Lewis Undoing Project Chapter 10 - The Isolation Effect

Two economists, Danny and Amos have worked on theories about choice.

they have found out that when they ask the question :

-      Would you prefer a 100% chance to win 500$

-      Or a 50% chance to win 1000$ ?

People choose the sure bet. However, when they reverse the question, and they ask about the losses, people don’t make the same choice and they become risk-seekers. 

Danny and Amos forgot their first theory very quickly to focus on that new one: people respond to probability not only with reason, but also with emotions, and that this emotion is stronger when the odds are far. Fox ex : if there is 1 in a billion chances, people will consider it as it was actually 1 in 10 000 chances. This explains lotery tickets. 

They developed this theory around 1975. 

They presented their theory at a conference in Jerusalem and were asked : what is a loss ?

They considered it was when you end up worse than your status quo. But how do you determine someone’s status quo ?

Someone’s reference is a state of mind, that you can manipulate by changing the formulation of the question. 

They discovered the phenomenon of framing : 2 things that should be identical, but the way they differ makes the difference and the choice changes.
Amos and Danny also discovered the isolation effect : people facing a risky choice fail to put it in context. 

Another economist, Thaler, was very easily bored with things as a child and thought he was lazy when he was probably just dyslexic. He got into graduate school and wrote his thesis about infant mortality in the USA. After working in a consulting firm, he became a university teacher. After working for a long time on a theory about the price of human life, he developed another theory. 

He made a list of irrational things that people do and that economist claim they don’t do. He named that list the endowment effect. He thought that economics were trying to study the aspects of human nature, but economists were forgetting about human nature. Other economists didn’t like this theory very much, because they felt he was undermining their work, so they justified by saying that people only made mistakes very occasionally. 

Thaler discovered an article from Khaneman and Tversky, who are actually Danny and Amoss, and he read about systematic bias. Thaler felt that if people made systematic mistakes, they couldn’t be ignored. If people could be systematically wrong, markets could too. 

When Thaler read their theory, he discovered that it explained a lot of things on his list, so he wrote a letter to Tversky.

Danny and Amos worked a lot on their theory, polishing it, so it is ready to be published. For a long time, they looked for internal contradictions in their theory. 

They came up with the name “Prospect theory”.