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Kahneman’s focus has been on judgment, the forming of an opinion about what is, or will be, the case. Now he turns his attention to choice, the selection of some course of action as being preferable to alternatives. Judgment involves deciding what is true. Choice involves deciding what to do. According to expected utility theory, which is the dominant choice paradigm in economics, rational choice involves:

     (1)    Quantifying the desirability, or utility, of each possible outcome and gauging how probable each choice option makes each outcome.

     (2)    Using probability-weighted averaging to calculate the expected utility of every choice option.

     (3)    Selecting the option with the highest expected utility.

Utility is not the same thing as monetary value; the 18th-century mathematician Daniel Bernoulli pointed out that a gift of, say, $100 brings a poor man more happiness than a rich one, which implies that as people’s wealth increases, the same amount of money has less and less psychic value. Except for this adjustment, however, rational choice proceeds just as if the goal were to maximize expected monetary wealth. Kahneman gives the name “Econs” to ideal decision-makers whose behavior follows this model.

Kahneman argues that a representation of how flesh-and-blood human beings think, the standard choice model is flawed in several respects. Humans, he insists, behave quite differently from Econs. This is the most technical part of the book. The explanations are not always perfectly clear, and the figures don’t always exactly match the text, but the key points come through:

•    Utility should be assigned not to outcomes simply as such, but to changes from a reference state. The reference state, or adaptation level, represents the status quo. Whatever the status quo is, people grow attached to it and resist change. Example: people want more compensation to give up an object that has been theirs for an hour (a mug, say, or a chocolate bar) than what they would pay for the same item at a store. This phenomenon is called the “endowment effect.”

•    For most people, the marginal utility of money declines in magnitude not only as gains get larger but as losses get larger. That is, the difference between a $1,000 loss and a $1,100 loss matters less, psychologically, than the difference between a zero loss and a $100 dollar loss.

•    People are “loss averse.” That is, a $100 loss has a greater psychological impact than a $100 gain. As Kahneman explains, this fact should be reflected in Figure 10 of Chapter 26 by an abrupt change of slope as the curve passes through the origin. (The figure, poorly rendered, does not clearly show the kink.)

These three points are the main tenets of prospect theory, developed by Kahneman and Tversky as an alternative to expected utility theory. However, there is another important complication: when weighing their options, people do not weight outcomes strictly by probability. Rather, they attach more significance to probabilities at the extremes. When people think about the probability of an event, the difference between 0 and 5 percent and the difference between 95 and 100 percent each loom larger than the difference between 50 and 55 percent.

Rare events engage people’s emotions and imaginations out of proportion to the events’ likelihood. The economist Maurice Allais pointed out that this quirk in people’s thinking naturally leads to plainly irrational, self-defeating choice behaviors. Ultimately, Kahneman believes the thinking patterns identified by prospect theory are rooted in System 1 habits shaped by millennia of evolution. Loss aversion, for example, reflects evolutionary hard-wiring for a stronger, more rapid response to threats of harm than to prospects of material benefit.

In the remaining chapters on choice, Kahneman considers various ways in which people’s decisions are influenced by contextual factors. The main findings:

The likelihood of rare events
People tend to overestimate the likelihood of a rare event much more when presented with a verbal description of the event than when making a decision based on past experience. Kahneman’s explanation is that the description engages the imagination and allows the event to stand out, in a way it doesn’t stand out in memory. Example: When a basketball fan is asked to estimate the probability that a given team in the conference semifinals will win the NBA playoffs, and is then asked the same question about each of the other seven teams, the estimates for all eight teams will add up to more than 200 percent, which is impossible.

Loss aversion
Loss aversion in the form of fear of regret or blameworthiness biases people toward inaction rather than action, or toward doing the conventional thing rather than the unconventional one.

Loss aversion also encourages the sunk-cost fallacy. Example: A theatergoer will not pay to replace a lost ticket, because that would feel like paying double, even though the same person would buy a ticket after an equivalent loss of cash for unrelated reasons.

Finally, loss aversion causes people to be heavily influenced by whether their choices are framed positively or negatively. Example: Doctors feel better about a course of action that will save 200 out of 600 fatally ill people than one that will fail to save 400 out of 600.

Broad framing versus narrow framing
People choose more logically when they consider several choices (Kahneman calls this broad framing) than when they make one decision at a time (narrow framing). Example: Stock traders do much better, on average, when they base their trading decisions on policies (such as “When inflation is falling, I buy stock in manufacturing firms”) than when they consider each decision by itself.

Similarly, people tend to make more stable moral judgments when they consider several cases at once instead of each case by itself. Example: People’s judgments about appropriate victim compensation in lawsuits improve, Kahneman asserts, when the people are prompted to compare the punitive damages they would award in one case to the amount they would award in another. (As Kahneman notes, the legal system does not agree with him: jurors are routinely instructed not to compare the case at hand to other cases.)

 

 

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