Prospect Theory

Starting out from the observation that the linguistic representation of the outside environment influences the way people make sense of it, prospect theory contends that people do not evaluate choices in absolute terms but compare options to a reference point. A reference point is essentially a heuristic device that helps the decision-maker process information quickly but, at the same time, also biases the decision. While Kahneman and Tversky defined the reference point as the status quo, it may also be the status quo ante or some future expectation.¹⁴³ Options will take up a value with regard to this reference point, depending on whether they mean an improvement (gains) or deterioration (losses) toward this reference point. This is suggestive in two ways. First, should a shift in reference point occur, a reversal of preferences among equivalent option may follow. Second, the utility function is S-shaped:

in the loss domain, it is convex and in the gain domain it is concave (figure 1).

Moreover, gains and losses have different psychological effect on people. Losses always loom larger than gains as the oft-quoted statement from Jimmy Connors, the tennis player, demonstrates this point very well. “I hate to lose more than I like to win.”¹⁴⁴ Consequently, people value what they have more than what they might gain and will take larger risks and make a bigger effort to avoid losses than to secure gains. This is also true in

142 McDermott and Cowden 1999, 124-125.

143 Taliferro, Jeffrey W. 2004. “Power Politics and the Balance of Risk: Hypotheses on Great Power Intervention in the Periphery.”Political Psychology 25 (2): 185-186.

144 Taliferro 2004, 186.

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the sense that once a risky option has been selected, decision-makers are likely to stick to it longer than the success of the chosen course of action would warrant.

+ Value

Losses Gains

– Value

Figure 1.Prospect theory’s subjective utility function¹⁴⁵

However, people do not make an equal effort for every additional loss or gain: losses and gains closer to the reference point are seen as more important. Furthermore, losses stay with people longer than gains, giving them a greater level of dissatisfaction over time than the satisfaction they draw from gains. A consequence of the persistence of gains is that those who could not make peace with past losses will display a preference for risk. Hence the preoccupation with losses also influences the shape of the utility curve: it will be asymmetrical – steeper in the domain of losses.¹⁴⁶

Unlike EU theory that assumes that the evaluation of alternatives is a one-phase process,¹⁴⁷ prospect theory divides the decision making into a two-stage process of an editing or framing and an evaluation phase. The editing phase is where manipulation my take place in the decision-making process.¹⁴⁸ In the editing phase, six mental operations take place that help

145 Adopted from Kahneman and Tversky 1979, 279.

146 Masters, Daniel. 2004. “Support and Non-Support for National Rebellion. A Prospect Theory Approach.”

Political Psychology 25 (5): 704-705.

147 Schoemaker, Paul J. H. 1982, “The Expected Utility Model: Its Variants, Purposes, Evidence and Limitations.”Journal of Economic Literature20 (2): 532.

148 Boettcher, William A. III. 2004a. “The Prospects for Prospect Theory. An Empirical Evaluation of International Relations Applications of Framing and Loss Aversion.”Political Psychology 25 (3): 334.

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define the decision situation. These are coding (definition of the reference point and then casting the options in terms of gains and losses), combination (the tendency to add together the likelihood of events that present identical outcomes), segregation (decision-makers focus on the aspects they find most relevant to the problem, ignoring others),cancellation (decision-makers ignore the dimensions in the evaluation of two alternatives that are identical), simplification and dominance (probabilities are not only rounded, but outcomes with small probabilities are discarded and highly likely outcomes are treated as certainties) The results of editing prospects vary, depending on the order in which the editing procedures are performed.

Finally, once the editing is done, people tend to accept the formulation of options, making it quite unlikely that they would recast the situation in other terms. In the evaluation phase, the preferred option is selected after examining the edited prospects.¹⁴⁹

2.2.3.1 The Applicability of Prospect Theory to Politics

In spite of all the improvements on EU theory, prospect theory suffers in three respects, which are especially problematic when it comes to applying prospect theory to political phenomena.

However, these may be eliminated by further research. First, a theory of framing effects is missing. The development of such a theoretical addition is helpful in seeing how alternatives are framed and option defined. If editing processes are used as assumed, because they are quick and efficient means in coming to a decision, there may be a general rule how the process of editing – if not the content – of choices emerge. Second, prospect theory was created as a theory of individual decision-making, and, in its present form it is not applicable to group decisions. This is of special importance in foreign policy, where decisions are often the results of group deliberations.

149 Kahneman and Tversky 1979. McDermott 1998, 15-35; Masters 2004, 704-8; and Taliferro 2004, 185-188 provide succinct summaries of prospect theory. For a summary solely on framing, see Boettcher 2004a, 332-334 and 2004b 333-335.

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Third, although prospect theory was an improvement on EU theory as it was able to accommodate cognitive information-processing mechanism, it says nothing about the role of emotions. This is a serious shortcoming, since cognitive psychologists have already called attention to hot cognition – the fact that cognition takes place within the context of emotions.

Moreover, experiments seem to suggest that emotions are not only unavoidable nuisance in decision-making, but they also perform vital tasks in the process. Neuroscientists discovered that people who are cut off from emotional referents because of illness and accident have difficulty in making the simplest decisions about their lives.¹⁵⁰

How much prospect theory is applicable to international relations is a matter of dispute.

