Misbehaving: The Making of Behavioral Economics Read Online Free PDF Page B

uses one theory to serve both normative and descriptive purposes. Consider the economic theory of the firm. This theory, a simple example of the use of optimization-based models, stipulates that firms will act to maximize profits (or the value of the firm), and further elaborations on the theory simply spell out how that should be done. For example, a firm should set prices so that marginal cost equals marginal revenue. When economists use the term “marginal” it just means incremental, so this rule implies that the firm will keep producing until the point where the cost of the last item made is exactly equal to the incremental revenue brought in. Similarly, the theory of human capital formation, pioneered by the economist Gary Becker, assumes that people choose which kind of education to obtain, and how much time and money to invest in acquiring these skills, by correctly forecasting how much money they will make (and how much fun they will have) in their subsequent careers. There are very few high school and college students whose choices reflect careful analysis of these factors. Instead, many people study the subject they enjoy most without thinking through to what kind of life that will create.
    Prospect theory sought to break from the traditional idea that a single theory of human behavior can be both normative and descriptive. Specifically, the paper took on the theory of decision-making under uncertainty. The initial ideas behind this theory go back to Daniel Bernoulli in 1738. Bernoulli was a student of almost everything, including mathematics and physics, and his work in this domain was to solve a puzzle known as the St. Petersburg paradox, a puzzle posed by his cousin Nicolas. † (They came from a precocious family.) Essentially, Bernoulli invented the idea of risk aversion. He did so by positing that people’s happiness—or utility, as economists like to call it—increases as they get wealthier, but at a decreasing rate. This principle is called diminishing sensitivity. As wealth grows, the impact of a given increment of wealth, say $100,000, falls. To a peasant, a $100,000 windfall would be life-changing. To Bill Gates, it would go undetected. A graph of what this looks like appears in figure 2.
    FIGURE 2
    A utility function of this shape implies risk aversion because the utility of the first thousand dollars is greater than the utility of the second thousand dollars, and so forth. This implies that if your wealth is $100,000 and I offer you a choice between an additional $1,000 for sure or a 50% chance to win $2,000, you will take the sure thing because you value the second thousand you would win less than the first thousand, so you are not willing to risk losing that first $1,000 prize in an attempt to get $2,000.
    The full treatment of the formal theory of how to make decisions in risky situations—called expected utility theory —was published in 1944 by the mathematician John von Neumann and the economist Oskar Morgenstern. John von Neumann, one of the greatest mathematicians of the twentieth century, was a contemporary of Albert Einstein at the Institute of Advanced Study at Princeton University, and during World War II he decided to devote himself to practical problems. The result was the 600-plus-page opus The Theory of Games and Economic Behavior , in which the development of expected utility theory was just a sideline.
    The way that von Neumann and Morgenstern created the theory was to begin by writing down a series of axioms of rational choice. They then derived how someone who wanted to follow these axioms would behave. The axioms are mostly uncontroversial notions such as transitivity, a technical term that says if you prefer A over B and B over C then you must prefer A over C. Remarkably, von Neumann and Morgenstern proved that if you want to satisfy these axioms (and you do), then you must make decisions according to their theory. The argument is completely convincing. If I had an important