Economics is a notoriously imperialist discipline. Economists are more prone to colonize other scholarly fields than be colonized by them (sociology was an early “victim”). The singular exception to this pattern was Daniel Kahneman’s work in experimental psychology which eventually convinced the economics profession that he had a point – we are not the paragon of rationality assumed in mainstream economics. Instead, we have an innate tendency to think and act in ways that systematically compromise rationality. Such deviations are called “behavioral biases”, and they have become the focus of a vibrant sub-branch of economics known as Behavioral Economics. For his pioneering contributions, Kahneman received the 2002 Nobel Prize in economic science, the first time the prize was awarded to a psychologist.
Among the many of Kahneman’s discoveries, the one that really impressed me was Prospect Theory. If you’ve ever studied economics, you would have come across something called utility functions. An utility function is an upward-sloping concave curve with utility or satisfaction on the vertical axis and money or wealth on the horizontal axis. That the curve was thought to have this shape was taken as the “gospel truth” in mainstream economics since the time of Alfred Marshall, the distinguished 19th-century British economist. The positive slope meant that people always desire more wealth than less (uncontroversial), though with diminishing marginal utility (which signifies risk aversion). Kahneman argued on the basis of his laboratory experiments with his chief collaborator Amos Tversky (1937-1996) that it is the change in wealth and not absolute wealth that is the unit of utility. In place of the concave utility function, Kahneman’s work, which appeared in the highly prestigious economics journal, Econometrica in 1979, led him to formulate an S-shape value function (see figure below).
In theoretical terms, the S-shaped curve means that people tend to be risk averse in the domain of gains and risk seeking in the domain of losses. The change in curvature from the standard utility function appears to be a rather minor change of focus, but a wealth of subsequent research has vindicated Kahneman’s insight. People’s risk propensity do tend to depend on whether they are already gaining wealth or are on the losing side. Risk aversion in the domain of gains explains, for example, why investors tend to sell their winning stocks too early (in case their winners become losers) and why gamblers who lose at the table are prone to keep betting (becoming more risk-seeking in the domain of losses for the hope of recovering what was lost).
I remember having a lot of fun incorporating Kahneman’s ideas in my Finance class when I was teaching in business school, and also testing those ideas empirically in my research. Students took Kahneman’s ideas like fish to water, probably because they resonate so intuitively with the way people actually behave. My research also took off in a vigorous way as one dataset after another provided nearly unequivocal support for Prospect Theory and the implications of the behavioral biases that Kahneman demonstrated over his long and fruitful career. Kahneman died a few days ago (on March 27) at the age of 90. He will be greatly missed.