INTRODUCTION

The concept of utility has carried two different meanings in its long history. As Bentham (1789) used it, utility refers to the experiences of pleasure and pain, the “sovereign masters” that “point out what we ought to do, as well as determine what we shall do.” In modern decision research, however, the utility of outcomes refers to their weight in decisions: utility is inferred from observed choices and is in turn used to explain choices. To distinguish the two notions I refer to Bentham's concept as experienced utility and to the modern usage as decision utility. Experienced utility is the focus of this chapter. Contrary to the behaviorist position that led to the abandonment of Bentham's notion (Loewenstein 1992), the claim made here is that experienced utility can be usefully measured.

The chapter has three main goals: (1) to present a detailed analysis of the concept of experienced utility and of the relation between the pleasure and pain of moments and the utility of more extended episodes; (2) to argue that experienced utility is best measured by moment-based methods that assess current experience; (3) to develop a moment-based conception of an aspect of well-being that I will call “objective happiness.” The chapter also introduces several unfamiliar concepts that will be used in later chapters.

Pleasure and pain are attributes of a moment of experience, but the outcomes that people value extend over time. It is therefore necessary to establish a concept of experienced utility that applies to temporally extended outcomes. Two approaches to this task will be compared here.

INTRODUCTION

Economists rarely draw the distinction between normative models of consumer choice and descriptive or positive models. Although the theory is normatively based (it describes what rational consumers should do), economists argue that it also serves well as a descriptive theory (it predicts what consumers in fact do). This paper argues that exclusive reliance on the normative theory leads economists to make systematic, predictable errors in describing or forecasting consumer choices.

In some situations the normative and positive theories coincide. If a consumer must add two (small) numbers together as part of a decision process, then one would hope that the normative answer would be a good predictor. So if a problem is sufficiently simple the normative theory will be acceptable. Furthermore, the sign of the substitution effect, the most important prediction in economics, has been shown to be negative even if consumers choose at random (Becker, 1962).

The standard models of decision making assume that preferences do not depend on current assets. This assumption greatly simplifies the analysis of individual choice and the prediction of trades: indifference curves are drawn without reference to current holdings, and the Coase theorem asserts that, except for transaction costs, initial entitlements do not affect final allocations. The facts of the matter are more complex. There is substantial evidence that initial entitlements do matter and that the rate of exchange between goods can be quite different depending on which is acquired and which is given up, even in the absence of transaction costs or income effects. In accord with a psychological analysis of value, reference levels play a large role in determining preferences. In the present paper we review the evidence for this proposition and offer a theory that generalizes the standard model by introducing a reference state.

Expected utility theory reigned for several decades as the dominant normative and descriptive model of decision making under uncertainty, but it has come under serious question in recent years. There is now general agreement that the theory does not provide an adequate description of individual choice: a substantial body of evidence shows that decision makers systematically violate its basic tenets. Many alternative models have been proposed in response to this empirical challenge (for reviews, see Camerer, 1989; Fishburn, 1988; Machina, 1987).

The tendency to hold losers too long and sell winners too soon has been labeled the disposition effect by Shefrin and Statman (1985). For taxable investments the disposition effect predicts that people will behave quite differently than they would if they paid attention to tax consequences. To test the disposition effect, I obtained the trading records from 1987 through 1993 for 10,000 accounts at a large discount brokerage house. An analysis of these records shows that, overall, investors realize their gains more readily than their losses. The analysis also indicates that many investors engage in taxmotivated selling, especially in December. Alternative explanations have been proposed for why investors might realize their profitable investments while retaining their losing investments.

The thesis of this essay is that decision makers are excessively prone to treat problems as unique, neglecting both the statistics of the past and the multiple opportunities of the future. In part as a result, they are susceptible to two biases, which we label isolation errors: their forecasts of future outcomes are often anchored on plans and scenarios of success rather than on past results and are therefore overly optimistic; their evaluations of single risky prospects neglect the possibilities of pooling risks and are therefore overly timid. We argue that the balance of the two isolation errors affects the risk-taking propensities of individuals and organizations.

The cognitive analysis of risk taking that we sketch differs from the standard rational model of economics and also from managers' views of their own activities. The rational model describes business decisions as choices among gambles with financial outcomes, and assumes that managers' judgments of the odds are Bayesian, and that their choices maximize expected utility.

INTRODUCTION

The assumption that agents are rational is central to much theory in the social sciences. Its role is particularly obvious in economic analysis, where it supports the useful corollary that no significant opportunity will remain unexploited. In the domain of social policy, the rationality assumption supports the position that it is unnecessary to protect people against the consequences of their choices. The status of this assumption is therefore a matter of considerable interest. This article will argue for an enriched definition of rationality that considers the actual outcomes of decisions, and will present evidence that challenges the rationality assumption in new ways.

