Behavioral economics and prospect theory's critique of rational choice

Bernoulli's Errors

Economics tends to take a rather strange view of how people's psychology operates when making decisions, versus the field of psychology. Instead of making choices based upon personal preferences, economics views human decision-making as a rather abstract process. For example, people are assumed to make choices between apples and oranges based upon price alone. But the intuitive choice is not necessarily the most rational choice. The chapter also discusses Bernoulli's supposition that people prefer a 'sure thing' versus a risk. However, in the real world, individuals often act in ways that seem risky, foolhardy, and against their best interests. Economics often fails to consider that decision-maker's perceptions of utility and risk depend upon their perceptions of their personal wealth -- and the history of their wealth, not rationality alone.

Prospect Theory

This chapter begins with a self-examination: Bernoulli's theory rests on the notion that people are sensitive to small shifts in wealth, yet the author admits that 'off the cuff' he could not give an assessment of his own financial status in such an exact manner. There are also emotional attachments to decisions Bernoulli fails to heed. People dislike losing and like winning. They can also become 'adapted' to winning or losing, which affects their emotional perceptions of the experience. Even monetary differences seem emotively different ($900 versus $1,000 seems greater in disparity than $100 and $200). People are also more likely to make bad decisions when all of their options seem bad. Prospect Theory, as proposed by the author, is more useful than simpler Utility Theory because the decision-maker's starting point must be taken into consideration.

Bad Events

We are naturally, as humans, inclined to 'think fast' when confronted with bad events. Even words like 'vomit' produce a visceral reaction within us that is stronger than good words. The long-term success of a relationship -- negative or positive -- often is more dependent upon avoiding the negative. This affects our long-term planning. We set short-term financial goals and while it might be more rational to try to make as much money as possible in the long-term, once we meet the short-term goal we