Nobel Prize winner Daniel Kahneman died today.His work integrates psychology into economics in the following ways: prospect theory It's a major improvement.from New York Times Obituaries:
Professor Kahneman happily points out and explains what he calls common brain “quirks.” Behaviorists believe that the most important of these is loss aversion: For example, why does losing $100 hurt twice as much as gaining $100 brings pleasure?
Among its many implications, loss aversion theory suggests that it would be foolish to constantly check one's stock portfolio, as the pain experienced in the stock market is likely to lead to overcaution and may even be self-defeating.
Loss aversion also explains why golfers putt better when making par on a given hole than when making birdie. They work harder on their par putts because they desperately want to avoid a bogey or losing a shot.
For a detailed account of Kahneman's contributions, you can read this book Thinking, fast and slow. Technically, prospect theory helps resolve some of the key paradoxes in expected utility theory.from Nobel Prize website:
Maurice Allais (1953a), winner of the 1988 Economics Prize, first pointed out the departure from the von Neumann-Morgenstern-Savage expected utility decision theory when he proposed the so-called Allais paradox. on (see also Ellsberg, 1961, for a related paradox). For example, many people prefer a lottery that gives a certain payoff of $3,000 to a lottery that has an 80% chance of winning $4,000 or 0 otherwise. However, some of these people also prefer a 20% chance of winning $4,000 to a 25% chance of winning $3,000, even though in both options the odds of the gain are scaled down by the same factor of 0.25 ( from 80% to 20%, and from 100% to 25%). This preference violates the so-called substitution axiom of expected utility theory…
A surprising finding is that people are generally more sensitive to differences in outcomes from some non-constant reference level (such as the status quo) than to absolute outcomes. This focus on changes rather than levels may be related to the established law of psychophysical cognition that humans are more sensitive to changes than to levels of external conditions such as temperature or light.
Furthermore, people appear to be more averse to losses relative to reference levels than attracted to gains of the same magnitude.
There's some left The math behind prospect theory:
Key differences between expected utility and prospect theory: (i) Expected utility is concerned with levels, whereas prospect theory evaluates changes relative to the status quo [i.e., w vs. Δw](ii) Prospect theory allows for utility functions and risk preferences to capture gains relative to losses [i.e., u(w) vs. v(w)] ]and (iii) expected utility theory takes probabilities as given, while prospect theory uses decision weights to explain how individuals view those probabilities [i.e., p vs. π(p)].
While prospect theory may represent real-world human decision-making processes more accurately than expected utility theory, some criticisms of prospect theory are that (i) through repeated games, individuals often revert to something closer to an expected utility framework, and (ii) ) Researchers argue that determining each person's “as is” value is often challenging in practice.
Nonetheless, the Nobel Prize is well-deserved, and Kahneman's (and his collaborator Amos Tversky's) scientific contributions will live on forever.
