Tuesday, December 10, 2013

Thinking, Fast and Slow, A Catalog of Fallacies: Part 4

Now for the fourth part of the book, and the last part of this series.  This part focuses on the disparity between the image of the rational agent in classical economics and the image of the agent as observed by psychology.

Reference Point
A reference point is a context, usually quantitative, relative to which a person bases decisions involving risk.  For instance, a person with $100 may be offered a bet in which she has 50% chance of winning $70, and a 50% chance of losing $70.  The $100 is the reference point.  People have been shown to behave differently at different reference points.  Someone who has more money is less likely to be risk averse.

Endowment Effect
This describes the behavior of individuals with respect to highly prized items.  Once an individual obtains a sought after item for a certain price, she is unwilling to to sell it at a price that is significantly higher than the price she bought it for.  Our emotional attachment to items prevents us from behaving as rational actors in a market.

Loss Aversion
Occurs when the individual inflates the potential cost of losses.  This is partly derivative of the endowment effect.

Negativity Dominance
A psychological phenomenon wherein potentially negative states loom larger in the mind than positive.

Possibility Effect
Utility increases disproportionately when the likelihood of a desired outcome goes from zero to some small positive number.

Certainty Effect
Like the possibility effect, utility increases disproportionately when the likelihood of a desired outcome goes from some high probability to 100%.  We tend to overweight desired outcomes that are certain, as opposed to desired outcomes that have a high, but not certain probability of occurring.

The possibility and certainty effect also applies to losses.  We tend to overweight small risks, and are willing to pay more to eliminate them altogether.

The bottom line is that improbable outcomes are overweighted, whereas certain outcomes are underweighted.

The possibility and certainty effect combine to form what Kahneman calls the "Fourfold Effect"

This model can be used explain how people behave with respect to rare events.

Disposition Effect
A bias in which an individual makes decisions based on short term gains.

Sunk Cost Fallacy
The decision to invest additional resources in a losing prospect when better investments are available.

Taboo Tradeoff
This describes the resistance individual place against any tradeoff that increases risk, even if the increase in risk is acceptable, and potential gives better yields in the long run.

Fear of losses seems to be a powerful explanatory tool in behavioral economics.

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