- Prospect theory
- Prospect theory is a model of choice under risk in which people judge outcomes as gains or losses from a reference point and feel losses more than gains.
- Expected utility theory
- Expected utility theory is the standard model of choice under risk, in which people weight the utility of each possible final level of wealth by its probability.
What behavioural economics adds to the rational model
Can you name the five ideas behavioural economists add to the rational model of choice?
The first four are the parts of prospect theory; the fifth is about time rather than risk.
Reference dependence is judging an outcome as a gain or a loss against a reference point, such as what you expected or already have, rather than by final wealth.
Can you think of an example?
Two colleagues each get a £2,000 bonus. One expected nothing and is delighted; the other expected £5,000 and is disappointed. Their bank balances say they did equally well.
Loss aversion is focusing more on a loss than on an equal gain, so that losing a sum pains people more than gaining the same sum pleases them.
Can you think of an example?
Offered a coin toss that loses £100 on tails, most people want a win of around £200 on heads before they will play, although any win above £100 makes the bet favourable.
Diminishing sensitivity is feeling each extra pound of gain or loss less than the one before, the further the outcome lies from the reference point.
Can you think of an example?
The step from losing £10 to losing £20 stings; the step from £1,010 to £1,020 barely registers. So offered a sure loss of £500, or a coin toss between losing £1,000 and losing nothing, many people gamble.
Probability weighting is treating small chances as if they were larger than they are, and near-certain outcomes as if they were less sure than they are.
Can you think of an example?
A lottery jackpot with odds of millions to one feels worth a ticket, and a rare burst pipe feels worth insuring at well above its expected cost, by the same person in the same week.
Present bias is giving extra weight to costs and benefits that fall now compared with any later date, so plans made for the future are abandoned when it arrives.
Can you think of an example?
On Sunday a student plans to revise on Monday evening. On Monday evening a film wins. Nothing about revision or the exam changed; only which of them was happening now.