Kahneman’s prospect theory

To those familiar with the internal contradictions of classical economic theory, Daniel Kahneman’s prospect theory discussed in Thinking, Fast and Slow brings something of a relief: by accepting the apparent irrationality of agents, economics becomes, well, more rational as a whole. And yet, applying the results of psychological research to economics, as Kahneman does, raises several questions.

Due to the very nature of economics, its analysis does not rely to any significant extent on experiments (notwithstanding the fact that some of the more controversial policies or management decisions are indignantly termed “experiments” by their opponents). Instead, economics uses econometric methods and models for its studies, comparing collected data with certain assumptions and predictions. Psychology, on the other hand, relies mostly on designed studies to reach its conclusions. The majority of these studies is small and is conducted in a laboratory setting.

And herein lies the rub: a lab experiment does not necessarily reflect realistically the behavior of real people in real life. The “helping experiment” described by Kahneman is just one example (whether or not the experiment was real or just invented for the purpose of the study). First of all, Kahneman elaborates extensively about the importance of an appropriate sample size. And then, in another section, he comments on an instructive study that had all of 15 (that is: fifteen!) participants. That means that each individual participant brought a weight of 6.7% to bear on the result of the study.

Another question is just who the participants in psychological studies typically are. It is all-too well known that most such research is conducted in an academic environment using easily and readily available subjects: undergraduate students. Numerous flyers around U.S. campuses offer $5, $10, or even $40 for 15-120 minutes of participation in a psychological study. That fact and the amount of remuneration by itself limits the number of likely participants, since even well-endowed academic institutions with superior grant-writing skills do not have unlimited resources, and funds available for allocation are often spoken for by multiple research projects. Then, there are psychology students who are required both to participate in psychology labs and to conduct their own field studies. As anyone who ever tried to have a bit of rest in an undergraduate lounge knows, students routinely attempt to poll their peers to complete some psychology assignment. Unless a researcher or a student has the tenacity and financial resources for serious incentives to venture outside campus, the majority of such psychology studies will inevitably be done on undergraduates – hardly a group representative of society as a whole, especially when it comes to rational and responsible economic decision-making.

Of course, having undergraduates as study subjects does not begin to account for the entirety of sample bias – those students are also mostly a self-selected sample. One group will be psychology majors who find themselves compelled to conduct and participate in studies as a quid pro quo with their friends (I poll you, you poll me). Another class will be students who try to make some extra money without having to leave campus, by, in a manner of speaking, becoming regular lab rats. Psychology students are expected to know the basic principles of study design. That means that they will most likely know that they are tested on something entirely different than the purported questions. Even non-majors will, with sufficient experience, figure out quickly what the studies are likely to be really about. As in all or most standardized tests, bright college students learn how to beat the system and to anticipate the “correct” answer, if only to avoid feeling embarrassed by being fooled by the study itself.

And then there is the difference between real life and research – many students will simply not care which of the two or three options on the screen they choose. And yet studies understandably try to compel their subjects to make a decision by not providing a “whatever” option.  Assigning far-reaching conclusions to haphazard choices forced on students who try to fulfill some other requirement (lab credits or $10) constitutes a very shaky ground on which to base behavioral science. Additionally, a choice between an assured $100 and $1,000,000+ with a 10% probability is purely hypothetical in a laboratory setting, hence not really subject to empirical verification the way tradeoffs between small “prizes” such as chocolates and coffee mugs would be. Similarly, counting on students to come out of their study booths to react to simulated choking sounds after they had presumably been through several other unpleasant lab-orchestrated situations sounds a bit like too much optimism.

Obviously, polling instead faculty members who actually work in psychology will not make the study any less biased than using undergraduates. What might happen, though, is that they will indeed be tested on the application in their own decision making of the theories they profess to use in their scholarly work. As Daniel Kahneman showed on the example of statistical applications to sample size, even here there is an uncomfortable and quite readily apparent gap between theory and practice.

We may accept, however, that for purely statistical reasons (since the same results are confirmed over and over in numerous studies, so they would at least appear to suffer from the same inherent flaws to very similar degree), psychological findings regarding economic decision-making are still fairly sound. After all, in real life people overwhelmed with countless daily decisions often simply rely on the intuitive responses of System 1 to “simplify their lives” without engaging in too many tiresome analyses that involve the actual use of cognitive faculties of System 2. 

Should we, then, side with Sunstein’s or Slovic’s opinion on policymaking and risk? Due to the nature of democracy, public opinion, however irrationally flawed and swayed by rumors and unfathomable influences, does have an irresistible effect on public officials who, aside from the judiciary, are in a constant state of running either for office or for reelection. But who says policy consultants are really impartial, either, and not themselves susceptible to fallacies in assessing risk? Still, Kahneman’s postulate to accommodate public fears regardless of their merits leads down a very slippery slope, as history has shown on countless occasions ranging from witch hunts to the Red Scare to plays on xenophobic fears sometimes capable of reaching, under a confluence of unfortunate circumstances, a culmination like the Holocaust.