Daniel Kahneman is an American-Israeli psychologist, economist, professor, award-winning author, and Nobel Laureate. He is most famous for his pioneering work on human judgment and decision-making which he applied to economic theory. He is widely regarded as one of the founding fathers of behavioral economics and was also instrumental in developing the field of hedonic psychology.
Daniel Kahneman's Childhood
Daniel Kahneman was born in Tel Aviv, Israel in 1934 to Lithuanian Jewish parents. He spent his childhood years in Paris, France, where his father worked as the head of research in a chemical factory. The family lived in relative comfort until the occupation of France by the Germans in 1940.
When Kahneman was seven, his father was arrested by German forces and spent six weeks in a detention camp. After his release, the family fled to another region of the country, moving from village to village until they eventually settled in the center of France. His father died in 1944 from poorly managed diabetes. After the liberation of France, Kahneman, his mother and sister moved to Palestine to join other members of their family.
From an early age, Kahneman developed a fascination for the complexity of human behavior. In his own words, he displayed “some aptitude for psychology” while still quite young. As a child, he compiled a notebook of essays detailing his reflections on various aspects of life, the first of which he wrote before age 11 on the subject of faith. Kahneman described his childhood self as “intellectually precocious,” though “physically inept.”
During his teenage years, Khaneman’s interest in what made people think and act in certain ways intensified. By age seventeen, he was determined to study psychology, although economics also emerged as a recommendation during vocational guidance.
Kahneman completed his first degree at the Hebrew University in Jerusalem, with a major in psychology and minor in mathematics. During his studies he developed a keen interest in the work of social psychologist Kurt Lewin, and the subfield of neuropsychology. So fascinated was he by his lectures in neuropsychology that for a brief time, he gave serious thought to switching his career path to neurology.
In 1954, after completing his B.A. in psychology, Kahneman was drafted into the Israeli Defence Force as a second lieutenant. After one year, he was transferred to the Psychology branch of the army where he was involved in assessing the character of candidates for officer training. He was later tasked with developing an interview method for combat-unit recruits to assist with selection of recruits and assignment of duties.
Kahneman developed a structured interview schedule that was used by interviewers to rate candidates on six different aspects of personality. Kahneman’s method showed a higher degree of validity than previous methods and his interview system continued to be used for several decades.
Kahneman left the army in 1956 and was granted a fellowship by the Hebrew University to pursue graduate studies abroad. He commenced his studies in January 1958 at the University of California at Berkeley. Kahneman described himself as an eclectic graduate student who dabbled in a diverse range of subject areas, including subliminal perception, vision, personality testing, philosophy, and psychoanalysis.
Kahneman wrote his dissertation in the spring of 1961 on the relations between adjectives in the semantic differential. He spent the summer of that year conducting research in the ophthalmology department of the university before returning to Jerusalem. There, he began teaching in the psychology department at the Hebrew University, rising to the rank of professor in 1970.
Kahneman taught at Hebrew University from 1961 to 1978 and at the University of British Columbia from 1978 to 1986. From there, he moved to UC Berkeley where he served as a professor until 1994. In 1993, he became the Eugene Higgins Professor of Psychology at Princeton University and Professor of Psychology and Public Affairs at Princeton’s Woodrow Wilson School of Public and International Affairs. Since 2007, he has served as Professor Emeritus of both posts. He is also a fellow of the Center for Rationality at the Hebrew University in Jerusalem.
Kahneman developed prospect theory in 1979 together with his cherished colleague and friend, Amos Tversky. The theory describes how people make decisions when their choices involve uncertainty, probability, and risk. According to prospect theory, most people prefer to hold onto the wealth they have, rather than risk their wealth to attain more. It also claims that because people do not like to experience losses, they would rather take a risk to avoid a loss than take a similar risk to make a gain.
Kahneman claims that the decision-making process has two phases. These are:
1) The Editing Phase
In this phase the decision-maker edits a complicated decision into a simpler one. However, the way the decision maker edits, may vary from one moment to the next depending on situational circumstances. Whether a decision-maker likes a particular option or not may be affected by the framing effect. The framing effect is a principle that a person’s choice may be influenced by the way the available options are presented or “framed” through different wording, settings, or situations.
To get a better understanding of the framing effect, it may be helpful to consider two consent forms for surgery. On one version of the form, patients are told the surgery has an 80% chance of success. On another version of the form, patients are told the surgery has a 20% chance of failure. Although the statistical probabilities are identical, more patients are likely to sign the first consent form because the information was presented in a positive light.
2) The Evaluation Phase
After the options are framed and edited, the decision-making process moves to the evaluation phase. In this phase, the decision-maker computes the possible outcomes of each option as well as their likelihood. The decision-maker then chooses the option that results in higher value or utility.
The evaluation phase uses statistical analysis to measure and compare the outcomes of each prospect. It has two statistical aggregates that measure change: the value function and the weighting function. A diagram of the value function is shown below.
Prospect theory has several key features:
- Loss Aversion
- Small vs High Probabilities
- Reference Dependence
Certainty - People usually prefer options with certainty. Consider the following scenario:
Option A: You have a 100% chance of winning £100
Option B: You have a 50% chance of winning £200
Which option would you choose?
