Editing Behavioral economics (section)

== Prospect theory ==
[[File:Daniel Kahneman (3283955327) (cropped).jpg|thumb|200px|[[Daniel Kahneman]], winner of the 2002 Nobel Prize in economics]]
In 1979, Kahneman and Tversky published ''[[prospect theory|Prospect Theory]]: An Analysis of Decision Under Risk'', that used cognitive psychology to explain various divergences of economic decision making from neo-classical theory.{{sfn|Kahneman|Diener|2003}} Kahneman and Tversky utilising prospect theory determined three generalisations; gains are treated differently than losses, outcomes received with certainty are overweighed relative to uncertain outcomes and the structure of the problem may affect choices. These arguments were supported in part by altering a survey question so that it was no longer a case of achieving gains but averting losses and the majority of respondents altered their answers accordingly. In essence proving that emotions such as fear of loss, or greed can alter decisions, indicating the presence of an irrational decision-making process. Prospect theory has two stages: an editing stage and an evaluation stage. In the editing stage, risky situations are simplified using various [[heuristic]]s. In the evaluation phase, risky alternatives are evaluated using various psychological principles that include:

*[[Reference dependence]]: When evaluating outcomes, the decision maker considers a "reference level". Outcomes are then compared to the reference point and classified as "gains" if greater than the reference point and "losses" if less than the reference point.
* [[Loss aversion]]: Losses are avoided more than equivalent gains are sought. In their 1992 paper, Kahneman and Tversky found the median coefficient of loss aversion to be about 2.25, i.e., losses hurt about 2.25 times more than equivalent gains reward.<ref name="TverskyKahneman1992">{{cite journal|first1=Amos |last1=Tversky |first2=Daniel |last2=Kahneman |year=1992 |title=Advances in Prospect Theory: Cumulative Representation of Uncertaintly |journal=Journal of Risk and Uncertainty |volume=5 |issue=4 | pages=297–323|issn=0895-5646|doi=10.1007/BF00122574|s2cid=8456150 }}[https://link.springer.com/article/10.1007/BF00122574 Abstract.]</ref>
* Non-linear probability weighting: Decision makers overweigh small probabilities and underweigh large probabilities—this gives rise to the inverse-S shaped "probability weighting function".
* Diminishing sensitivity to gains and losses: As the size of the gains and losses relative to the reference point increase in absolute value, the [[marginal utility|marginal]] effect on the decision maker's utility or satisfaction falls.

In 1992, in the ''Journal of Risk and Uncertainty'', Kahneman and Tversky gave a revised account of prospect theory that they called [[cumulative prospect theory]].<ref name="TverskyKahneman1992" /> The new theory eliminated the editing phase in prospect theory and focused just on the evaluation phase. Its main feature was that it allowed for non-linear probability weighting in a cumulative manner, which was originally suggested in [[John Quiggin]]'s rank-dependent utility theory. Psychological traits such as [[Overconfidence effect|overconfidence]], [[Affective forecasting#Projection bias|projection bias]] and the effects of limited attention are now part of the theory. Other developments include a conference at the [[University of Chicago]],{{sfn|Hogarth|Reder|1987}} a special behavioral economics edition of the ''[[Quarterly Journal of Economics]]'' ("In Memory of Amos Tversky"), and Kahneman's 2002 Nobel Prize for having "integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty."<ref name="kahneman">{{cite web|title=Nobel Laureates 2002|publisher=Nobel Foundation|url=http://nobelprize.org/nobel_prizes/lists/2002.html|access-date=2008-04-25|archive-url=https://web.archive.org/web/20080410071445/http://nobelprize.org/nobel_prizes/lists/2002.html|archive-date=10 April 2008 |url-status=live}}</ref>

A further argument of Behavioural Economics relates to the impact of the individual's cognitive limitations as a factor in limiting the rationality of people's decisions. Sloan first argued this in his paper 'Bounded Rationality' where he stated that our cognitive limitations are somewhat the consequence of our limited ability to foresee the future, hampering the rationality of decision.<ref>{{cite book |last1=Simon |first1=Herbert |title=Utility and Probability |date=1990 |publisher=Palgrave Macmillan |isbn=978-1-349-20568-4 |pages=2}}</ref> [[Daniel Kahneman]] further expanded upon the effect cognitive ability and processes have on decision making in his book [[Thinking, Fast and Slow]]. He delved into two forms of thought: fast thinking, which he considered "operates automatically and quickly, with little or no effort and no sense of voluntary control",<ref>{{cite book |last1=Kahneman |first1=Daniel |title=Thinking, Fast and Slow |date=2011 |publisher=Farrar, Straus and Giroux |isbn=978-0374275631 |pages=22}}</ref> and slow thinking, the allocation of cognitive ability, choice, and concentration. Fast thinking utilises heuristics, or shortcuts, which provide an immediate but often irrational and imperfect solution. He proposed that hindsight bias, confirmation bias, and outcome bias (among others) originate from such shortcuts. A key example of fast thinking and the resultant irrational decisions is the 2008 financial crisis.