Jack S. Levy, “Prospect Theory, Rational Choice, and International Relations,” International Studies Quarterly, 41, 1 (March 1997), pp. 87-112.
Prospect theory is a theory of choice under conditions of risk--of the evaluation of prospects, not of the editing of choices. Findings of reference dependence, the endowment effect, the reflection effect, framing effects and preference reversals, and nonlinear responses to probabilities in individual choice contradict expected-utility choice theory. Prospect theory is an alternative theory constructed to integrate anomalies in expected-utility theory to form a more accurate theory of choice. The main problem of prospect theory is that it emerges from experimental research in highly structured laboratory settings with static conditions of risk in non-interactive settings, none of which hold in the real world. Moreover, individual actions do not necessarily parallel the actions of collective groups of people. It is also difficult to determine apriori which anomalies of expected-utility choice theory are operating in a given situation, so prospect theory has little predictive value. More theoretical foundations rather than empirical evidence would benefit prospect theory.
I. Expected Utility
a) Expected-utility theory assumes that an actor’s utility for a particular good is a function of net asset levels of that good and that preferences over outcomes do not depend on current assets. Current assets affect marginal utilities and preferences over strategies, not preferences over outcomes or terminal states.
b) Violates of expected utility are not necessarily violates of rational choice.
c) There is a fair amount of evidence from experimental studies of asset markets and auctions that utility maximization models do fairly well in accounting for many aspects of aggregate market behavior.
1. Experience, learning, incentive, informational efficiencies, and discipline in market settings may create stable preferences and optimizing behavior which are well-approximated by rational economic models.
II. Experimental and Empirical Evidence
a) People make choices that violate expected-utility theory. They:
1. evaluate choices with respect to a reference point (reference dependence);
2. overweight losses relative to comparable gains;
3. engage in risk-averse behavior in choices after gaining, but risk-acceptant behavior in choices after losing;
i. this pattern of risk orientation breaks down for very small probabilities or for catastrophic losses
4. respond to probabilities in a nonlinear manner.
b) Endowment effect - people overvalue what they have.
c) The framing of a reference point affects choice.
1. In a static situation, framing is predetermined by situation (usually the status quo) or experimental design.
d) Instant endowment effect – people accommodate to gains immediately
1. Subsequent setbacks are considered losses instead of foregone gains.
e) Attempts to demonstrate the anomalies of expected-utility theory can be explained by absence of financial incentives or opportunities for learning, by transaction costs, or other economic variables have failed.
III. Possible Implications of Experimental and Empirical Evidence for International Relations
a) State leaders take more risks to maintain international positions, reputations, and domestic political support than they do to enhance those positions.
b) After suffering losses, political leaders have a tendency not to accommodate to those losses, but instead to take excessive risks to recover them.
c) After making gains, political leaders have a tendency to accommodate to those gains and take excessive risks to defend them against subsequent losses.
d) because accommodation to losses tends to be slow, sunk costs frequently influence decision makers’ calculations and state behavior.
e) It is easier to deter an adversary from making gains than to deter him from recovering losses.
f) Cooperation among states or other actors in social dilemmas is more likely if the issue involves cooperation in not taking from the commons (foregone gains) than if it involves contributing to the public good (actual losses).
IV. Prospect Theory
a) Prospect theory is one of a number of alternative theories of individual choice that behavioral decision theorists have constructed in an attempt to integrate observed anomalies in expected-utility theory into a more descriptively accurate theory of choice using an S-shaped value function.
1. Kahneman and Tversky (1979) who developed it, distinguished two phases in the choice process:
i.Editing phase – actor identified the reference point, available options, possible outcomes, and the value and probability of each of those outcomes.
ii.Evaluation phase – actor combines the values of possible outcomes, reflected in an S-shaped value function, with their weighted probabilities (as reflected in the probability weighting function) and then maximizes over the product (the “prospective utility”).
b) Prospect theory is a theory of choice under conditions of risk.
V. Shortcomings of Prospect Theory
a) The descriptive generalizations on which prospect theory is based emerge from static conditions of experimental research in highly structured, non-interactive laboratory settings make it difficult to extrapolate its findings to the complex world of international relations where the consequences of one’s actions are partially a function of the actions of another.
1. It is extremely difficult in the real world to identify whether an actor selects a particular option because of framing, loss aversion, or any other anomalies of expected-utility theory.
2. It is difficult to know what reference point actors in the real world use.
b) There is no theory behind the S-shaped value function; is merely a derivative of experimental evidence.
c) Like expected-utility and rational choice theories, prospect theory does not explain the intervening processes though which choices are made.
d) The experimental results from which prospect theory is derived were done on individuals, not groups. The aggregate of individual choices will not necessarily resemble individual choices. The roles of framing and the nonlinear probability weighting functions make translating individual choices in prospect theory into collective behavior difficult to mathematically deduce.