Adam Oliver, “Reflecting on Reflection: Prospect Theory, Our Behaviors, and Our Environment.” Behavioural Public Policy, 1-11, 2021.- A full-blown version of prospect theory includes both diminishing sensitivity in both the gains domain and the loss domain, as well as probability weighting, where low probability outcomes tend to be overweighted in valuing prospects and high-probability outcomes tend to be underweighted.
- Diminished sensitivity on its own implies risk averse behavior in the gains domain and risk seeking behavior in the loss domain.
- But, adding probability weighting to diminished sensitivity leads to what is called the "fourfold pattern" of risk preferences, or, the reflection effect.
- For high probability gains, diminishing sensitivity and underweighting combine to produce risk averse behavior. But for low-probability gains, overweighting tends to more than offset diminishing sensitivity, leading to risk loving behavior (as with the appeal of lotteries).
- For low probability losses, probability (over)weighting counters diminishing sensitivity, leading to risk averse behavior, while for high probability losses, (under)weighting combines with diminished sensitivity to lead to risk seeking behavior.
- Oliver examines whether the fourfold pattern of risk preferences is displayed with respect to life expectancy prospects, as well as to monetary prospects. For monetary prospects, a thirty-question interview protocol is administered to 60 university-affiliated people, with the (incentivized) questions focusing on eliciting certainty equivalents for prospective risky investment decisions.
- "the respondents generally became more averse to risk as probability increased in the domain of gains and as probability declined in the domain of losses, which... is consistent with the predictions of the prospect theory reflection effect [p. 4]."
- So for monetary decisions, the fourfold pattern holds up pretty well in the interview results, though less well when looking at low probability gains or losses.
- A second set of 60 interviews with different (though still university-affiliated) people is used to look at preferences in the health domain. Now it is certainty equivalents in terms of lifetime duration that are elicited. Again, the results are largely consistent with the fourfold pattern.
- Risk seeking in the case of high probability losses – money or life expectancy – seems to be the most intense of the risk preferences.
- Though the results are consistent with prospect theory, Oliver is skeptical of the notion that prospect theory explains these results. Instead, he offers an evolutionary story (involving abundance v. scarcity) for why the fourfold pattern might emerge even without full-on prospect theory-style preferences.
- That is, evolution might have favored a pattern of behavior, a heuristic, that calls for risk seeking with high-probability losses. For some people in some circumstances, such a "bias" might still be sensible.
- Two other articles that point to useful heuristics that might be interpreted as irrational biases come to mind: Chen and Schonger on ambiguity aversion and the heuristic not to transact with folks who know a lot more than you do about the transaction; and Smitizsky, Liu, and Gneezy on endowment effects and the heuristic that as a buyer you try to understate your willingness-to-pay and as a seller you tend to exaggerate the value of the good to you.
