There has been a long debate in economics about the rationality of people’s choice. In the early periods, academics (mainly mathematicians) assumed that people made choice based on mathematically calculated expected values. If people were faced with a decision to make, academics assumed that they will calculate the expected value for each of the options available and choose the one with the highest expected value.
This assumption was later challenged by Nicolas Bernoulli and modified by his cousin, Daniel Bernoulli. Nicolas Bernoulli challenged the theory by presenting a type of gamble which had an expected reward of infinity. Under the expected value assumption, people were expected to pay all their fortune, but in reality, they were likely to pay only a modest amount. This is a famous analysis now known as the St Petersburg paradox. Daniel Bernoulli modified the expected value assumption, so it will be consistent with this paradox. He insisted that what matters was the subjective value, or utility, rather than the expected monetary reward, and that this subjective value increased in a slower rate as the quantity of the reward increased.
Bernoulli’s theory has been developed into what is now called the expected utility theory. One of the key achievements in developing this theory was the work by John von Neumann and Oskar Morgenstern which defined most of the axiom now considered as completeness, transitivity, continuity and independence. Completeness requires that people can state their preference between the choices: whether they prefer A over B; B over A; or indifferent between A and B. Transitivity requires that if a person prefers A over B and B over C, the same person will prefer A over C. Continuity requires that if a person prefers A over B and B over C, there will be a probability p where the person will be indifferent between choosing B and a gamble offering A with probability p and C with probability (1-p). Finally, the independence axiom requires that the value a person places on the option will not differ by changing the probability or presenting other choices. These were the assumptions required for the expected utility theory to hold.
However, although many still think that the expected utility theory holds as a normative statement, many questions have been raised on its use as a descriptive statement. One of the earliest challenges may have been those from Maurice Allais questioning the independence axiom. He has shown, by a simple gambling example, that people’s preference might change by the context, and that they tend to prefer certainty over risk in a way that would violate the axiom. Like Allais, Daniel Ellsberg published a thought experiment showing that people preferred risk over uncertainty more than one would expect from the expected utility theory. Many studies, including those by Allais and Ellsberg, pointed violations on the axioms for the theory, and these findings led to the development of the prospect theory by Daniel Kahneman and Amos Tversky.
Kahneman and Tversky modified the expected utility theory regarding assumptions on utility and probability, so it will be consistent with these violations. On utility, they introduced concepts of reference points and loss aversion to the original theory. People were thought to be more sensitive to gains and losses from what they already have (reference point), rather than absolute outcomes, in measures of utility. Also, people were assumed to put more value on losses compared to gains: the amount of pain they will feel from being taken away some money would be larger than the amount of joy they would gain from being given the same amount of money (loss aversion). In regard to probability, they insisted that subjective probability would differ from mathematical probability. People tend to overestimate small probabilities and underestimate large probabilities. By introducing these modifications, Kahneman and Tversky succeeded in overcoming most of the violations pointed out to the expected utility theory.
At the same time Allais and Ellsberg were questioning the axioms of the expected utility theory, there were others questioning its validity from a different aspect. Herbert Simon raised questions on the concept that people try to maximise their utility. He claimed that people often tried to satisfice rather than optimise their decisions and used heuristics in this means. He insisted that because people have so much choices to make in a day, they would tend to keep simple rules to make satisfying choices, instead of optimising them by considering all the evidence for each decision. These heuristics, as beneficial as it may be, might cause biases in human decision making. They might make people change their decision based on how the choices are presented. Many heuristics and concepts that affect our decision are now introduced in the literature such as:
- Status quo bias: people are reluctant to move from the position they are already in
- Availability: people tend to assess the probability of an event by the ease with which similar instances can be brought to mind
- Anchoring: people often place heavy emphasis on particular prominent or salient features of goods or outcomes.
- Overconfidence bias: (self-explanatory, I think….)
- Confirmation bias: people look for information that supports the opinions they already have.
These counteraction to the expected utility theory led to an area of research what is now known as behavioural economics.
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