Behavioral Finance

CHAPTER 9

Prospect Theory

Chapter 8 examined the methods economists historically have used to model human behavior in the face of uncertainty. Economists assume each individual has a function that maps from every possible relevant level of wealth to a number that represents his or her happiness, and that under uncertainty each individual acts to maximize the expected level of happiness. That chapter considered one objection to expected utility known as the Allais Paradox.

A second problem with expected utility maximization lies in the assumption that individuals make decisions under uncertainty based solely on the eventual levels of his or her wealth. One simple way to see that this is unlikely to be a good approximation of human behavior is to realize that most individuals are unable to report their levels of wealth in a short amount of time within a reasonable degree of accuracy. Consumers could not be acting based on anticipated levels of wealth if they are not even aware of current wealth levels.

So if wealth isn't the issue, what is?

THE REFERENCE POINT

Consider the following set of choices, taken from Kahneman:1

In addition to what you already own, you receive $1,000 for sure and either:

• Another $500 for sure, or
• A 50 percent chance of nothing and a 50 percent chance of $1,000.

Second, consider this alternative set of choices.

In addition to what you already own, you receive $2,000 for sure and either:

• Lose $500 for sure, or
• Face a 50 percent chance of losing nothing ...