Most economic models rely on the major (ideal) assumption that we, individuals, are perfectly rational agents. The economic discipline which studies how we choose is called Consumer Preferences/Behaviour and it is indeed one of the pillars of Economic Theory.
The way economists model our preferences is through utility functions which basically are a measure of our level of satisfaction from consuming a certain set of goods. When an individual has the same “contentment” from consuming two different sets of goods, it is typically said that he is indifferent between consuming one set or another. In other words, there should be no need to give him incentives to switch from one to another. This holds (and actually makes sense) if we don’t take into consideration the psychological effects of going from one consumption style to the other, that is, this evaluation of indifference is made (at least for most of the times) without having into consideration any reference point – the status quo.
To illustrate how this leads to misleading results, suppose we want to analyze how you choose between Salary and Leisure time. Suppose now that I have exactly the same tastes as you with regards to these “goods” and, furthermore, that I have exactly the same salary and leisure time as you. Suddenly, we are given two options – an increase of 1000 euros on the salary or 15 more days of leisure – which make us equally happier. In other words, we are indifferent between getting one option or the other, as long as we get them. Suppose now you were the one who got the 1000€ increase in your salary and, a month later, you are given the possibility of switching with me, the guy who got the 15 more days of vacation. You probably just thought “there is no way I am abdicating my 1000€ for 15 miserable days of vacation”. Theoretically, economists predict that, in fact, you should be completely fine with it. Since these 2 options make us equally happy, we should be indifferent between having one or the other. Are you really willing to abdicate from your 1000€? I know I am not willing to abdicate my 15 extra days of vacation!
This loss aversion paradox has, in fact, been quite explored by Daniel Kahneman and Amos Tversky in the so called Prospect Theory. These authors argue that if we want to study how satisfied a person is with what she has (which is more or less what utility functions do) we cannot restrict ourselves to questions regarding specific values of consumption levels. Instead, you should focus on shifts from the situation you are facing now. Additionally, they found clear evidence that we weight losses much more than gains of equal value.
Suppose you and I are very much alike, except that I own 1000€, while you own 4000€. Suppose now we face 2 options: 50/50 chances of owning 1000€ or 4000€ – the risky option – or own 2000€ for sure – the safe option. We are basically facing the same thing: an expected wealth of 2500€ or a certain wealth of 2000€. Economists would predict us to choose the same thing, but will we? Well, from my part, if I choose the sure thing I double my wealth for sure, which is quite appealing! If I take the risk, however, whether I don’t gain nothing, which is a bit disappointing, or quadruple my wealth, which is great (but uncertain). I better stick with the sure thing.
You, on the other hand, must be thinking that if you take the sure thing you will, for sure, loose half your wealth, which sounds catastrophic. If you take the risk, however, there is a 50% chance that you don’t loose anything at all, which seems quite comforting. Hence, the same choice made us actually choose different things due to the psychological power of losses!
Basic economic theory is blind to the fact that each loss weights more to you than a gain of equal value, and that you make your choices having as reference your present situation. And it is due to this blindness that economists usually fail to predict our behaviour. All in all, we, as humans, are not as rational as economists would like us to be. Indeed, as Richard Thaler appropriately distinguished, Humans do not always behave as Econs (economic agents).
David Dias Pissarra,