Prospect Theory Essay ⋆ Political Science Essay Examples ⋆ EssayEmpire

Prospect theory is the most influential behavioral theory of choice in the social sciences. Psychologists Daniel Kahneman and Amos Tversky created it in 1979 when they discovered that how someone thinks about a choice influences one’s attitude toward risk. To illustrate, when given a choice between a sure gain of $900 and a 90 percent chance of $1,000, and a choice between a sure loss of $900 or a 90 percent chance of a loss of $1,000, most people take the sure gain of $900 and the 10 percent chance of losing nothing. Since the expected values of the choices are identical, people “should” bet the same way in each gamble. This observation strikes many people as counterintuitive and thus captures the genius of prospect theory: people choose more risk to avoid an outcome they view as a loss, and choose less risk to obtain an outcome they view as a gain. Kahneman won the 2002 Nobel Prize in Economics for his work with Tversky, who died in 1996.

No one likes to lose, and in this sense people are all loss averse. But for prospect theorists, loss aversion means that people will assume more risk to avoid an outcome framed as a loss than they will to obtain the identical outcome framed as a gain. For example, people feel differently about a policy that guarantees 90 percent employment than one that guarantees 10 percent unemployment. Framing a policy as a gain (90 percent employment) puts people in a domain of gain and makes them risk averse; framing a policy as a loss (10 percent unemployment) puts people in a domain of loss and makes them willing to accept more risk to avoid that outcome. Identical problems should be viewed identically, but they are not when the framing of a choice puts one in a domain of gain or of loss, which then systematically influences one’s choices. People are loss averse because preferences are reference dependent. Rather than use the objective features of a choice as the basis for a decision (e.g., an absolute gain or a final state of employment), people pay attention to changes from some reference point (e.g., a gain or a loss). Because people dislike losing more than they like to win, they will assume more risk than they would in a different frame to escape that loss. Being in a domain of loss makes people risk acceptant, and this can be a source for either conflict or cooperation.

Applications

The political implications of prospect theory are profound. Unlike normative theories such as rational choice that explain how people should make decisions, prospect theory describes how people make decisions, which is especially valuable in strategic settings (i.e., where one’s best move depends on the other’s move). According to prospect theory, policy makers in a domain of loss will accept more risk than they would if they were in a domain of gain. They might escalate a military intervention that is going poorly, gamble on a risky rescue mission, or embrace radical economic reform because they are in a domain of loss. An actor who frames discontinuing action as a loss may assume more risk to continue that action than would an actor who has the capability of action but has not yet started it. For example, compelling a state to surrender its chemical weapons stockpile is harder than deterring a state from developing such weapons.

More generally, risk aversion might account for the relative stability of the international system. If people value what they have more than what they covet, then decision makers would be most likely to accept the risk of war to avoid losing what they have, rather than risk war when they see an opportunity to acquire more. Appropriate strategies of influence depend on whether actors are in a domain of gain or loss. For example, one should use threats against actors seeking gains—because threats increase risk to actors who are averse to risk—and use promises for actors seeking to avoid losses. Identifying predictable biases makes prospect theory a powerful tool for anticipating an individual’s behavior as well as the behavior of financial markets.

Controversies

Critics focus on three problems with using prospect theory to explain political decisions. First, prospect theory has no theory of frames. Because preferences are reference dependent, empirical applications of prospect theory must identify whether an actor is in a domain of gain or loss. Outside the lab, people create their own frames and this complicates using prospect theory. For example, will a dictator view the development of a nuclear weapon as a newfound gain and thus be risk averse, or will other concerns (e.g., a collapsing economy) keep the dictator in a domain of loss making him risk acceptant? No solution exists to the problem, though political scientists have explored techniques for assessing domain. Some scholars use the status quo as the basis for an actor’s reference point: foreign policy setbacks create a domain of loss and a desire for a return to a precrisis status quo.

Second, measuring loss aversion in the field is difficult because it is often unclear whether one is being risk averse or risk acceptant. For example, is invading a country that might have nuclear weapons riskier than not invading that country? Reaching a consensus on these issues can be difficult even with access to archives. Using an economic definition of risk can address the problem: the more extreme the possible outcomes, the riskier the choice; the more moderate the outcomes, the less risky the choice. Nonetheless, observers will sometimes differ in their assessments of risk and this complicates measuring loss aversion.

Third, psychological experiments cannot capture how people behave in real environments. Markets and international bargaining are too complex, and decision makers are too sophisticated, for such a simple psychological theory. Prospect theorists respond that experts reveal the same biases as do novices, and giving people greater incentives to reason carefully may make them more confident in their responses. However, it does not make them more accurate. Testing hypotheses in the field that have been contradicted in the lab is probably a mistake, but testing hypotheses derived from prospect theory that have been repeatedly confirmed in the lab is normal science. Whether prospect theory reveals how people behave in real settings is an empirical question, which is why political scientists who use prospect theory are committed to detailed empirical case studies.

Bibliography:

Davis, James W. Threats and Promises:The Pursuit of International Influence. Baltimore: Johns Hopkins University Press, 2000.
Farnham, Barbara. Roosevelt and the Munich Crisis: A Study of Political Decision-making. Princeton: Princeton University Press, 1997.
Jervis, Robert. “Political Implications of Loss Aversion.” Political Psychology 13, no. 2 (1992): 187–204.
Kahneman, Daniel, and Amos Tversky. “Prospect Theory: An Analysis of Decision under Risk.” Econometrica 47, no. 2 (1979): 263–291.
McDermott, Rose. “Prospect Theory in Political Science: Gains and Losses from the First Decade.” Political Psychology 25, no. 2 (2004): 289–312.
Risk Taking in International Politics: Prospect Theory in American Foreign Policy. Ann Arbor: University of Michigan Press, 1998.
Mercer, Jonathan. “Prospect Theory and Political Science.” Annual Review of Political Science 8, no. 1 (2005): 1–21.
Schaub, Gary. “Deterrence, Compellence, and Prospect Theory.” Political Psychology 25, no. 3 (2004): 389–411.
Stein, Janice G., and Louis W. Pauly, eds. Choosing to Cooperate: How States Avoid Loss. Baltimore: Johns Hopkins University Press, 1993.
Taliaferro, Jeffrey W. Balancing Risks: Great Power Intervention in the Periphery. Ithaca: Cornell University Press, 2004.
Weyland, Kurt. The Politics of Market Reform in Fragile Democracies: Argentina, Brazil, Peru, and Venezuela. Princeton: Princeton University Press, 2002.

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