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

This psychologist, besides being one of the few who has won a Nobel Prize, is known for his research on limited rationality, in which he questions the idea that human beings are fundamentally rational.

In this article we will see the theory of perspectives of Kahneman and his usual collaborator, Amos Tversky . This model is one of the main developments of the classic concept of expected subjective utility, very relevant in economics and psychology.

Biography and works of Daniel Kahneman

Daniel Kahneman was born in 1934 in Tel Aviv, although he grew up in France during the time surrounding World War II. His family later 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 his PhD in Psychology from the University of California, Berkeley, where he also studied mathematics. He would later become a key figure in the study of human judgement, in behavioural economics and in hedonistic psychology , an aspect of positive psychology that focuses on the analysis of pleasure and the aspects that favour 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 in conditions of uncertainty was particularly noteworthy. 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, part of Princeton University in 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

Kahneman and Tversky’s prospective theory, also known as the theory of perspectives or the theory of aversion to loss, develops the hypothesis of expected utility, a concept from the economic theory of games that states that people choose the alternative that they consider most useful from those available for facing a specific situation.

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

Furthermore, we attach more importance to small losses, even if they are unlikely, than to moderate gains; the authors call this “loss aversion” .Because of our aversion to loss, if we are presented with two equivalent alternatives of which one is formulated in terms of profits and one in terms of losses, we will most likely choose to avoid the latter. In short, we would rather avoid losses than profits.

So, for example, if two financial advisors propose to invest in the same stocks but the first one stresses that they have a moderate average return and the second one that its profit ratio has decreased in the last years, we will prefer the offer of the first advisor.

Kahneman and Tversky stated that the prospect of loss has a greater emotional impact than that of gain and that we tend to perceive the probability of harm as being 50/50, regardless of whether it is much lower.

Main concepts

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

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The benchmark is roughly identified with the average expectation for a given benefit or cost . This benchmark can be an amount of money, such as the usual price of an asset or the salary we earn 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 kilogram of tomatoes costs 60 cents in a shop on our street and 50 cents in another one 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 in buying an appliance.

Applications of this model

The theory of perspectives is often applied to people’s economic behaviour . It is useful for predicting behavior in areas such as organizational psychology, gambling and economics 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 status quo if they are offered alternatives that do not give them greater satisfaction, such as when someone rejects a better paying job than the one they already have because accepting it would mean a change of address and lifestyle.

Likewise, Kahneman’s theory justifies the so-called endowment effect , which makes people give greater value to some things than they objectively have for emotional reasons. Following the previous example, it is possible that someone chooses to continue living in his current city because most of his loved ones reside there.