by Georgia McKirgan
Classical economics, from Adam Smith to David Riccardo to Alfred Marshall, is based on a couple of key assumptions. Economic actors (individuals and companies) seek to maximise their utility (satisfaction) by making perfectly rational decisions in possession of perfect information. When these people come together in a market, these motivations and preferences result in the type of market behaviour that we are forever charting in class, using traditional demand and supply curves. As I was thinking about applying this to real world situations, I kept coming across examples where people were not completely rational in their economic behaviour. This bothered me, but I kept assuming that while individuals may not follow these classical patterns of behaviour, a theoretical model based on these assumptions may still give valuable insights in to the real world. I thought no more about this problem until I came across the work of psychologists Daniel Kahneman and Amos Tversky who published a paper in 1979 about Prospect Theory which challenged the classical Expected Utility Theory.
Prospect Theory can be understood with a few simple examples. A key assumption in Prospect Theory is 'Loss Aversion' which means that losses hurt more than gains feel good. This differs from expected utility theory in which a rational agent would have a symmetrical utility curve around zero. In a laboratory setting, Kahneman and Tversky conducted a number of experiments. Subjects were asked to choose between a pair of probability-weighted outcomes. First, they were asked to choose between a 100% chance of winning $500 and a 50% chance of winning $1,000. The majority of respondents chose the 100% chance of winning $500. As the two choices are equal on a probability-weighted basis, the classical theory would suggest people should be neutral between the two choices. On the loss side, subjects were asked to choose between a 100% chance of losing $500 or a 50% chance of losing $1,000. Rather than take a guaranteed loss of $500, most subjects took the option of a 50% chance of a $1,000 loss. Take another example. Subjects were asked to put a dollar value on two life insurance policies. One would cover the subject from death for a period of 10 years. The other would cover the subject from death in a terrorist attack for 10 years. On average, the subjects put a higher value on the second policy despite the fact that the first policy covered terrorism as well as any other kind of death in the same 10 year period. For the subjects, death in a terrorist attack sounds worse than other kinds of death so they ascribe a higher value to a policy that covers that event despite the fact that the other policy has more coverage. Basing economic theories on more accurate descriptions of how economic actors behave sounds like a much better approach. These are not random errors of judgement but predictable cognitive biases.
Kahneman and Tversky eventually won the Nobel Prize for Economics, despite the fact that they are both academic psychologists. Based on their work, Behavioural Exonomics has developed into one of the most fertile areas of Economics for new thinking. While most of Kahneman and Tversky's experiments were conducted in a laboratory setting, Prospect Theory can be used to better understand many real-life economic situations and one obvious example is financial transactions. The Loss Aversion component of Prospect Theory leads to something called the 'Disposition Effect', the empirical finding that owners of financial assets have a greater propensity to sell an asset that has risen in value since purchase (locking in a profit) rather than sell assets that have fallen in value (locking in a loss). This is puzzling because many asset prices tend to exhibit 'momentum' where assets that have done well, continue to perform well and assets that have performed poorly, continue to lag. A rational approach to this scenario would be to sell the asset that has gone down and hold the asset that has gone down...contrary to what is observed.
Prospect Theory can also be used to be explain the valuation of many technology stocks. Because of the spectacular performance of stocks like Apple ($1.60 in 2002, $150 in 2017), investors tend to overpay for the shares of new companies that might become the next Apple, Facebook or Google. Investors overpay for the small chance that one of theses shares make make them a huge profit.
In 'The Wealth of Nations', Adam Smith talked about the 'invisible hand' which refers to the self-regulating nature of the marketplace in determining how resources are allocated based on individuals acting in their own self-interest. This makes even more sense when we accept that the way these individuals understand their own self-interest is impacted by the aforementioned cognitive biases. We can still build robust economic theories that can be used to predict how markets behave and develop but the fact that humans are not completely rational in terms of how they make economic decisions need not undermine the models if these cognitive biases are fully recognised and incorporated.
At the end of this process, I have a much better understanding of why subjects like Economics and Psychology are grouped together as Social Sciences. The overlap between these subjects is increasing and we need to draw on all of them to build a better understanding of how our society works. Markets and economies are made up of human actors. We cannot have a proper understanding of what is going on without recognising how humans make decisions. Rather than ignore these aspects, I'd rather fully embrace them.