Prospect Theory, Expected Utility Theory and Death

Behavioural Economics is a method of economic analysis that applies psychological insights into human behaviour to explain economic decision-making. Behavioural Economics factors in the effects of psychological, emotional, social and cognitive factors on the economic decisions of individuals. It increases the explanatory power of economic theory by providing it with more realistic psychological foundations as opposed to the standard assumption of the ‘rational’ being.

Daniel Kahneman and Amos Tversky are the two most popular figures in Behavioural Economics. They gave us something called the Prospect Theory. In their paper “choices, values and frames”, they show that loss has a much more significant impact than a gain. People are loss averse, meaning we strictly prefer avoiding losses to acquiring gains.

This essay looks at why we fail to factor in death from two theories all of us study in Microeconomics, Expected Utility Theory and Prospect Theory.

Death is the greatest loss we face. It brings on some of the hardest times in our life. Yet we choose to pretend as though it is not something real. Using the categorizations Secretary Rumsfeld popularized, death would be a ‘known known’ but the time of death is an ‘unknown known’ (known because death is inevitable). But we choose to put both into the ‘unknown unknown’ category. We deny its existence. And when death finally comes knocking at our door, we pretend as though it is a blackswan event, something that is “very hard to predict, rare event beyond the realm of normal expectations in history”. The probability of death is 1. It is a certain event.

We economists love things like the ‘rational’ person, the ‘average’ person and many such creations of our own. So bear with me while I create a ‘rational’ person. The underlying assumption we make is that a rational person would like to maximize utility. For an “average” person, a loss would give negative utility and a gain would give positive utility. So by definition, death would give us negative utility. (It is important to highlight the exclusions – we exclude the case where the average person is eagerly looking forward to someone dying and thereby gains positive utility when someone dies, whatever his/her motivations maybe).

A ‘rational’ person, given that he is loss averse and knows for a fact that death is certain, would try and mitigate the loss caused by death (by this I mean factor it in and not create some mind transfer tech or immortality potion!). So by factoring in death, when the time of loss comes, the negative utility that the person may derive would be lower than what he/she would have experienced being unprepared. Hence, a utility maximizing person would factor this in as early as possible to reduce the guaranteed “loss”.

Why do we not factor this in early? Why do we pretend that it doesn’t exist or won’t happen to us? When we lose some of our hard earned money on stocks, it does hurt us. We could feel low for days. Now recollect how you felt when you lost someone. Did the sense of loss end in a few hours/day? Chances are it may have taken longer. Do we not want to acknowledge it because recognizing it daily would make it literally impossible to live anything close to the life we live today? Why do we not spend more time factoring death into our lives?

Let us try explaining this phenomenon through Prospect Theory.

Prospect theory is proposed as an alternative to the Expected Utility Theory. It introduces concepts such as certainty effect, isolation effect and framing effect. Isolation effect is when people generally discard components that are shared by all prospects under consideration. This leads to inconsistent preferences when the same choice is presented in different forms.

“Value is assigned to gains and losses rather than to the final assets and in which probabilities are replaced with decision weights. Decision weights are generally lower than the corresponding probabilities, except in the range of low probabilities.”.

Death is the component shared by all prospects under consideration at any point in life. Using Prospect Theory, we could maybe conclude that most of the stimuli we get from our surroundings, be it ads or conversations with friends or movies or any other channel, frames life as a ‘gain’ before death rather than highlighting death. Hence, this could change the way in which we view death. We don’t look at life as a linear progression to a certain death, but rather as a series of moments of possible “experiences” before some event in the distant future, namely death (obviously we all die in our old age, who dies before that anyways. Ring a bell?).

Because most of us look at death as an event sometime in the future, there are two implications. The first being we tend to think people around us are also on the same timeline as us. We fail to recognize that they have a timeline of their own. They could be 20 years ahead or 50 years ahead. We fail to factor this in.

The second, because we look at it as something in the distant future, so the probability is reduced from 1. This added to the fact that the decision weight is lower, tends to compound the problem when we are hit with the loss of someone.

So in summary, the problem could arise from a combination of isolation effect and the way in which we ‘frame’ of life and death in our daily lives, as well as the way in which we assign weights and probabilities to death.

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