In both cases, the expected value is the same.
Option A → 1.0 x £100 = An expected value of £100
Option B → (0.5 x £200) + (0.5 x £0) = £100 + £0 = An expected value of £100
According to prospect theory, most people would choose Option A. They prefer the certainty (£100) offered by Option A more than the possibility of extra value (£200) offered by Option B. So people typically avoid risk and take any guaranteed gains that are offered.
Loss Aversion - The value function shown in the diagram above is steeper for losses than gains. This is because a loss is assigned greater value than a gain. For most people, losing £100 makes them feel worse than winning £100 makes them feel good. In other words, a loss creates a bigger psychological and emotional impact on people than a gain does.
Consider Person A who wins £200 but instantly loses £100 and Person B who wins £100 and loses nothing. Prospect theory suggests that Person A may feel worse than Person B because he experienced a loss along the way, even though in the end he has the same amount of money as Person B.
As mentioned before, people dislike losses so much that they may take greater risks than normal to avoid losing.
For example, which option below would you prefer?
Option A: 100% chance of losing £100
Option B: 50% chance of losing £200 or nothing
In both cases, the expected value is the same.
Option A → 1.0 x -£100 = An expected value of -£100
Option B → (0.5 x -£200) + (0.5 x £0) = -£100 + £0 = An expected value of -£100
When given the choice, most people choose Option B. They choose Option B even though the risk exists that they may lose £200. However they seek this riskier option because they want to avoid the guaranteed loss offered by Option A. They are more risk-seeking and willing to gamble in the hopes of losing nothing.
Small vs High Probabilities - Prospect theory suggests that people usually give excessive weight to events with low probability and insufficient weight to events with high probability. For example, people may treat an event with a probability of 99% as if it had a 90% chance of happening. And they may treat an unlikely event with a probability of 1% as if it had a 10% chance of happening.
Reference Dependence - According to prospect theory, people usually focus less on their overall net worth and more on their relative gains and losses from a reference point. To get a better idea of what this means, consider a person who is very concerned about how his salary stacks up against that of his workmates. If everyone in his company gets a 50% raise, he would be happy, but his relative position compared to everyone else is unchanged. He would likely be more interested in getting a 25% raise if everyone else in his company received nothing. He is more focused on earning more than his workmates than his overall net worth.
Prospect theory claims that the reference point when evaluating gains and losses matters. If your net worth is £1,000,000 and you lost £5 this morning, you may conclude that the loss is insignificant. But what if you had a different reference point? For example, if all the money you had in your pocket this morning was £5 for your morning coffee and you lost it, you may become very upset despite the fact that you are a millionaire.
During the 1990’s, Kahneman’s focus shifted to what he and his colleagues termed “hedonic psychology.” According to Kahneman, hedonic psychology is the study of what makes our lives and experiences pleasant and unpleasant. It is closely related to the field of positive psychology and deals with topics such as happiness, sadness, pain, pleasure, satisfaction and dissatisfaction.
One of Kahneman’s main contributions to this subfield was his suggestion that well-being is not a unitary concept but is comprised of two distinct components: experienced well-being and evaluative well-being. Experienced well-being has to do with how people feel about their experiences in the moment, as they are occurring. Evaluative well-being refers to how they feel about their experiences after they have passed. As Kahneman pointed out, the distinction is important because people’s feelings about the same experience may differ depending on whether they are presently going through that experience, or recalling it.
Another significant contribution made by Kahneman to this branch of psychology is the concept of the focusing illusion, which he developed in conjunction with David Schkade. According to Kahneman and Schkade, the focusing illusion occurs when people direct their attention to just one aspect of a situation, while neglecting the many other factors that are also important. The focusing illusion typically leads to errors in judgment.
Kahneman and Schkade demonstrated the focusing illusion in a study involving two groups of participants: students attending Midwestern universities and students attending California universities. Participants were asked to rate their own life satisfaction and to predict how a hypothetical person would rate their life satisfaction if they lived in California versus the Midwest.
Although there was no significant difference in self ratings of life satisfaction between the two groups, both Midwest and California students predicted that the hypothetical person would be happier living in California. Kahneman and Schkade suggested that this was due to participants’ tendency to focus on the most salient differences between the two locations (namely, the beaches, natural beauty and good weather typically associated with California), while neglecting other important factors (such as job opportunities, cost of living, and the social environment) that also have a bearing on life satisfaction.
Applications of Prospect Theory
As prospect theory involves decision-making, its principles have been applied to many fields and industries. Some of the most common applications involve:
- Insurance - As people tend to overweigh low probability events when making judgments, they may be persuaded to pay insurance for potential disasters that are very unlikely to occur.
- Gambling - People are willing to risk a relatively small sum of money for the chance of winning a big jackpot because they overweigh the low probability of winning. This principle is often employed by lotteries. People who suffer a loss while gambling are also more likely to keep taking risks as they try to recoup their losses.
- Finance and Investing - A financial advisor may influence his client to invest in a particular stock by showing him that stock’s excellent returns over a one month period. However, by changing the reference point, the client may see that the stock has been in a steady downtrend for several years.
