Maps of Bounded Rationality: Psychology for Behavioral Economics. (d. Kahneman)

Essay                                                                                                           Nikolaeva Daria

Maps of Bounded Rationality: Psychology for Behavioral Economics. (D. Kahneman)

Daniel Kahneman held his Prize Lecture December 8, 2002, at Aula Magna, Stockholm University. The work was done with Amos Tversky during a long and unusually close collaboration. Together, they explored the psychology of bounded rationality in the domains of judgement and decision making under uncertainty. This essay presents a current perspective on the three major topics of their joint work: heuristics of judgment, risky choice, and framing effects. An evolutionary perspective of intuition: Perception → Intuitive thinking → Reasoning. Some of the most highly skilled cognitive activities are intuitive: playing chess at the master level, appreciating social situations. But intuition is prone to systematic biases and errors which are sometimes not correct at all, and are rarely corrected perfectly. In the remainder of this talk Daniel Kahneman illustrated two central properties of perception and how they affect intuitive judgments and choices. To illustrate this idea, he draws an analogy from perception to intuitive thinking and following through that analogy to experimental consequences.

1. Changes vs States. Perceptual representations highlight changes and differences. They are largely insensitive to the level of a state that is maintained for a period of time. If judgements and choices operate on representations that conform to the rules of perception, we expect changes to be salient and maintained states to be mostly ignored. This observation has significant consequences for the interpretation of decision market.

Bernoulli’s great idea. Bernoulli observed that psychological value (utility) does not increase proportionately with money amounts. He proposed that a gamble should be assessed by its expected utility not by its expected value. Expected utility theory is the dominant theory of decision making to this day. Bernoulli’s error. Bernoulli’s second idea was that the merchant evaluates outcomes by considering the wealth he will possess under different contingencies (the ‘carriers of utility’ are states of wealth). In Bernoulli’s analysis you answered the first question (in which gamble was stated in gains and losses) by transforming it into the second (stated in terms of wealth). This is clearly wrong: the answers to the two questions are not the same; none of you thought of your wealth until prompted.

The assumption that final states are the carriers of utility was accepted without much question until recently. The idea that outcomes are evaluated as gains and losses was the core of detailed treatment of risky choice in prospect theory, later extended to riskless choice. The analogy to perception and the borrowed concepts of adaptation and of a neutral reference point guided the development of Prospect Theory from the start.

The value function is defined on gains and losses and is characterized by three features: 1) it is concave in the domain of gains, favoring risk aversion; 2) it is convenient during losses, favoring risk seeking; 3)most important, the function is sharply kinked at the reference point, and loss-averse - steeper for losses than for gains. Bernoulli’s error - the idea that the carriers of utility are final states is not restricted to decision-making under risk. Indeed, the incorrect assumption that initial endowments do not matter. The error of reference-independence is built into the standard representation of indifference maps. It is puzzling to a psychologist that these maps do not include a representation of the decision maker’s current holdings of various goods – the counterpart of the reference point in prospect theory. The parameter is not included, because consumer theory assumes that it does not matter.