. Cites, however, are different to real impact. And very, very little research in economics has properly applied prospect theory. Indeed, given that the original paper is a pretty tough read, I would be surprised if many of the people citing the paper have read it. Kahneman, therefore, seems a bit over-optimistic in saying economists have endorsed prospect theory. More apt is to ask why they have ignored it.
       Prospect theory puts together four basic ideas: (i) People judge outcomes relative to a reference point, so we get gains and losses. (ii) People are risk averse for gains and risk loving for losses. (iii) People overweight small probabilities and underweight large probabilities. (iv) The reference point will depend on context and the way the situation is framed. An example can help put things in context.
  • (Option A) gives £900 for sure and (option B) gives £1000 with probability 0.9 and £0 with probability 0.1. Would you choose option A or B?
Most people go for option A which shows risk aversion for gains. The 0.1 probability of getting £0 is also over-weighted. Consider a further example:
  • I'll give you £1000 to start off. Then (option C) you lose £100 for sure and (option D) you lose nothing with probability 0.9 and lose £1000 with probability 0.1.
Most people go for option D which shows risk loving for losses. Comparison of these two choices also shows the importance of framing. A versus B is exactly the same as C versus D. Yet many choose A and D!
       All four of the basic ideas in prospect theory are crucial to take account of when analyzing economic behavior. For instance, anytime that a person buys or sells something outcomes will be judged relative to a reference point. So, the decision made will depend on framing, mental accounting and how gains and losses are coded. For example, people buy a lot more stuff when they use a credit card than if they use cash. And people are far more reluctant to sell something into which they have put sunk costs. None of this could be predicted by the standard economic model. So why has prospect theory been ignored?
         The main reason is probably the marketing of the theory. Prospect theory was sold as a package for modelling risky choice. This was interpreted as meaning it only needs to be used if all the four basic ideas above appear relevant. Thus, prospect theory is relevant for explaining things like tax evasion, but not much else. This interpretation is wrong. It's enough that one of the basic ideas is relevant for prospect theory to be relevant. Wrong or not, the common interpretation gives economists a convenient excuse to ignore the theory. 
         While convenience is probably the main reason economists have ignored prospect theory, there are better reasons to question its usefulness. Any theory is judged by its ability to make testable predictions. And the problem with prospect theory is idea (iv). We now know that the reference point a person has in mind when making a decision can be just about anything. One person's loss can be another's gain. This is a big problem when it comes to making testable predictions. Recent work tries to tie down the reference point, such as a paper by Koszegi and Rabin, but the psychological heart of prospect theory starts to get ripped out. In its pure form prospect theory starts to become anything is possible.
         We also know that prospect theory is not good at explaining some of the things it was seemingly designed to explain. Consider, for example, the disposition effect bias whereby investors are more likely to sell stocks that have made a gain while holding on to stocks that have made a loss. Loss aversion seems a ready explanation for this - people do not want to cash in on a loss. Barberis and Xiong, however, showed that loss aversion can make the disposition effect even more of a puzzle. Basically, loss averse investors should buy more of the rising stock and sell some of the losing stock to best avoid realized losses.
         The fact that prospect theory is not perfect is not a reason to ditch it. The standard economic model is very far from perfect. Again, however, the foibles of prospect theory provide a convenient excuse to ignore it.
         I write all this as a firm believer that prospect theory should be used a lot more in economics. What it can do far exceeds what it cannot. So will things change? In his book Kahneman says that he can understand why prospect theory is not taught in undergrad econ classes. Well I cannot! I think its high time that prospect theory was brought into the classroom. This seems to me the only way to avoid another generation of economists who ignore the theory. And I think it is key that prospect theory, and behavioural economics more generally, makes its way into the core of principles classes, and not as some add on or option to be chosen. So, if you have not already done so, read Kahneman's book!

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