Daniel Kahneman
Introduction
In his Nobel speech and biography, Kahneman states that he invited Tversky to Hebrew University for hosting a lecture between 1968 and 1969. From this short lecture appearance, collaboration between Amos Tversky and Kahneman had begun. The first paper published jointly was Belief in the Law of Small Numbers in 1971. From thereon, seven articles were published in peer-reviewed journals between 1971 and 1979. Other than Prospect Theory, another important article published jointly was Judgment Under Uncertainty Heuristics and Biases.
Works of Kahneman
Although Daniel Kahneman has been known as a psychologist, but in 2002, he was awarded Nobel Memorial Prize in Economics for his outstanding Prospect Theory. Kahneman has been known to serve as a psychologist for Israeli Defense Forces with a B.Sc degree with major in psychology and a minor in mathematics. He obtained his PhD degree in psychology from University of California, Berkley.
Cognitive Psychology
Kahneman started working in 1961 in Hebrew University of Jerusalemwhere he taught visual perception, concentration and attention. In 1966, his first publication Pupil Diameter and Load on Memory appeared in prestigious journal, Science (Lindzey, and Runyan 23).
Behavioral Economics
Kahneman and Amos Tversky have done major works in behavioral economics collaboratively. They discussed an importance of descriptive theory on rational behaviors. Contemporary behavioral economics has been discussed in relation to economics.
Judgment and Decision-Making
Kahneman collaborated with Tversky when he started working on decision-making and judgment. These two have collaborated in publishing many seminal articles in the field of decision-making and judgment. These collaborations led these scientists to lay down foundations of Prospect theory in 1979.
Hedonic Psychology
Nineties is the era when Kahnemans focus slowly began to shift from behavioral economics and behavioral psychology to hedonic psychology. Hedonic psychology is closely related to the field of positive psychology and in nineties, positive psychology was emerging as a new field ((Lindzey, and Runyan 45).
Kahnemanhas defined hedonic psychology as a field that defines pleasant and unpleasant life experiences. This field studies a relationship between pleasure and pain, satisfaction and dissatisfaction, sadness and happiness, interest and boredom, and joy and sorrow. Many factors in these cases play their roles in different circumstances that range from biological factors to society related factors and these factors have their roles in suffering and enjoyment.
Prospect Theory
In 1979, in collaboration with Tversky, Kahneman presented Prospect Theory. This Nobel Prize winning theory successfully describes procedures of understanding decisions where several alternatives are involved. These alternatives involve risks and unexpected outcomes. This theory explains real life choices rather than optimal choices that sets it apart from other theories.
Prospect Theory is descriptive of a situation in which individuals have to make choices of losses and gains in financially unstable and unpredictable situations. Prospect originally referred to a lottery. Thereby prospect has been related to lotteries and gambles where outcomes are unpredictable and outcomes are related with probability distribution over them. Thereby outcome and probability most closely relate to prospect. This theory has been considered as a realistic alternative to Expected Utility Theory given in psychology (Kahneman, Knetsch, and Thaler 1325).
Decision Making Processes
Two decision processes have been described in this theory, editing and evaluation.
Editing Phase
First step of decision-making has been linked with heuristics by saying that possible financial outcomes are organized and ordered based on heuristics or techniques of problem solving based on experiences (Tversky, and Kahneman 323). Here, some outcomes are viewed as being identical and reference points are designated. Outcomes that are arranged in a lower order are considered as losses while outcomes arranged in a higher order are considered as gains.
This phase is identified by combining many probabilities that are associated with single and related outcomes. A prospect may be associated with a riskless component and in editing phase, any risky components are removed from prospects. From within these choices made, during a process known as cancellation, ensures that probability pairs associated with a common outcome are discarded (Barberis., Huang and Santos 5).
Evaluation Phase
Second phase in Prospect theory is an evaluation phase. Based on all potential outcomes, a value or a utility is calculated and computed along with respective probabilities and here an alternative having a higher utility is selected over the others.
Formula for Evaluation Phase
In its simplest from, formula that was designed by Tversky and Kahneman is
U w(p1)v(x1)w(p2)v(x2)..
whereas x1 and x2 are potential outcomes and p1, p2 are their respective associated probabilities. Value function has been defined by value v that assigns a value to an outcome. Probability weighting function is assigned to w. Probability weighting reflects that people show certain kinds of reactions when they face unexpected probability events. As compared to Expected Utility Theory, Prospect Theory measures losses as well as gains. Lesser reactions are shown by people when larger or lower probability events are seen.
