Prospect theory is one of the foundation stones of behavioral economics. Subsequently it has
numerous implications for practice and in this post I will present four of
them. These four principles were introduced by Richard Thaler. Mr. Thaler is an
economist, but what made his work special is that he embraced behavioral
insights and incorporated them in his work on economics.
I strongly recommend his book Nudge
written with Cass R. Sunstein. It
is a wonderful collection of how insights from behavioral sciences can be used.
Before
presenting the four principles proposed by Richard Thaler, I would like to
invite you to take a look at the graph for the utility (value) function from
prospect theory.
As you can see, this function is concave
for gains and convex for losses. In simpler words, for gains: in the case
of large amounts the benefit per unit decreases. Similarly for loses: in the
case of large amounts the pain per unit decreases.
In addition, as you can see from the
graph, the slope of the function is
steeper for losses compared to the area of gains. This is loss aversion. In
brief, a loss hurts more than the pleasure brought by an equal gain.
Keeping this in mind, here are the
four principles of integration or segregation of outcomes proposed
by Richard Thaler:
First,
segregate gains. When faced with a large gain, the utility (benefit)
per unit decreases (the function is concave). This implies that two smaller gains are better than a larger
one with a value equal to the sum of the two smaller ones.
For example if you are to offer a
future discount of 100 Euros in the form of a voucher, it will be better for
the client to receive two vouchers of 50 Euros.
In mathematical expression this
would go like this:
U(50) + U(50) > U(100)
Second, integrate losses. In the case of losses the function is
concave, this implying that the pain of
a large loss is smaller than the added pain of two smaller losses that summed
up are equal in value with the larger loss.
For example if someone has to
suffer a pay cut it is better to say that his overall annual salary will be
smaller with 3000 Euros in total than to say that 2000 Euros will be cut from
the actual salary and 1000 will be cut from the annual bonus.
In mathematical expression this
would go like this:
U(-2000) + U(-1000) > U(-3000)
Don’t get me wrong, I am not
saying that the person will not feel pain (disutility). It is just a comparison
between two amounts of pain.
Third, cancel losses against larger gains. Since losses loom larger than gains, it is better to have a smaller
gain than a larger gain and a loss.
For example, if you have two
projects that might or might not pay off and one of them brings a profit of
1000 Euros, while the other failed to become profitable and lead to a loss of
200 Euros. Instead of seeing the outcome as 1000 Euros gain and 200 Euros loss
it is much better to see it as 800 Euros gain.
In general losses bring a pain
that is twice as large as the pleasure of a gain in equal amount would be. In
this case the 200 Euros loss will be perceived as a “pain” that could be
compensated by a gain of 400 Euros. This would leave you with the benefit (utility
/ pleasure) of only 600 Euros.
In mathematical expression this
would go like this:
U(-200) + U(1000) < U(800)
Fourth,
segregate “silver linings” (large loss, small gain). The utility
function is concave in the case of losses, implying that the difference between
in the pain generated by a loss of 1000 Euros and the pain generated by a loss
of 1010 Euros will be very small. At the same time in the area of gains the
function is convex, but only for larger values. This implies that when having to deal with a large loss and a
small gain it is better to not integrate them.
For example, if your car broke
down and you need to pay 1010 Euros for repairing it and in the same day you
play the lottery and win 10 Euros, it is better to see these two outcomes
separately. Truly, the pain of losing 1010 Euros is roughly the same as losing
1000. At the same time, the pleasure of wining 10 euros in a lottery is quite
large in comparison with no wining anything.
In mathematical expression this
would go like this:
U(-1010) + U(10) > U(-1000)
These principles proposed by R. Thaler seem common sense, but at the
same time they are very important and sometimes we simply don’t take them into
account.
This post is documented from: Thaler,
Richard H. (1985), "Mental Accounting and Consumer Choice," Marketing
Science, 4 (3), 199-214.
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