The Theory Of Perspectives Or How To Value Losing And Winning

The theory of perspectives, also known as prospective, involves concepts from psychology applied to economic behavior. There are several theorists who have addressed this issue, two fundamental references in this field being Daniel Kahneman and Amos Tversky, his regular collaborator.

In general terms, the theory of perspectives refers to how we make decisions in contexts of uncertainty. In other words, how people value the fact of losing or winning when there are not enough tools to predict the possible results of a decision.

What economists and psychologists have found is that many subjective factors are involved in economic decisions that occur in such contexts. Kaheman and Tversky, through the theory of perspectives, show us that there are many decisions in which the weight of the subjective is so evident that they become illogical.

The expected value and the expected profit

The oldest model for evaluating decision-making processes is known as the “expected value” model. This was based on a completely rational premise: people always choose the option  that brings them a higher level of profit.

However, when analyzing the behaviors in detail, it was found that this was not the case. A person who has a high-status job, for example, is not always willing to exchange it for another job that makes more money. He prefers to preserve the prestige that his position brings him, despite the fact that another job offers him more resources.

This crack gave rise to the emergence of a new model: that of expected utility. In this, it was already taken into account that there were subjective factors that shaped decision-making. His approach says that people choose an option based on the utility that it reports to them. The concept of utility is personal, therefore it depends on each individual.

A classic example

Although it sounds very logical, it has also been proven that the expected utility theory is  not always fulfilled. This can be seen with a classic example: a person says that his goal is to always earn more. These two options are then proposed to you:

• 61% chance of winning € 120,000.
• A 63% chance of winning 100,000 euros.

What will you choose? If it is consistent with your objective, the logical thing is that you choose the first option, since the increase in the probability of winning in the second case is not significant and, instead, the prize may be higher. However, this can change when there are two other options:

• A 98% chance of winning € 120,000.
• A 100% chance of winning 100,000 euros.

In this case, it will no longer matter that there is only a 2% difference between one probability and another. The safest thing is that the person decides to earn less, but achieve it safely. As you can see, there is an inconsistency in your decision.

The theory of perspectives

Based on all the above, Kahneman and Tversky propose that there are other criteria that are actually imposed when making decisions. They called this the perspective theory and it is based on three basic premises.

The three premises

The first premise of perspective theory is the benchmark: something is perceived as a higher or lower profit, depending on the starting point or expectation.

If a person is paid less than what they should earn, for example 300 euros a month, and at the end of the year, without waiting, they give them a bonus of 100 euros, it will feel like a big profit. If your income is 1,000 euros and they give you the same bonus, it will seem negligible. And if you win 600 euros, you will see it as a good bonus, but not a determining one.

In practice, the one who is earning the most is the one who gives the least importance to the bonus they receive. The one who barely cares about the bonus is also winning significantly. The paradox is that it has more impact and generates a greater sense of profit in those who are earning less with it.

The previous premise leads to the second, which is the “decrease in sensitivity.” The more you earn, the less sensitive you are to a new gain, unless it is very large.

The third premise is that of “loss aversion”: a person has more intense feelings when he loses 100 euros than when he wins them. In other words, the loss generates a greater psychological impact.

In conclusion

The theory of perspectives indicates that, based on all of the above, there are certain patterns of behavior. In general, when there is a high chance of winning and a small chance of losing, people choose not to take risks out  of loss aversion.

If there is a low probability of making a big profit, people are willing to take a high risk. If there is a high probability of winning, but also a high probability of having a big loss, people also tend to avoid risk.

The premises of prospect theory are applied consistently in gambling, insurance companies, marketing strategies, and even political campaigns.