Monday, September 27, 2010

Prospect Theory and Utility, Price and Rights

Talking with my friend Damien over lunch today, I got to thinking about some very stupid questions:
1) Let's say someone offered you a sum of money, $X, to not wear jeans at all for the next year (presume it's suitably enforced so that you will always comply). How big would X have to be for you to accept?
2) Let's say someone offered you a sum of money, $X, to never use a fork or fork-like object (spork, etc) for eating ever again. Presume it's suitably enforced so that you will always comply. How big would X have to be for you to accept?
I'd expect significant variation in peoples' answers to both questions (I don't get to wear jeans to work anyway, for example, so not wearing jeans would impact me less than others - though I like jeans a lot more than most people do, I think. Women have more alternatives to jeans during leisure time - dresses, skirts - and I know some girls who never wear pants, ever. A lot of people are better than I am with chopsticks.), but the interesting part is how those sums relate to sums in the rest of my life.
Damien posited that about $100,000 would be enough to make him give up forks forever. (He claims that $200-$300 would be enough to give up jeans for a year, but I doubt that's true, given that he has spend that much on a pair of jeans before...). My answers were higher on both counts - at least a million for the fork question.
The funny thing is that a million dollars is a LOT of money (surprise!) - would I really forgo a lot of years of cumulative earnings just so I can use a fork, a utensil for which there are plenty of substitutes?
The reason for my answer, I think, comes down to a few things -
1) I'm young, live cheaply / don't have trouble managing my budget because there aren't that many things I really want to buy, and am probably wildly overoptimistic about my future earnings capacity relative to future expenditures (wedding, house, childrens' college, etc), and thus estimate that the marginal utility I will get from spending a million extra dollars over the rest of my life will be less than the marginal utility from using forks (the "rational" response except only a blind idiot would project future expenditures that low, and thus discount one MILLION dollars, and in any other context, I wouldn't make that discount),
2) path dependence - I have used a fork for my whole life and am good with it, but am much worse with chopsticks. A stupid reason, because I'm sure I'd get very good at using spoons or knives or chopsticks as replacements pretty quickly - I probably underestimate the ease of transition, which is part of...
3) prospect theory. I significantly overvalue potential losses and undervalue potential gains. As an investor who pays a lot of attention to the psychology that goes into my own decisions and my psychological reaction to risk and opportunity cost, I sometimes like to think I'm a little more immune from prospect theory than most, but apparently, I just suffer from overconfidence, just like everyone else...
Food for thought and self-reflection. Lunch break's over, back to work.

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