Brian Easton looks at how the Prospect Theory of Behavioural Economics makes economic analysis difficult

This is a re-post of an article originally published on pundit.co.nz. It is here with permission.

Behavioural economics has been described as the most revolutionary thing which has happened to economics for ages. The notion that people do not behave like ‘rational economic men’ (women are mainly ignored) undermines the microeconomic foundations of the subject. Not the empirical evidence on which economics is based – only its interpretation. It also impacts on normative economics, as this column explores.

I’ve written a number of pieces on behavioural economics (see here). This column explores the part known as ‘prospect theory’ for which Daniel Kahneman was awarded a Nobel laureateship in 2002 (as would have been his co-researcher Amos Tversky had he been alive). The theory unites three basic observations: people treat gains differently from losses (known as ‘loss aversion’); people place unequal weight on outcomes with certainty compared to those with uncertainty; and the structure of a problem itself may affect the choices made.

This column focuses on loss aversion, with an example of how it complicates analysis. Suppose a good quality cost-benefit analysis – they occur less frequently than they should – concludes that a project would generate an extra net $1 (add as many zeros as you feel necessary). Because the study is of high quality it also will set out winners and losers, finding perhaps that the winners receive a benefit of $3 and the losers $2 – giving the net aggregate benefit of $1.

Typically the economist is not allowed to tradeoff the winner’s gains against the loser’s losses, because that involves the political judgement of comparing people’s welfare; the profession has no particular expertise in interpersonal comparisons. In principle the tradeoff is left to politicians, although sometimes economists don a politician’s hat – without telling the public – and advocate one way or the other.

Some economists argue, using ‘Hume’s Law’ (David Hume would be embarrassed to be associated with it), that ‘a dollar is a dollar’ and favour the project since it adds a dollar to the economy. (There is also a complicated theory of ‘compensation’ which need not detain us here.)

What ‘loss aversion’ says is that different dollars have different values. Suppose you did not know you were a winner or loser but that your chances were half and half of being either. The empirical evidence is that, as a rule, most people would prefer not to lose the $2 dollars despite the equal possibility of winning $3. Typically their tradeoff is between wanting a $4 win in exchange for a $2 loss. In effect, they are valuing a dollar lost the same as two dollars gained – bang goes Hume’s law.

In which case how does progress happen when there is loss aversion? Surely there will an inertia from the loss aversion often outweighing the immediate gains from progress.

In a market, winners frequently succeed and losers suffer because there is no market mechanism to compensate losers. How often does a news story amount to the losers appealing to the government to protect them from a market decision which is against their interests?

Where politicians have some influence, the project may still go ahead despite the losses outweighing the gains. The political decider may favour the winners over the losers, the costs of opposing by the losers may outweigh the loss from the project (especially if there are a lot of small losers and a few huge winners), the losers may not realise they are being screwed and so on.

You can see one of the reasons why the evidence points to market economies progressing –with greater innovation and higher output – more than ones which are dominated by a centralised authority. You can also see how market decisions will be continually appealed to government to be overruled or moderated, not to mention the difficulties governments face when they are making changes. So while on conventional measures there may be progress of a kind, there may be considerable grumpiness from people offsetting the gains with double their losses.

And yet there is progress. The complexity is captured in a story about Ken Findlay, a feisty truckie and trade unionist. When the freezing works he worked at was closed and jobs were lost, he was a prominent and vociferous objector. Some years later he said  that the closure was the best thing which happened. I did not ask him why – alas he died last year, so I can’t ask him now. I am left with the puzzle of the apparent contradiction.

I doubt that his protests at the time were just on behalf of his devastated mates. Rather, he seems to have changed his mind or perhaps, it might be better to say, that his thinking evolved or that his subsequent experience was not as damaging as he feared.

Most of the experiments on which behavioural economic theory is based, perhaps inevitably, have very short time dimensions so they tell us little about how people’s thinking evolves through time. The one hint comes from Kahneman’s Thinking Fast, Thinking Slow. It suggests that we do not handle time in the way models of rational economic man assume.

This is all very troubling – behavioural economics is troubling to the rational thinker. Here is the best I can conclude at this stage.

First, the indicators we generally use to measure economic progress may not reflect improvements in the wellbeing of everyone (even after acknowledging their standard limitations).

Second, those who are hurt by change may be more hurt than those who benefit from it. We may ignore or discount the losers; sometimes we don’t even notice them.

Third, people may handle ‘progress’ differently in the long term from the short term. It is possible that many remember the short-term downsides and forget the long term upsides.

Not very strong conclusions, I’m afraid. Like so much of behavioural economics, the main conclusion is not to be too confident of conclusions dependent upon the traditional framework of the rational economic man.

*Brian Easton, an independent scholar, is an economist, social statistician, public policy analyst and historian. He was the Listener economic columnist from 1978 to 2014. This is a re-post of an article originally published on pundit.co.nz. It is here with permission.