Prospect Theory and the Brain

Whether we like it or not we face risk every day of our lives. From selecting a route home from work to selecting a mate, we rarely know in advance and with certainty what the outcome of our decisions will be. Thus, we are forced to make tradeoffs between the attractiveness (or unattractiveness) of potential outcomes and their likelihood of occurrence. The lay conception of risk is associated with hazards that fill one with dread or are poorly understood (Slovic, 1987). Business managers, for example, tend to see risk not as a gamble but as a “challenge to be overcome” and see risk as increasing with the magnitude of potential losses (e.g., March and Shapira, 1987). Likewise, medical clinicians tend to see risk as exposure to loss or harm to oneself or others (Furby and Beyth-Marom, 1992). Decision theorists, in contrast, view risk as increasing with variance in the probability distribution of possible outcomes, regardless of whether a potential loss is involved. For example, a prospect that offers a 50 50 chance of paying $100 or nothing is more risky than a prospect that offers $50 for sure even though the risky prospect entails no possibility of losing money. This core idea serves as the focus of discussion in Chapter 9, which discusses the many approaches to risk in the study of human and animal preferences. Since the work of the American economist Frank Knight (1921), however, economists have distinguished decisions under risk from decisions under uncertainty. In decisions under risk, the decision maker knows with precision the probability distribution of possible outcomes, as when betting on the flip of a coin or entering a lottery with a known number of tickets. In decisions under uncertainty the decision maker is not provided such information but must assess the probabilities of potential outcomes with some degree of vagueness, as when betting on a victory by the home team or investing in the stock market. This distinction between risk and uncertainty is also developed at greater length in Chapter 9.