The Perspective Theory Of Daniel Kahneman

A theory about how we value the possibility of losing or winning when making a decision.

In the field of psychology applied to economic behavior , the figure of Daniel Kahneman stands out, an American-Israeli author whose work has focused on the determinants of decision-making in situations in which profits and losses are uncertain. 

This psychologist, in addition to being one of the few who has won a Nobel Prize, is known for his research on limited rationality, in which he calls into question the idea that the human being is fundamentally rational.

In this article we will look at the perspective theory of Kahneman and his regular collaborator, Amos Tversky. This model represents one of the main developments of the classic concept of expected subjective utility, very relevant in economics and psychology.

Biography and work of Daniel Kahneman

Daniel Kahneman was born in 1934 in Tel Aviv, although he grew up in France around the time World War II. Later his family moved to Palestine. From his childhood and youth, Kahneman highlights the relevance of human interaction and complexity in Jewish culture and his own interest in existentialism as fundamental factors in his decision to become a psychologist.

In 1961 he received a doctorate in psychology from the University of Berkeley, California, where he also studied mathematics. Later he would become a key figure in the study of human judgment, in behavioral economics and in hedonistic psychology, a branch of positive psychology that focuses on the analysis of pleasure and the aspects that favor or harm it.

In 2002 Kahneman won the Nobel Prize in Economics in recognition of the many contributions to this field that he has made from psychology in collaboration with the late Amos Tversky. His work on decision-making under conditions of uncertainty was particularly highlighted. He has also received awards from the American Psychological Association and the Society of Experimental Psychologists, among others.

Kahneman is currently Professor Emeritus and Senior Research Fellow at the Woodrow Wilson School of Public and International Affairs, which is part of Princeton University, New Jersey. He is also an honorary member of the Universities of Berkeley and British Columbia, as well as the Hebrew University of Jerusalem and other institutions.

Kahneman and Tversky’s theory of perspectives

The prospect theory of Kahneman and Tversky, also known as the theory of prospects or loss aversion, develops the hypothesis of expected utility, a concept from game economic theory that states that people choose the alternative that we consider the most. useful among those available to face a specific situation. 

According to the theory of perspectives, when there is uncertainty about the results, we tend to opt for certain rewards over less probable ones , even if the value of the former is lower. 

We also attach more importance to small losses, even if unlikely, than to moderate gains; the authors call this “loss aversion. Due to our aversion to losses, if we are presented with two equivalent alternatives of which one is formulated in terms of profit and the other of losses, we will most likely choose to avoid the second. In short, we prefer to avoid losses than to profit.

Thus, for example, if two financial advisers propose to invest in the same shares but the first one highlights that they have a moderate average return and the second that their profit ratio has decreased in recent years, we will prefer the offer of the first advisor.

Kahneman and Tversky stated that the loss perspective has a greater emotional impact than the profit perspective and that we tend to perceive the probability of loss as 50/50, regardless of how much less.

Main concepts

In addition to the concept of loss aversion that we have already seen, the perspective theory contributes two other fundamental aspects: the evaluation relative to a reference point and the variable sensitivity.

The benchmark is roughly identified with the average expectation for a given benefit or cost. This reference point can be an amount of money, such as the usual price of a good or the salary that we obtain each month, or any other quantitative indicator.

The concept of variable sensitivity refers to the fact that our sensitivity to losses decreases as the reference point increases. For example, if a kilo of tomatoes costs 60 cents in a store on our street and 50 in another that is 15 minutes away, we will probably choose to buy in the second one, but we will not make the same effort to save 10 cents on the purchase of an appliance.

Applications of this model

Prospects theory is frequently applied to people’s economic behavior. It is useful for predicting behavior in areas such as  organizational psychology, gaming, and the economy itself.

This model explains different psychological effects, such as the “status quo”. In economics, this term refers to the fact that people often prefer to maintain the current state if we are offered alternatives that do not provide us with greater satisfaction, as happens when someone rejects a better paid job than the one they already have to accept. it would imply a change of address and lifestyle.

Likewise, Kahneman’s theory justifies the so-called endowment effect, which makes people give a higher value than they objectively have to some things for emotional reasons. Following the example above, someone may choose to continue living in their current city because most of their loved ones reside there.

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