4 The Reality of Homo sapiens
You have already tested the reality of being a member of Homo sapiens in Chapters 1 and 2 by engaging in a variety of thought experiments and learning second-hand about experiments that have measured the extent to which people like you and me fall victim to effects such as Depletion, Priming, and Conformity, to name a few. Now it is time for you to engage in the same laboratory experiments that Kahneman, Tversky, Thaler, and others famously devised so that you can test just how far Homo sapiens deviate from the rationality axioms and other thresholds of consistency in our choice behavior. Before diving into the experiments though, we need to discuss (at some length) Kahneman and Tversky’s (1979) revision to the expected utility theory presented in Chapter 3, which they called Prospect Theory. This is behavioral economics’ bedrock theory. Making this detour here will enable us to set some crucial benchmarks for the experiments to follow.
Prospect Theory**
Several of the departures from the traditional rational choice model featured in Kahneman and Tversky’s (1979) Prospect Theory conveniently arise in what appear to be innocuous adjustments to our original graph of utility function depicted in Figure 3.1. As we will see, these adjustments are nuanced, so be careful not to jump to conclusions.[1]
For example, Kahneman and Tversky (1979) propose that people do not normally consider relatively small outcomes—like the wins and losses of the lotteries we’ve previously encountered—in terms of their total wealth, but rather in terms of the lottery’s gains and losses independent from their initial wealth level. And just as an individual’s utility can be represented as a concave function of the size of a gain from a lottery, the same can be said of a loss (i.e., the difference in (dis)utility between a loss of $200 and a loss of $100 appears greater than the difference in (dis)utility between a loss of $1,200 and a loss of $1,100). And to the extent that people suffer from “loss aversion,” the concave function defined over losses is steeper than that defined over gains (i.e., Homo sapiens consider a loss of $X more averse than an equal but opposite gain of $X is deemed attractive).
These adjustments to the standard utility function first depicted in Figure 3.1 are pictured below in Figure 4.1, resulting in the individual’s “value function.”
Figure 4.1. Homo sapiens’ Value Function (Prospect Theory)
Begin by noticing that the “reference point” for the value function is not the individual’s initial wealth level.[2] Rather it is the origin of the graph, here corresponding to $0. Next, as mentioned above, note that utility derived from gains, or a lottery’s winnings, is concave just as it is for our original utility function . Thus, the value function similarly depicts diminishing sensitivity to gains. Finally, note that the individual’s disutility derived from a lottery’s losses is not only concave (thus depicting diminishing sen