Prospect Theory
The modern era of applied decisional sciences can be seen to have begun in 2002. In that year, the Nobel Prize Committee awarded the prize in economics to a psychologist with absolutely no training nor official experience in economics; in the process recognizing and sanctioning a new field – Behavioral Economics.
According to the official citation, Daniel Kahneman was given this recognition “for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty” along with Vernon L. Smith “for having established laboratory experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms”.
Kahneman’s empirical findings were seen as a challenge to the assumption of human rationality prevailing in the modern economic theory of Neumann and Morgenstern as proposed in 1944. Michael Lewis, author of Moneyball and The Undoing Project (we’ll get to those connections shortly) points out that, while Kahneman shared the Nobel in 2002 with someone with whom he had not collaborated,
Prospect theory was, in fact, the result of a collegial and personal sharing of the minds between Kahneman and Amos Tversky. Unfortunately, Tversky died before the Nobel Committee made its choice and the Nobel Prize is never awarded posthumously.
In Lewis’ words (from The Undoing Project):
“The prospect theory is an economics theory developed by Daniel Kahneman and Amos Tversky in 1979 (as part of their fascinating work for the Israeli Defense Forces) …. It is the founding theory of behavioral economics and of behavioral finance and constitutes one of the first economic theories built using experimental methods…. contrary to the expected utility theory, which models the decision that perfectly rational agents would make, the prospect theory aims to describe the actual behavior of people.”
In the original formulation of the theory, the term prospect referred to the predictable results of a lottery. However, the prospect theory can also be applied to the prediction of other forms of behaviors and decisions. At the risk of grossly oversimplifying Prospect Theory – Tversky and Kahneman were looking for a way to replace irrational human decisioning with something closer to experience-quantified algorithmic models.
In 2011, Kahneman wrote the bestselling book, Thinking Fast and Slow, which explains the theory in his terms and shows how it works in real life. That book, which has sold close to two million copies, is the subject of a subsequent essay in this series.
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