Last month, I reviewed Freakonomics by Stephen J. Dubner and Steven Levitt and learned how to view the world from a new perspective, critically analysing outcomes and the rationale leading to them. This led me to further discover the relatively new branch of economics aptly named behavioural economics. In classical economics, a core assumption also built into economic models is that economic agents behave rationally. Producers wish to maximise their profits and consumers wish to maximise their utility – their total satisfaction gained from consuming a good or service. Behavioural economics is a blend of psychology and economics, considering external social and cognitive influences in decision making.

A fundamental theory in behavioural economics is prospect theory, devised by Daniel Kahneman and Amos Tversky in their 1979 book, ‘Prospect Theory: An Analysis of Decision under Risk.’ It builds off utility theory in classical economics, in which economic agents choose the outcome that maximises their utility. Kahneman and Tversky’s work show that influences, such as loss aversion, mean that consumers do not always pick the utility maximising option. Loss aversion is the idea that deals with the psychology of losses and gains. We tend to be affected more by losses compared to gaining the same amount, based on a specific reference point. For example, you are given two options:

Option A: 50% chance of gaining £10,000 and a 50% chance of gaining £0

Option B: 100% chance of gaining £5,000

Prospect theory states that we are more likely to choose the second option. This is because we are risk averse, and so will prefer with certainty to gain £5,000 as opposed to taking the chance on an even higher reward at the cost of gaining nothing. However, what happens if we slightly change the potential outcomes?

Option A: 50% chance of losing £10,000 and 50% chance of losing £0

Option B: 100% chance of losing £5,000

This time, it is predicted that you will choose option A. What has changed in this scenario is that we have become more risk seeking, relying on the probability of not losing any money at all than losing the same amount that we would have gained earlier. This is the idea of loss aversion, and can be viewed graphically, as shown.

The graph suggests that there is a greater negative value placed on an increase in losses, as opposed to a smaller positive value gain when faced with the same increase in gains.

This graph can be applied to a final example, in which the expected outcome is the same, yet there is a deviation in our option preference. In a famous experiment conducted by Kahneman and Tversky, they gave two groups of participants two options based on the given scenario:

It is expected that a disease is going to kill 600 people.

Option A: You can guarantee saving 200 lives

Option B: You have a 1/3 probability of saving 600 lives and 2/3 probability that no lives will be saved

A second group of participants were given these options:

Option A: 400 people will die

Option B: There is 1/3 probability no one dies and a 2/3 probability everyone dies

In the first group, the majority vote was Option A, whilst to the second group, Option B was the majority vote. You will notice that the outcome remains the same, yet its phrasing influences people. In reference to the first option, participants are either faced with a loss or gain, and as explained earlier, treat these differently. Furthermore, the second group is faced with the prospect of more deaths, as opposed to the more optimistically phrased, ‘saving of lives.’ The experiment demonstrates the framing effect and loss aversion as part of prospect theory all in play here.

These observations also exist in the real world and was recently explored by Laura Kudrna and Kelly Ann Schmidtke regarding the Covid-19 pandemic. They noticed that when the government’s marketing slogan was changed from the initial, ‘save lives,’ campaign to emphasising the idea that people will die if rules are breached, there appeared to be more of a public response.

Such framing of situations are constantly used by advertising agencies. For example, ‘85% less fat,’ appears like a healthier alternative to the actual, yet exactly the same reality, of ‘15% fat.’ Look out for such advertisements that use the framing effect to positively frame perhaps less flattering information about products.

Prospect theory can also be used to explain various other behavioural economic principles, such as the endowment effect. The endowment effect states that we have an emotional bias towards overvaluing an object we already own irrespective of its market value and so are less likely to give it away. For example, if you were given a £200 statue by your grandmother and were offered £400 for it, you may be less likely to give it away due to the sentiment behind it. This is another example of consumers not behaving rationally and works in conjunction with loss aversion and prospect theory.

Overall, whilst the purpose of economics can be debated, (though it is often believed to be aiming for the equitable and efficient distribution of resources) at its core, it is about studying the behaviour of economic agents in order to make predictions about the future. Behavioural economics and prospect theory thus form a fundamental branch from classical economics in achieving this and can be seen in the real world today.