• Notes on a Nobelist, Part II: Kahneman on Choice with Risk

    This post is short. Use the balance of your time to read something else. Can’t find anything? Try one of my favorite sources.

    This is the second post in a three-post series that summarizes Daniel Kahneman’s Nobel lecture as printed in The American Economic Review in December 2003 (full free version). The first post was on heuristics of judgement and a subsequent post will be on framing effects. This post is about models of choice in the presence of risk. As before, my comments are [in brackets] (actually, there is only one comment).

    We only need to consult our own experience to verify that perception is reference-dependent. A bath of 80°F will feel warm relative to a 60°F one and cool relative to a 100°F one. The same is true about our satisfaction with respect to different states of wealth. That is, we can be risk averse with respect to gains while loss averse with respect to loss. It matters a great deal what the starting point (the reference point) is.

    Kahneman goes to great length in his article to stress that prior work that assumed reference-independence is a poor model of individual behavior. A main idea of his “prospect theory” is that the degree to which we value a unit of wealth depends on our initial endowment. Studies have found that the selling price an individual would assign to a good is often a factor of two higher than the buying price he would assign. That is, the value assigned to the good depends on whether or not you own it (the “endowment effect”).

    Such reference-dependent decision making helps promote the maintenance of the status quo as the disadvantages of alternatives loom larger than advantages. [Political implications…]

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