The Value Theory

Reading the book “Misbehaving” by Richard Thaler, I found myself very interesting in the field of Behavioural Economics. Some parts of the book burned my eye and I would like to introduce those interesting reading moments here, on Medium.

Danny Kahneman and Amos Tversky wrote the paper about decision-making called “The Value Theory”. This paper, later called “Prospect Theory” brought Dany a Nobel Prize 2002. In this paper, the author explains that there are two types of Economic Theory — normative and descriptive. The normative theory tell us how to think about some particular issue. The phrase “how to think” does not imply the morally correct, but logicaly consistent manner. This is called “the rational choice theory”. For example, the Pythagorean theorem represents the normative theory. As we know, the Pythagorean theorem tells us that if we know the lenght of the two sides of a right triangle, we can calculate the one side that left.

For example, suppose we have two parts of a railroad track, each one kilometer long. Suppose that they are attached at their ends. Assuming that the temperatures are very high, the railroad tracks starting to expand each by 1 centimeter. Because they are strengthened to their ends, the only way that these railroad tracks can expand is up. Two railroad tracks are so rigid that it will remain in its shape (straight line) even when they are raised. The problem is as follows:

Consider one side of the road. We have a right triangle with one cathetus (base) which is 1 kilometer, and the hypotenuse which is 1 kilometer and 1 centimeter. What is the altitude? In other words, how much the tracks rises above the ground?

The most of the people would say something about 1 or 2 centimeters, but the right answer is 4,5 meters. If we use “rational choice” theory as a model, most of the people should use the Pythagorean theorem as a lodestar and come with an answer of 4,5 meters. This brings us to the core problem of traditional economics. Most of the economists uses one theory for normative and descriptive purpose. For purpose of explanation, take into the consideration the company theory. The company will operate to maximize their profits or the value of the company. Further elaboration of this theory suggests the way in which this goal can be achieved. For achieving this goal, company should set prices at the level where marginal costs equals marginal revenues. The comparison to this could be the Gary Becker theory of human capital formation. People should choose the education that they want to get, and how much money and time to invest in it, by forecasting how much money (and fun) they will have in their careers.

This brings us back to the 1738. when Daniel Bernoulli, the student of almost everything (including mathematics and physics), solved the St. Petersburg Paradox. This puzzle was set by his cousin Nicolas. Suppose you are offered to gamble. You need to throw a coint until it falls to its head. If you receive tail on your first throw you win 2$, on your second throw 4$ and so on. The amount doubles each time. The value of this series is infinite, so why people do not want to pay large amounts for participation in this competition? Bernouli response was that people get diminishing value with each increase in their wealth. Bernouli is the guy who invented the term risk aversion. He found out, that, the consumption utility increases but at the decreasing rate. This principle is called the diminishing sensitivity.

The theory of decision making in risky situation is called the “Theory of Expected Utility”. This theory was introduced 1944. by two authors, John von Neuman and Oscar Morgenstern. The very essence of the theory is that if you prefer A from B and B from C, the more you will love A from C.

In the very conclusion, I would say that the book is about the fact that Kahneman and Tversky tried to make aditional theory. The theory about actual choices of humans, and not rational choices of “Econs”.