If utility theory doesn’t work, then what does?
One alternative is prospect theory, developed by the author.
Kahneman’s prospect theory challenges utility theory by showing that when we make choices, we don’t always act in the most rational way.
Imagine these two scenarios for example: In the first scenario, you’re given $1,000 and then must choose between receiving a definite $500 or taking a 50 percent chance to win another $1,000. In the second scenario, you’re given $2,000 and must then choose between a sure loss of $500 or taking a 50 percent chance on losing $1,000.
If we made purely rational choices, then we would make the same choice in both cases. But this isn’t the case. In the first instance, most people choose to take the sure bet, while in the second case, most people take a gamble.
Prospect theory helps to explain why this is the case. It highlights at least two reasons why we don’t always act rationally. Both of them feature our loss aversion — the fact that we fear losses more than we value gains.
The first reason is that we value things based on reference points. Starting with $1,000 or $2,000 in the two scenarios changes whether we’re willing to gamble, because the starting point affects how we value our position. The reference point in the first scenario is $1,000 and $2,000 in the second, which means ending up at $1,500 feels like a win in the first, but a distasteful loss in the second. Even though our reasoning here is clearly irrational, we understand value as much by our starting point as by the actual objective value at the time.
Second, we’re influenced by the diminishing sensitivity principle: the value we perceive may be different from its actual worth. For instance, going from $1,000 to $900 doesn’t feel as bad as going from $200 to $100, despite the monetary value of both losses being equal. Similarly in our example, the perceived value lost when going from $1,500 to $1,000 is greater than when going from $2,000 to $1,500.
