Or ‘How Expected Utility Theory was Successfully Challenged by a Nobel Prize-winning Hypothesis’
2002’s Nobel prize-winning economist Daniel Kahneman wrote about Prospect Theory, which is hard to summarise succinctly because he wrote an entire thesis to explain it.
He and his academic partner Amos Tversky examined how economic decision-making is not always rational, whereas orthodox economic theory held decisions were made on the basis of utility – the maximum return on a given amount of resources. Expected utility theory originated in Bernoulli’s 1738 essay, which argued that when faced with a choice involving risk, the logical action is to “maximize the expected utility of wealth.” In other words, the more capital you have, the more likely you are to put it at risk for expected returns. It follows that poor people will be more risk averse and less inclined to invest in financial products with a concerning risk profile.
Hence, poor people do not sell insurance products, because they cannot afford to pay an insurance premium if the owner makes a claim.
Kaheman et al had a problem with the assumption of expected utility, on the basis of a number of experiments they had conducted where even highly intelligent people like students at Princeton and University of Michigan failed basic logic and maths tests because they took a cognitive short cut. Let System 1 be our ‘intuitive’ reasoning, one which has evolved to be rapid response and influenced by emotions and immediate concerns as much as by experience. And let System 2 be our ‘analytical’ reasoning, which is slower but more thorough and draws more on our learned experience.
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