Prospect Theory and Reference Points

Expected Utility Theory (EUT), being the very core of economics studies, has loopholes of its own, which specifically arise during the experiments conducted in the attempts to have empirical results. These experiments showed on various occasions that EUT predictions do not hold. This is an indicator that the underlying assumptions of EUT could sometimes be considered strong and not reflective to the reality, which is why other alternatives were proposed by behavioral economics.

Prospect Theory (PT) is one of these alternatives, and it takes a different approach. A prospect consists of different outcomes along with the associated probabilities of those potential outcomes being realized. According to PT, people make decisions under risk by going through two stages – editing (coding, combination, segregation, cancellation, simplification, detection) and evaluation. The latter, in its turn, consists of four main points – reference points, loss aversion, diminishing marginal sensitivity and decision-weighting. The first one will be discussed in detail in this paper.

Reference points are points denoted as zero on the value scale, with outcomes having values measured as deviations from this reference points in terms of gains and losses. Rather than looking at results in absolute terms, PT tried to find relativity, one of the ways being the introduction of reference dependence. This phenomenon is able to explain different anomalies economists encountered in experiments.

Kahneman and Tversky (KT, 1979) state that the assumption of relative dependence and outcomes being considered relative to the reference points is compatible with basic principles of perception and judgement. They claim that our perceptual apparatus is attuned to the evaluation of absolute magnitudes. When we respond to attributes such as brightness, loudness, or temperature, the past and present context of experience defines an adaptation level, or reference point, and stimuli are perceived in relation to this reference point (p. 277). It is often assumed in analysis that the relevant reference point for evaluating gains and losses is the current status of wealth or welfare, but this need not to be the case. In particular, the relevant reference point may be the expected status rather than the current status (Klaes and Wilkinson, 2012). To better illustrate it consider the following: a person places one hand in cold water and the other one in hot water for a certain time. Later he places both hands in normal temperature water. It appears that the subject should feel the same temperature on both hands, but from past experience we all probably have had the strange sensation of the hand that has been in the cold water feeling warm and vice versa for the other hand. It seems that the brain is unable to override the separate reference points (cold and hot) of previous temperature that it formed in the past.

Happiness studies have been very popular for a while now, and the phenomenon that is quite often referred to as “Happiness Treadmill,” is a vivid example of an anomaly of the standard model. Statistics show that the income of average Americans has been increased by 40% in real terms since 1972. Yet in spite of this, they report no difference in happiness. This has been the case in other countries as well.

There is also empirical evidence that supports reference points concerning the gender gap. Rizzo and Zeckhauser (2007) use data from the Young Physicians’ Survey and find that males set higher reference incomes and respond more strongly to reference incomes compared with females. They show that reference incomes explain the gender gap in earnings and earnings growth rates. Expectations are another point that play a crucial role in relative incomes. However, this is not very unique and specific to incomes only, but rather could be applied to other spheres as well. For example, if a student expects to receive a grade of fifteen, but ends up receiving thirteen, which by the way is still considered to be a good grade, she tends to be rather not so satisfied with the result. From personal experience, I can claim this is a very typical result to the above described situation.

Another interesting phenomenon when it comes to reference points, is the status concern. A student receiving ten might feel kind of devastated for the low grade, but it seems not so bad, when she finds out that the majority of the students received lower than her. I think this is also a situation we all can relate, if not in the role of a student, but in most other situations.

In spite of the fact that Prospect Theory gives answers to various anomalies as opposed to EUT, PT still has just as well-developed criticism. Among other arguments is the point of internal contradictions in particular proposed by Birnbaum (2008), who cites other empirical studies that are claimed not to be aligned with PT. He states that PT can explain most empirical results ex post by applying the editing rules selectively, but it has troubles predicting on ex ante basis, which obviously is a huge disadvantage.

Another judgement, which specifically refers to the reference points, is the exogeneity of them. Lacking this tool to determine the reference points endogenously also affects the estimation of the effects of loss-aversion. It is a necessary condition, which is not fulfilled by the theory. A good example of this is the endowment effect, which claims that subjects are going to value the endowment they received for free for the purposes of the experiment differently than if they were to earn it. In practice though, it is really hard to design an experiment that overcomes this issue by allowing the subjects to experience real losses without destroying the incentive to participate in the first place and at the same time create the needed reference points.

Yet a different interesting approach is taken by Plott (1996) to attack Prospect Theory. He came up with discovered preference hypothesis (DPH), which states that people’s preferences are not necessarily revealed in their decisions, but rather they need to be discovered by information gathering, deliberation and trail-and-error learning.

Observing the reality and trying to model it by coming up with a theory, has its reciprocal process of testing and applying this theory to the reality usually through experiments. This is when anomalies arise. This time, people attempt to create a model that will encounter these inconsistencies. Persistent deviation from the Expected Utility Theory or the standard model, as it is commonly referred to, has been shown in experiments, which created the motivation to construct alternative theories, one of which is Prospect Theory. This theory, on its turn, has its own anomalies and inconsistencies, which supports the fact that no theory is perfect. It is highly probable that depending on the situation, one theory is better suited than the other.

Reference points are chosen as a key point from the PT to be discussed in the paper. It has been proved to be very useful in different studies of behavioral economics. Considering the general interdependency of the entire world, it is reasonable to include that in the theory itself as well. Rather than looking at outcomes in absolute terms, PT compares them to the current or expected outcomes, which seems to be more reflective to the reality. There are many studies supporting the existence of reference points, which also solve the anomalies experienced by the standard model.

Just like any other theory, PT also has its disadvantages. The main counterarguments of internal contradictions, the exogeneity of reference points, and the discovered preference hypothesis, are discussed in the paper, which highlight the negative aspects of Prospect Theory. These points are, in fact, valid aspects on the limitations of PT, and should be examined in great detail to try to develop the theory even further.

Taking into account all the arguments discussed in the paper, I would like to point out the usability of Prospect Theory and reference points specifically. It does give answers to different problems and inconsistencies encountered by the standard model. The point of relativity and relative dependence is logical and reasonable given our experiences. However, just as important are the downsides of the theory that are presented in the paper. It is probably preferable to have a variety of models, use a mix of theories depending on the situation, rather than follow one blind and abandon the rest. It is crucial to be aware of the limitations of theory that is being used not to end up with biased results.

References

Birnbaum, M.H. (2008) new paradoxes of risky decision making. Psychological Review, 115 (2), 463-501

Kahneman, D. and Tversky A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47, 263-91.

Plott C.R. (1996). Rational individual behavior in markets and social choice processes: The discovered preference hypothesis. In K.J. Arrow, E. Colombatto, M. Perlman, and C. Scjmidt (Eds), The Rational Foundations of Economic Behavior. New York: St. Martin’s Press, 225-50.

Rizzo J.A., and Zeckhauser, R.J.  (2007). Pushing incomes to reference points: Why do male doctors earn more? Journal of Economic Behavior and Organization, 63(3), 514-36.

Wilkinson, N., and Klaes, M. (2012). An Introduction to Behavioral Economics.

 

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