Behavioral Economics, By Daniel Kahneman's Theory Of Economics

Before the theories of behavioral economics clarified by Daniel Kahneman, economics was a generally straightforward field. Adding this new approach to consumer behavior makes us seem less like robots acting only as economics expects us to act and more like the more or less irrational beings we are. Daniel Kahneman is one of only a couple non-economists and the first psychologist to win the Nobel prize in Economics for his work in the relatively new field of behavioral economics. Kahneman begins his book by dividing the mind into two parts: System 1 and System 2, thinking fast and slow. System 1 is described as fast thinking; it is the portion of our mind that operates effortlessly and automatically, as if on autopilot. System 1 helps us

In figure 5 we see an indifference map for two goods: income on the y-axis and leisure on the x-axis. Each point that lies on the indifference curve indicates a combination of the two goods that results in the same utility. All points along the curve are equally desirable; furthermore, a point on a higher indifference curve will result in a higher utility than that of any point on the lower curve. This, however, does not take loss aversion into account. Take the example Kahneman provides of the “hedonic twins” Albert and Ben. Albert lies at position 1 with a salary of $60,000 and 3 weeks of vacation and Ben at position 2 with a salary of $40,000 and 5 weeks of vacation. Because Albert and Ben are hedonic twins they share the same indifference curve and utility. Now, Albert and Ben have the option to move from position 1 and position 2 to position 3. Standard theory says that because position 3 lies on a higher indifference curve Albert and Ben will gain more utility thus be more likely to accept the promotion. Kahneman’s prospect theory says otherwise. Prospect theory believes that due to loss aversion both men would rather stay in the positions they are in now. Let’s say in position 3 Albert and Ben would receive an income of $50,000 and 4 weeks of vacation. If Albert switches from position 1 to position 3 he gains an extra week of vacation but a salary cut of $10,000. If Ben switches from position 1 to position 3 he gains a $10,000 raise but loses a week of vacation. Although there is a desirable aspect to both cases, prospect theory shows there is a level of loss aversion that causes Albert and Ben to remain in their current positions. The new reference point Albert values the $10,000 salary cut as a greater loss than the gain he would