Value function (v)
Loss Aversion
Graph shows value function as it passes through a reference point forming an S shape. Graph shows that values that are achieved by value v are asymmetrical. Asymmetry implies that if same variations are introduced in real situations than losses have a higher impact as compared to gains and this situation is referred to as loss aversion (Kahneman, and Tversky 265).
Risk Aversion Behavior In Gains
In this theory, there is interplay of small probabilities. Moreover, it has been highlighted by Tversky and Kahneman that there is a convexity and concavity in value function that has been noticed to lead to four-fold model of risk attitudes. In this case, risk aversion behavior in gains involves small probability gains and moderate probabilities. This has been explained as a fact in theory that people like to buy lottery tickets as well as make investments in shares but still carry an instinct to invest money in a conservative manner (Tversky and Kahneman 300).
Applications of Prospect Theory
In economics, Prospect Theory can explain reflection effect in a more detailed manner. Reflection effect has been studied under gains or losses where risk aversion or risk seeking is reversed in many cases especially in case of disposition effect.
An adoption made from Prospect Theory is Pseudo-Certainty Effect. This theory refers to the fact that people have a tendency to make choices that are more risk averse if calculated probabilities are more positive. Similarly, decisions are more risk seeking if calculated probabilities are negative. This theory is an explanation of a real life situation where a person may buy both an insurance policy as well as lottery ticket (Kahneman, Knetsch, and Thaler 1340).
In many cases, it has been seen that economists in a schematic interpretation manner, often referred to as framing, interpret outcomes. This framing has been linked with utility that is received by these economists. This very aspect has been used in behavioral economics and mental accounting. There are many situations to which framing and prospect theory has been linked. Situations like these have been seen to be inconsistent with economic rationality. These ranges of situations include excess returns puzzle,equity premium puzzle,andlong swings PPP puzzle related to exchange rates and these situations are based on endogenous prospect theory in case of Imperfect Knowledge Economics (Kahneman and Tversky 280).
Utility in many cases is reference biased. In economics, utility is a count of relative satisfaction as well as desirability in consumption of various services and goods thereby economists may refer to an increase or a decrease in utility. Consequently, explanation of economic behavior is given in terms of utility. Utility has been observed to be reference biased as compared to additive utility functions that have been underlined in neo-classical economics. This highlights that people are interested in not only the values that they receive but also the values that are received by others. This hypothesis has been considered as a link with psychology of happiness that asserts that subjective measures of an individuals wellbeing are observed to be stable over a period of time even if standards of living are increased largely.
John A. Lynn who has been a well-known military historian has argued that Prospect Theory has provided an insight into foreign policy that was designed by Louis XIV.
Cumulative Prospect Theory
Moreover it has been researched that in Decision Theories, a term Stochastic dominance is used that defines a situation in which one lottery, based on probability distribution over outcomes, dominates another. These are based on preferences, which are in turn based on outcomes. However only limited knowledge of preferences is required in relation to distribution of outcome and these depend on risk aversion in some cases (Lindzey and Runyan 56). It has been argued that first version of Prospect Theory clearly violated Stochastic dominance. Stochastic dominance argues that one lottery is being dominated by another even if outcomes of a dominant lottery are worse. There were problems in Prospect Theory and later research removed these problems. There was an addition of intransitivity in preferences of Prospect Theory. Thereby a revised version of Prospect Theory was developed that was known as Cumulative Prospect Theory.
Main changes that were introduced in Cumulative Prospect Theory were derivation of probability weighting function from Rank-Dependent Expected Utility Theory. Cumulative probabilities in this case have been changed rather than probabilities. This introduces an overweighting of some extreme events occurring with lower probabilities thus it does not refer to overweighting of small probability events themselves. Cumulative Prospect Theory has applicability of being used on many outcomes that are more continuous.
Conclusion
Thereby it can be added here that prospects are in a positive domain, certainty effects starts to play its roles as it leads to a risk averse behavior in case of gains and outcomes that are predicted and sure. On the other hand, if prospects are in a negative domain, risk-loving preferences are exhibited by population for larger losses, which are more probable.