Even Kahneman and Tversky disagreed on this point: Kahneman believed that trying to apply prospect theory to international relations was futile while Tversky often used examples from international relations in his own work.¹⁵¹ Besides the general problems of prospect theory, importing it to areas other than economics or psychology raises several questions. Boettcher argues that prospect theory has often been applied to international relations without testing its applicability to contexts with substantial differences from the experimental conditions used in developing prospect theory. First, prospect theory is a theory of decision under risk, while foreign policy decision-situations are characterized by conditions of both risk and uncertainty.

Second, unlike experimental situations, which are highly structured, foreign policy problems are (in)famously ill-structured.¹⁵²

In addition, there are some methodological issues that plague research. The analysis of historical case studies often avoids eliminating competing explanations such as the one provided by subjective expected utility theory. Furthermore, analyzing historical cases often

150 McDermott 2004, 304-310; Bueno de Mesquita, Bruce and Rose McDermott. 2004. “Crossing No Man’s Land: Cooperation From the Trenches.”Political Psychology25 (2): 271-287.

151 Bueno de Mesquita and McDermott 2004, 274; McDermott 1998.

152 Boettcher, William A. III. 1995. “Context, Methods, Numbers and Words: Prospect Theory in International Relations.”Journal of Conflict Resolution 39 (3): 561-583; Levy, Jack S.1992. “Prospect Theory and International Relations: Theoretical Applications and Analytical Problems.”Political Psychology 13 (2): 292-299.

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involves the aggregation of international and domestic costs and benefits, which is a very complex task, producing vague results. Also, researchers are “forced to interpret verbal expressions of probability,” since decision-makers almost never use numerical estimates of probability. This is a problem inasmuch as the psychological literature on verbal probability expressions has already discovered that individuals tend to interpret the same frequency terms differently, and use frequency words imprecisely and without any discernible pattern.¹⁵³

2.2.3.2 Prospect Theory and International Relations Research

In order to fill the gap of testing prospect theory against expected utility and verbal probability theories, Boettcher experiments with foreign policy and economic problem sets.

He concludes that prospect theory performs better than the other theories. However, prospect theory displays the expected outcome most when the experimental situations closely resembled ones used by Kahneman and Tversky. It also performs better in foreign policy problem sets than in economic problem sets, suggesting that respondents take the stakes more seriously when the issue was about life and death rather than about financial gains and losses.¹⁵⁴

In another study, Boettcher focuses on the more general problems of the theory, namely its application to group settings and framing or the lack of a framing theory. Experimenting with problems from the domain of politics, he finds that the framing effect with regard to group decisions is only weakly supported, but apart from group settings, “framing may, under certain conditions, produce clear and robust preference reversals.”¹⁵⁵ In another article, he examines what conditions may help politicians sell humanitarian interventions to the general American public and concluded that the location of the conflict, the race/ethnicity/religion of

153 Boettcher 1995.

154 Cf. Levy 1992, 304 who argues that risk-seeking behavior maybe reversed in situations, such as wars, that are characterized by the prospects of catastrophic losses.

155 Boettcher 2004a.

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conflict participants, and the prospects for casualties influence the public’s willingness to consent to the risk of intervention, while foreign policy frames (the situation presented as gains or losses), the framing source (official vs. nonofficial), the type of humanitarian crisis (human rights violation by regime or as a result of the breakdown of central government) either have an insignificant impact or their effect points to the opposite direction than predicted.¹⁵⁶ Masters found a connection between the framing of ethno-national conflicts as territorial struggles and people’s willingness to support rebellion.¹⁵⁷

A more traditional international relations approach has been taken by a variety of scholars. Taliferro engages in theory development by molding defensive realism with prospect theory. He generates four testablealbeitoften banal and problematic hypotheses with regard to great power intervention on the periphery. For instance, he hypothesizes that loss aversion makes the status quo the reference point for decision-makers whether they expect losses or gains in relative power status.¹⁵⁸ It appears that Taliferro failed to note that the combination of the gain and loss frameworks with realism does not so much support defensive realism and undermines the notion of offensive realism, but through gains and losses in power status, the loss/gains framework could help him define the scope of the two realisms. Offensive realism is a function of the loss framework and the defensive one is that of the gains frame.

Berejikian used prospect theory to improve on the empirically problematic aspects of deterrence theory and developed a model, starting out of the assumption that deterrence is more likely to be effective when both states are in a gains frame, and less likely to be effective when either or both are in a loss frame. His model, however, still needs to be tested.¹⁵⁹

156 Boettcher 2004b.

157 Masters 2004.

158 Taliferro 2004.

159 Berejikian, Jeffrey D. 2002. “A Cognitive Theory of Deterrence.”Journal of Peace Research 39 (2): 173.

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Haas tests the predictive power of prospect theory as opposed to expected-utility based deterrence theory on the outcomes of the Cuban missile crisis. By examining the frames of Kennedy and Khrushchev, the utility of various courses of action and the weighing functions associated with alternatives, he finds that both leaders operated in a loss frame, took extremely risky steps but as the (negative) consequences of high probability outcomes, such as starting a war, was weighted as if their outcomes were certain, both leaders shrank from their consequences. All in all, he interpreted his findings as evidence that prospect theory was a better predictor of the final outcome than the theory of deterrence.¹⁶⁰ Last but not least McDermott engages in a parallel demonstration of theory, showing the utility of prospect theory in explaining historical foreign policy decisions such as the Iranian hostage rescue mission or the American side of the Suez crisis.¹⁶¹