The workhorses of economic analysis are simple formal models that can explain naturally occurring phenomena. Reflecting this taste, economists often say they will incorporate more psychological ideas into economics if those ideas can parsimoniously account for field data better than standard theories do. Taking this statement seriously, this article describes 10 regularities in naturally occurring data that are anomalies for expected utility theory but can all be explained by three simple elements of prospect theory: loss aversion, reflection effects, and nonlinear weighting of probability; moreover, the assumption is made that people isolate decisions (or edit them) from others they might be grouped with (Read, Loewenstein, and Rabin 1999; cf. Thaler, 1999). I hope to show how much success has already been had applying prospect theory to field data and to inspire economists and psychologists to spend more time in the wild.

The 10 patterns are summarized in Table 16.1. To keep the article brief, I sketch expected utility and prospect theory very quickly. (Readers who want to know more should look elsewhere in this volume or in Camerer 1995 or Rabin 1998a). In expected utility, gambles that yield risky outcomes xi with probabilities pi are valued according to Σpiu(xi), where u(x) is the utility of outcome x. In prospect theory they are valued by Σπ(pi)v(xi - r), where π(p) is a function that weights probabilities nonlinearly, overweighting probabilities below.

INTRODUCTION

Expected utility theory has dominated the analysis of decision making under risk. It has been generally accepted as a normative model of rational choice (Keeney & Raiffa, 1976), and widely applied as a descriptive model of economic behavior, e.g. (Friedman & Savage, 1948; Arrow, 1971). Thus, it is assumed that all reasonable people would wish to obey the axioms of the theory (von Neumann & Morgenstern, 1944; Savage, 1954), and that most people actually do, most of the time.

Economics can be distinguished from other social sciences by the belief that most (all?) behavior can be explained by assuming that agents have stable, well-defined preferences and make rational choices consistent with those preferences in markets that (eventually) clear. An empirical result qualifies as an anomaly if it is difficult to “rationalize,” or if implausible assumptions are necessary to explain it within the paradigm. This column presents a series of such anomalies. Readers are invited to suggest topics for future columns by sending a note with some reference to (or better yet copies of) the relevant research. Comments on anomalies printed here are also welcome. The address is Richard Thaler, c/o Journal of Economic Perspectives, Johnson Graduate School of Management, Malott Hall, Cornell University, Ithaca, NY 14853.

After this issue, the “Anomalies” column will no longer appear in every issue and instead will appear occasionally, when a pressing anomaly crosses Dick Thaler's desk. However, suggestions for new columns and comments on old ones are still welcome. Thaler would like to quash one rumor before it gets started, namely that he is cutting back because he has run out of anomalies. Au contraire, it is the dilemma of choosing which juicy anomaly to discuss that takes so much time.

Although the standard economic theory of consumer preference assumes fixed tastes, the idea that tastes change over time is not controversial. Numerous ‘habit formation’ models have been proposed which assume that current consumption influences future tastes (Duesenberry, 1949; Pollak, 1970; Stigler and Becker, 1977). These models have been applied to such diverse phenomena as the development of tastes for music and food, substance addiction (Becker and Murphy, 1988), and the surprisingly high rate of return on equities relative to fixed-income securities (e.g. Constantinedes, 1990).

Although it is more complicated to model than fixed tastes, there is nothing intrinsically irrational about habit formation as long as economic agents can predict without bias the effect of their current behaviour on their own future tastes. If people are aware of the effect of their actions on their own future tastes, they can adjust their consumption in a rational manner - e.g. by desisting from crack based on anticipation of future disutility from addiction.

INTRODUCTION

Economics and psychology offer contrasting perspectives on the question of how people value things. The economic model of choice is concerned with a rational agent whose preferences obey a tight web of logical rules, formalized in consumer theory and in models of decision making under risk. The tradition of psychology, in contrast, is not congenial to the idea that a logic of rational choice can serve double duty as a model of actual decision behavior. Much behavioral research has been devoted to illustrations of choices that violate the logic of the economic model. The implied claim is that people do not have preferences, in the sense in which that term is used in economic theory (Fischhoff, 1991; Slovic, 1995; Payne, Bettman and Johnson, 1992). It is therefore fair to ask: If people do not have economic preferences, what do they have instead?

Indifference curves are normally taken to indicate corresponding trade-offs of goods A for B or B for A over the same interval: “the rate of commodity substitution at a point on an indifference curve is the same for movements in either direction” (James Henderson and Richard Quandt, 1971, p. 12). However, recent empirical findings of asymmetric evaluations of gains and losses imply that the presumed reversibility may not accurately reflect preferences, and that people commonly make choices that differ depending on the direction of proposed trades.

The evidence from a wide variety of tests is consistent with the suggestions of Daniel Kahneman and Amos Tversky (1979), and Richard Thaler (1980), that losses from a reference position are systematically valued far more than commensurate gains. The minimum compensation people demand to give up a good has been found to be several times larger than the maximum amount they are willing to pay for a commensurate entitlement. For example, when questioned about the possible destruction of a duck habitat, hunters responded that they would be willing to pay an average of $247 to prevent its loss but would demand $1044 to accept it (Judd Hammack and Gardner Brown, 1974). Respondents in another study demanded payments to accept various levels of visibility degradation that were from 5 to over 16 times higher than their valuations based on payment measures (Robert Rowe, Ralph d'Arge, and David Brookshire, 1980). Similar large differences in valuations of a wide variety of goods and entitlements have been reported in numerous survey studies.