- Marketing - A dairy company may get more customers by framing their products in a positive light. For example, yogurt may sell better if marketed as “90% Fat Free” rather than “10% Fat.”
- Economics - People, organizations, and governments can learn how to properly evaluate risk and make better decisions on how to use scarce resources if they apply the principles of prospect theory. This improves productivity, efficiency, and adds increased value to society.
- Medicine - Patients who need minor surgery are more likely to sign consent forms if medical statistics are presented in a manner that emphasizes benefits and health rather than risks and death. Patients who are experiencing chronic or life-threatening health issues are loss aversive and usually try riskier forms of treatment than patients with milder health conditions.
- Psychology - Prospect theory explains why people may react more strongly to threatening social cues in the environment than to supportive or helpful social cues. The asymmetry between losses and gains has also informed strategies to boost motivation and goal pursuit.
- Politics - People’s tendency to be risk-seeking when they experience loss and risk-averse when they experience gains has been applied to political attitudes for change versus stability. Prospect theory has also been applied to the field of international relations to explain political decisions that seem to involve irrational risks and identify broad patterns of foreign policy behavior.
Criticisms of Prospect Theory
One of the main criticisms of prospect theory is that it provides little explanation for the processes it describes. For example, the theory mentions the framing effect, but why decision-makers create the frames they use is not explored. Also, limited attention is given to other important factors that influence decision making such as human emotion, cognition, and the impact of time.
Prospect theory also claims that people perceive losses and gains differently. While this may be true for most people who are experiencing a loss in a specific situation for the first time, people who are exposed to similar situations on a regular basis may eventually demonstrate changes in their decision making as they learn from past experiences. This means the theory may be more accurate in describing decision making in strange situations than familiar situations.
Some of the main features of prospect theory may be applicable in some scenarios but not in others. For example, loss aversion may be strongly felt when a person is risking his or her own money. However, bankers and money managers may react differently when working with money that is not their own. Critics have emphasized that Kahneman never intended to apply the principles of prospect theory to fields outside of economics.
Daniel Kahneman's Books, Awards and Accomplishments
Kahneman published over 150 scholarly articles, as well as two books: the award-winning Thinking, Fast and Slow in 2011, and Attention and Effort in 1973. He was also co-editor for four other books:
- Heuristics and Biases: The Psychology of Intuitive Judgment, 2002
- Choices, Values and Frames, 2000
- Well-being: The Foundations of Hedonic Psychology, 1999
- Judgment under Uncertainty: Heuristics and Biases, 1982
During the course of his illustrious career, Kahneman received numerous awards, most notably the 2002 Nobel Prize in Economics, which he received for his work with Amos Tversky on prospect theory. His other accomplishments include:
- The Presidential Medal of Freedom, 2013
- The American Academy of Arts and Sciences Talcott Parsons Prize, 2011
- The APA Award for Outstanding Lifetime Contributions to Psychology, 2007
- Co-recipient of the University of Louisville Grawemeyer Prize, 2002
- Elected member of the National Academy of Sciences, 2001
- The Hilgard Award for Career Contributions to General Psychology, 1995
- The Warren Medal of the Society of Experimental Psychologists, 1995
- Co-recipient of the Distinguished Scientific Contribution Award of the American Psychological Association (1982)
Kahneman is a fellow of the American Psychological Association, the American Psychological Society, the Society of Experimental Psychologists, and the Econometric Society. He also holds honorary doctorates from several universities, including Harvard, Yale, and Cambridge.
Kahneman married Irah, an educational psychologist, in the 1950’s and their marriage produced two children. In 1978, he married a second time to Anne Treisman, a cognitive psychologist, and the pair moved to the University of British Columbia together. In 1986, they moved again, this time to UC Berkeley, and later to Princeton in 1993. Kahneman and Anne remained together until Anne’s death in 2018.
Kahneman maintains a strong connection to Israel and takes frequent trips there to lecture and to visit his children and grandchildren. He describes himself as “Israeli and American” and says spending time with his grandchildren is his “principal hobby.”
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Daniel Kahneman. (2020). In Encyclopedia Britannica. Retrieved from https://www.britannica.com/biography/Daniel-Kahneman
Goldstein, E. B. (2008). Cognitive psychology: Connecting mind, research, and everyday experience (2nd. ed.). Belmont, CA: Thomson Wadsworth.
Kahneman, D. (2002). Daniel Kahneman biographical. Retrieved from https://www.nobelprize.org/prizes/economic-sciences/2002/kahneman/biographical/
Kahneman, D. & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47(2), 263-292. Retrieved from https://www.its.caltech.edu/~camerer/Ec101/ProspectTheory.pdf
Prof. Dr. Daniel Kahneman. (n.d.). Retrieved from https://www.mediatheque.lindau-nobel.org/laureates/kahneman
Prospect theory. (n.d.). In Encyclopedia Britannica. Retrieved from https://www.britannica.com/topic/prospect-theory Publications. (n.d.). Retrieved from https://scholar.princeton.edu/kahneman/publications-0