The criteria for using the terms “rational” or “irrational” in non-technical discourse are substantive: one asks whether beliefs are grossly out of kilter with available evidence, and whether decisions serve or damage the agent's interests.

INTRODUCTION

It seems obvious that the decisions to invest in the stock market, undergo a medical treatment, or settle out of court depend on the strength of people's beliefs that the market will go up, that the treatment will be successful, or that the court will decide in their favor. It is less obvious how to elicit and measure such beliefs. The classical theory of decision under uncertainty derives beliefs about the likelihood of uncertain events from people's choices between prospects whose consequences are contingent on these events. This approach, first advanced by Ramsey (1931), gives rise to an elegant axiomatic theory that yields simultaneous measurement of utility and subjective probability, thereby bypassing the thorny problem of how to interpret direct expressions of belief.

In a recent educational television program, an amnesic patient was asked about his childhood and high-school experiences. Verbally fluent, he was able to converse about daily events but could not remember any details about his past. Finally, the interviewer asked him how happy he was. The patient pondered this question for a few seconds before answering, “I don't know.”

As Tom Schelling observed, “We consume past events that we can bring up from memory” (1984, p. 344). Thus, the memory of the past is an essential element of present well-being. As our opening anecdote suggests, the present alone may not provide enough information to define happiness without reference to the past. Yet memories have a complex effect on our current sense of well-being. They represent a direct source of happiness or unhappiness, and they also affect the criteria by which current events are evaluated. In other words, a salient hedonic event (positive or negative) influences later evaluations of well-being in two ways: through an endowment effect and a contrast effect. The endowment effect of an event represents its direct contribution to one's happiness or satisfaction. Good news and positive experiences enrich our lives and make us happier; bad news and hard times diminish our well-being. Events also exercise an indirect contrast effect on the evaluation of subsequent events. A positive experience makes us happy, but it also renders similar experiences less exciting. A negative experience makes us unhappy, but it also helps us appreciate subsequent experiences that are less bad. The hedonic impact of an event, we suggest, reflects a balance of its endowment1 and contrast effects. This chapter explores some descriptive and prescriptive implications of this notion.

The workhorses of economic analysis are simple formal models that can explain naturally occurring phenomena. Reflecting this taste, economists often say they will incorporate more psychological ideas into economics if those ideas can parsimoniously account for field data better than standard theories do. Taking this statement seriously, this article describes 10 regularities in naturally occurring data that are anomalies for expected utility theory but can all be explained by three simple elements of prospect theory: loss aversion, reflection effects, and nonlinear weighting of probability; moreover, the assumption is made that people isolate decisions (or edit them) from others they might be grouped with (Read, Loewenstein, and Rabin 1999; cf. Thaler, 1999). I hope to show how much success has already been had applying prospect theory to field data and to inspire economists and psychologists to spend more time in the wild.

The 10 patterns are summarized in Table 16.1. To keep the article brief, I sketch expected utility and prospect theory very quickly. (Readers who want to know more should look elsewhere in this volume or in Camerer 1995 or Rabin 1998a). In expected utility, gambles that yield risky outcomes xi with probabilities pi are valued according to Σpiu(xi), where u(x) is the utility of outcome x. In prospect theory they are valued by Σπ(pi)v(xi - r), where π(p) is a function that weights probabilities nonlinearly, overweighting probabilities below.

INTRODUCTION

Expected utility theory has dominated the analysis of decision making under risk. It has been generally accepted as a normative model of rational choice (Keeney & Raiffa, 1976), and widely applied as a descriptive model of economic behavior, e.g. (Friedman & Savage, 1948; Arrow, 1971). Thus, it is assumed that all reasonable people would wish to obey the axioms of the theory (von Neumann & Morgenstern, 1944; Savage, 1954), and that most people actually do, most of the time.

Economics can be distinguished from other social sciences by the belief that most (all?) behavior can be explained by assuming that agents have stable, well-defined preferences and make rational choices consistent with those preferences in markets that (eventually) clear. An empirical result qualifies as an anomaly if it is difficult to “rationalize,” or if implausible assumptions are necessary to explain it within the paradigm. This column presents a series of such anomalies. Readers are invited to suggest topics for future columns by sending a note with some reference to (or better yet copies of) the relevant research. Comments on anomalies printed here are also welcome. The address is Richard Thaler, c/o Journal of Economic Perspectives, Johnson Graduate School of Management, Malott Hall, Cornell University, Ithaca, NY 14853.

After this issue, the “Anomalies” column will no longer appear in every issue and instead will appear occasionally, when a pressing anomaly crosses Dick Thaler's desk. However, suggestions for new columns and comments on old ones are still welcome. Thaler would like to quash one rumor before it gets started, namely that he is cutting back because he has run out of anomalies. Au contraire, it is the dilemma of choosing which juicy anomaly to discuss that takes so much time.