Behavioural economics seeks to delve into the underlying reasoning behind human rationale, providing valuable insights into the decision-making of individuals amidst situations of uncertainty. This interdisciplinary field has been integral in helping to adopt effective policies and strategies, as it enables both firms and governments to ensure the true motivations and incentives of consumers are considered. Understanding the complexity of human rationale helps to challenge and grow traditional economic theory. However, a conflict arises within decision theory when attempting to identify the most descriptive model to encapsulate human behaviour, particularly between utility and prospect theory.
Utility theory is an economic theory that aims to describe all decision outcomes based on the concept of utility, predicting a ‘preference for dominant alternatives’ (Pittsburg State University, 1995). It is built upon three fundamental principles: 'expectation, asset integration and risk aversion' (Jong, 2018). The principle of expectation posits that individuals act with the intention of maximising satisfaction, upon assessing the potential benefits and costs that arise with each option. Asset integration entails the combination of resources to construct a representative utility value, considering the different factors which may make up one's utility. Furthermore, the concept of risk aversion asserts that individuals are circumspect in risky scenarios. They tend to be more inclined to accept lower expected utility to avoid the potential consequences linked with risky decisions.
Prospect theory similarly is a behavioural economic theory which aims to provide a framework for comprehending the reasoning behind individuals' decision-making in situations that involve risk. The theory was introduced by two renowned psychologists, Daniel Kahneman and Amos Tversky, in 1979. With the publication of their paper entitled 'Prospect Theory: An Analysis of Decision Under Risk', they sought to challenge the traditional assumptions surrounding utility theory and offer an alternative perspective. They argued that decisions made are not always driven by the intent of maximising utility but are influenced by other cognitive features. These factors include reference dependence, loss aversion and diminishing sensitivity. The principle of reference dependence asserts that individuals evaluate outcomes relative to a neutral reference point. Loss aversion is the notion that 'losses loom larger than gains' (Kahneman & Tversky, 1979). Moreover, the idea of diminishing sensitivity focuses on the magnitude of a gain or loss when considering utility rather than absolute values.
For centuries, utility theory has been a valuable framework for comprehending the behaviour of individuals in both risky and riskless situations. Originally developed to tackle the limitations of the expected utility model in predicting outcomes with 'risky prospects' (Tversky, 1989), prospect theory has been expanded qualitatively to the study of riskless choices by researchers such as Camerer et al. (1997) and Fehr and Schmidt (1999). Many of these studies suggest that while there are discontinuities around a reference point that separates gains and losses, both risky and riskless decisions illustrate similar patterns in this regard (Chung et al., 2019). However, quantitative investigations of diminishing sensitivity around a reference point in riskless scenarios are limited, instead relying on qualitative methods such as 'introspection' and an ‘intertemporal choice paradigm' (Chung et al., 2019).
In a 2019 experiment conducted by Chung, Glimcher, and Tymula, the versatility of prospect theory to riskless decisions in the loss domain was questioned (Chung et al., 2019). The experiment assessed consumer choices after implementing the Endowment effect. The results showed that in risky scenarios, the behaviour was consistent with the S-shaped value function, representing concave utility for gains and convex utility for losses, supporting the applicability of prospect theory in risky situations. However, in the riskless choice study, the researchers concluded that due to the slope of the indifference curve being equal to the ratio of gains and losses, loss aversion had no impact on the curves' curvature (Chung et al., 2019). Therefore utility theory's applicability in both risky and riskless scenarios illustrates its effectiveness.
Moreover, the intricate nature of prospect theory provides an unclear framework for understanding behaviour, unlike utility theory, which offers a simpler approach. Prospect theory's incorporation of cognitive influences such as loss aversion adds complexity to the model. In contrast, utility theory's assumption of consumers acting to maximise utility provides a more clear model for evaluating economic policy. Its normative guidance enables the consideration of the welfare of individuals to help them make optimal choices.
However, prospect theory's great intricacy allows for more accurate modelling of individuals' utility and precise decision-making. While utility theory assumes the maximisation of utility, Herbert Simon's research on bounded rationality challenges this assumption. Simon (1976) asserts 'Whereas economic man maximises, selects the best alternative from among all those available to him, his cousin, administrative man, satisfies, looks for a course of action that is satisfactory or 'good enough'.' (Simon, 1976). This perspective resonates with Kahneman and Tversky's (1979) that decision-makers are heavily influenced by cognitive principles, thus introducing the aspects of irrationality within the decision-making process.
Furthermore, considering the concept of diminishing sensitivity provides insight into how individuals perceive changes in outcomes, which subsequently influences their utility. For example, research by Stevens (1957) reveals that individuals are more likely to discern a difference between a 2kg and 3kg weight, but are less likely to perceive a distinction between a 22kg and 23kg weight (Stevens, 1957). Similarly, in the perspective of wealth, Kahneman argues that 'the subjective difference between $900 and $1000 is much smaller than the difference between $100 and $200 (Kahneman, 2011). Supporting this notion, Kim et al. illustrate that 'value-driven attention is based on relative value rather than absolute value' (Kim et al., 2022). By accounting for the magnitude of a change in outcome relative to a reference point, we can create a more accurate model of individuals' utility.
In addition, the principle of loss aversion can be pivotal when describing behaviour. Kahneman highlighted how the 'asymmetry between the power of positive and negative expectations has an evolutionary history' (Kahneman, 2011). Organisms have a greater chance of survival if they treat threats as more pressing issues in comparison to opportunities. This pattern of behaviour is encapsulated in the S-shaped function curve, with concave utility for gains and convex utility for losses. Loss aversion further provides reasoning for the endowment effect, where a bias occurs when individuals overvalue things they own, despite its objective market value (Kahneman et al., 1991). Individuals are more reluctant to give away a good once they have established ownership. Moreover, loss aversion can be used to describe the disposition effect, whereby 'when an individual investor sells a stock in his portfolio, he has a greater propensity to sell a stock that has gone up in value since purchase than one that has gone down' (Barberis et al., 2009). Due to the loss-aversive nature of investors, they are more reluctant to sell losing investments and are more likely to hastily sell winning investments. Therefore the consideration of loss aversion helps to adapt policies and marketing strategies in a way that resonates with individuals’ psychological bias, therefore leading to more effectual outcomes.
To conclude, utility theory has long served as a framework for uncovering individuals’ rationale, but it is crucial to acknowledge the existence of cognitive biases to truly encapsulate human behaviour. Factors such as reference dependence, loss aversion and diminishing sensitivity play a pivotal role in shaping individuals’ rationale and decision-making, deviating from traditional economic theory. To model behaviour effectively, a synthesis of prospect theory and utility theory could perhaps be implemented, combining prospect theory’s descriptive elements and utility theory’s normative elements. The integration, notably through the implementation of reference points, offers a more comprehensive understanding of individuals’ rationale and decision-making. Moreover, this not only provides a more accurate understanding of individuals’ rationale but also offers the chance to strengthen policy and intervention methods to align with individuals’ psychological biases when making decisions. By embracing this synthesis, we can therefore more precisely model human behaviour.
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