Following the schedule of our Reading Calendar.
We are entering a new section of the book, part IV. What is explained in this section made Kahneman and his colleague and friend Tversky famous, and gave Kahneman his Nobel Prize in Economy: challenging the assumptionsthat are at the core of economic theory on how we make decisions .
Kahneman explains the main ideas behind Morgenstern and von Neumann model on how we make decisions -the game theory- and the experiments they develop in order to check whether this theory applied to real people and how this leads to this prospect theory on how real humans make decisions. Prospect theory is described in more detail in the next chapter.
Morgenstern (left) and von Neumann (right) the two guys behind Game Theory and “rational” economics.
The main case discussed here is the “bias” of preferring the sure thing (like $80) versus a complex gambling in which one has 80% chances to win $100 and 20% chances to win only 10, which makes an expected value of $82.
We are also presented with a formulation of the risk aversion bias, which implies that loosing something weights more when facing a decision that winning the equivalent. The pain of loosing $100 is not compensated by the happiness of winning $100.
The first time I read this book I wondered how is this possible. And I’m wondering it again: if humans do not behave at all like the rational decision makers that Bernoulli, Morgenstern and von Neumann imagined, if traditional economics is wrong at its very core, why are we still using it to make economic, political and sociological models on how markets are going to develop and what the people is going to do?
An aside comment. Consider John von Neumann. He was one of the main authors helping to create:
One of the first computers
The mathematical theory behind such computers (von Neumann Architecture)
The atom bombs
The theory of Mutual Assisted Destruction (MAD) which defined the Cold War
The formalism of quantum mechanics
Game theory and its applications to economics
And then he is quite unkown. Very few people have heard about him. Maybe he defines so close the XXth century that nobody feels really comfortable with such a character.