Kahneman’s Psychology for Behavioral Economics

D. Kahneman Maps of Bounded Rationality: Psychology for Behavioral Economics The American Economic Review, 93(5), pp. 1449-1475, December 2003.

Kahneman reviews the work for which he and Tversky were awarded the Nobel Prize, with implications for behavioural economics. 

“Our research attempted to obtain a map of bounded rationality, by exploring the systematic biases that separate the beliefs that people have and the choices they make from the optimal beliefs and choices assumed in rational-agent models.”

This led to the field of ‘behavioural economics’, which became more prominent following the crashes of 2007 on.

Models of decision-making

There is a criticism of H. Simon’s rational model for not being a realistic descriptive of actual behaviours. An alternative is presented:

“The guiding ideas are (i) that most judgments and most choices are made intuitively; (ii) that the rules that govern intuition are generally similar to the rules of perception.”

The appropriateness of either the rational model or the new model for the decisions being made is not addressed, although terms like ‘biases’ suggest that the decision-makers are wrong, not the rational theory.

“The [intuitive] system tends to see what it expects to see—a form of Bayesian adaptation—and it is also capable of responding effectively to surprises. However, this marvelous creation differs in important respects from another paragon, the rational agent assumed in economic theory.”

The paper draws attention to context. Clearly intuition and Bayesian-style subjective probabilities depend on context. Examples are given where the context is not what was expected. In such cases the intuitive systems is ‘capable of responding effectively’, where ‘the rational agent assumed in [some] economic theory’ is not. Yet it is the former that is called ‘biased’.

Prospect theory

This is a reference-dependent theory of decision-making. It is motivated by:

“The proposition that decision makers evaluate outcomes by the utility of final asset positions has been retained in economic analyses for almost 300 years. This is rather remarkable, because the idea is easily shown to be wrong; I call it Bernoulli’s error.”

Kahneman introduces:

“Problem 1: Would you accept this gamble?
    50% chance to win $150
    50% chance to lose $100
Would your choice change if your overall wealth were lower by $100?”

Most people decline to gamble. Now Kahneman introduces:

“Problem 2: Which would you choose?
    lose $100 with certainty
or
    50% chance to win $50
    50% chance to lose $200
Would your choice change if your overall wealth were higher by $100?”

Here more people will gamble. From a utility perspective this seems reasonable. For example, suppose that I have enough cash to last me the week. Then under problem 1 (first part) not gambling is a safe thing to do, whereas gambling perhaps risks ‘not being able to put food on the table’. Under problem 2 (first part), unless I happened to have $100 to spare, I cannot fulfill my plans unless I gamble. In terms of utility, we can simply assume that losing $100 has a huge disutility for most people, not to be outweighed by the possibility of ‘jam on it’.

Kahneman says:

“Preferences appeared to be determined by attitudes to gains and losses, determined relative to a reference point, but Bernoulli’s theory and its successors did not incorporate a reference point.”

This seems odd, as Bernoulli seems to have been the first to introduce the idea of marginal utility:

“Somehow a very poor fellow obtains a lottery ticket that will yield with equal probability either nothing or twenty thousand ducats. Will this man evaluate his chance of winning at ten thousand ducats? Would he not be ill-advised to sell this lottery ticket for nine thousand ducats? To me it seems that the answer is in the negative. On the other hand I am inclined to believe that a rich man would be ill-advised to refuse to buy the lottery ticket for nine thousand ducats. If I am not wrong then it seems clear that all men cannot use the same rule to evaluate the gamble. … the determination of the value of an item must not be based on its price, but rather on the utility it yields. The price of the item is dependent only on the thing itself and is equal for everyone; the utility, however, is dependent on the particular circumstances of the person making the estimate.”

The figure in Bernoulli‘s paragraph 6, showing the non-linearity of the utility of money, is remarkably like Kahneman’s figure 6. In any case, not mentioning a reference point is not the same as forbidding one, and utility is supposed to mirror actual preferences. Kahneman’s criticisms seem more valied when applied to the supposed ‘economic man’, but were the experimental subjects typical of such people?

Kahneman rightly points out that economics has tended to focus on long-term decision-making, but concludes:

“The final states interpretation of the utility of outcomes is therefore a good fit for a rational-agent model.”

This seemed intended in a positive sense, but since the crashes of 2007 et seq it may also help explain the limitations of the rationality assumptions. This is because the ‘final state’ interpretation implicitly assumes long-term stability.

The original paper is Prospect Theory: An Analysis of Decision under Risk. This makes it clear that their version of utility theory is ‘expected utility theory’, which explicitly assumes that the utility is multiplied by probability. As noted above, this is not generally credible. The paper refers to “the substitution axiom of utility theory” by which if B is preferred to A then for any probability p, a probability p of B is preferred to a probability p of A. This is not actually a necessary part of utility theory, is unmotivated and is contradicted by the example above. It is also stated that utility theory demands that utility is assigned to a final wealth independent of the starting point. Again, this is not a necessary part of a utility theory. Prospect theory is a variant of utility theory that solves problems with naive expected utility theory and thus largely repeats Bernoulli.

Framing effect

This effect, described in The Framing of Decisions and the Psychology of Choice, appears to be a variation on the reference point. It is not clear if this would affect real-world decisions, or if subjects are taking cues about the appropriate reference point from the wording of the questions.

Attribute substitution

Kahneman shows that subjects tend to use similarity as a substitute for likelihood, which is reasonable. However, the paper confuses likelihood and probability (as does the original paper). (Recall that final probabilities take account of base-rate, whereas likelihoods do not.) Again, it is not clear if this is a genuine property or an artefact of the wording.

Conclusion

This has some interesting examples of the irrationality of human decision-making and a credible model of human decision-making, but some of the supposed examples appear to be consistent with ordinary utility theory, and some of the supposed biases appear to be due to a misunderstanding of utility theory. There is some conflict with the assumptions about ‘economic man’, but is not clear that the subjects or problems were typical of economics.

Unless you know better?

See Also

Cosmides and Tooby, who dispute the work on biases. Also, Keynes‘ and Ellsberg‘s more thorough criticisms of expected utility, or their alternatives which address true (Knightian) uncertainty.

Dave Marsay

 

4 Responses to Kahneman’s Psychology for Behavioral Economics

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