Chapter summary and key concepts

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.

The Endowment Effect

One of the first concepts students in introductory economics learn is that of an 'indifference curve,' which indicates, for example, how much an employee, values an additional hour of leisure vs. working an additional hour. Once again, the author stresses that this does not take into consideration the starting psychological reference point of the employee. There are also subjective externalities which can cause buyers to value certain goods and services more than those goods and services are really worth: a hard-won concert ticket that can be sold on the Internet for $3,000 might remain in a person's pocket, even though he paid $200 for the ticket and would not have paid such a generous sum for it himself. Home owners who have remained in their house for a long time value the home more than a real estate agent who solely looks at market price. The more other people want something, the more valuable it seems and goods for exchange and goods for use are also valued, subjectively in a different manner. Cultural differences regarding how money is viewed also play a role in terms of how people think, as well as if they are poor and all choices function as losses to some degree, given that the choice of one item means the giving-up of another, rather than a gain.