Nobel prize winner Daniel Kahneman handed away as we speak. His work incorporating psychology into economics by means of Prospect Concept has been a significant advance. From the N.Y. Instances obituary:

Professor Kahneman delighted in mentioning and explaining what he referred to as common mind “kinks.” A very powerful of those, the behaviorists maintain, is loss-aversion: Why, for instance, does the lack of $100 harm about twice as a lot because the gaining of $100 brings pleasure?
Amongst its myriad implications, loss-aversion idea means that it’s silly to verify one’s inventory portfolio continuously, because the predominance of ache skilled within the inventory market will most probably result in extreme and probably self-defeating warning.
Loss-aversion additionally explains why golfers have been discovered to putt higher when going for par on a given gap than for a stroke-gaining birdie. They fight tougher on a par putt as a result of they dearly wish to keep away from a bogey, or a lack of a stroke.

For a superb introduction of Kahneman’s contribution, one can learn the ebook Considering, Quick and Sluggish. Extra technically, Prospect Concept helped to unravel a few of the key paradoxes in anticipated utility idea. From the Nobel Prize web site:

Departures from the von Neumann-Morgenstern-Savage expected-utility theories of selections underneath uncertainty had been first identified by the 1988 economics laureate Maurice Allais (1953a), who established the so-called Allais paradox (see additionally Ellsberg, 1961, for a associated paradox). For instance, many people want a sure acquire of three,000 {dollars} to a lottery giving 4,000 {dollars} with 80% likelihood and 0 in any other case. Nonetheless, a few of these identical people additionally want profitable 4,000 {dollars} with 20% likelihood to profitable 3,000 {dollars} with 25% likelihood, although the chances for the beneficial properties had been scaled down by the identical issue, 0.25, in each options (from 80% to twenty%, and from 100% to 25%). Such preferences violate the so-called substitution axiom of expected-utility idea…

One hanging discovering is that individuals are usually rather more delicate to the way in which an consequence differs from some non-constant reference degree (similar to the established order) than to the end result measured in absolute phrases. This give attention to modifications slightly than ranges could also be associated to well-established psychophysical legal guidelines of cognition, whereby people are extra delicate to modifications than to ranges of outdoor situations, similar to temperature or mild.

Furthermore, individuals seem like extra adversarial to losses, relative to their reference degree, than attracted by beneficial properties of the identical measurement.

And a few of the arithmetic behind prospect idea:

The important thing variations between anticipated utility and prospect idea: (i) anticipated utility cares about ranges whereas prospect idea evaluates modifications in opposition to establishment [i.e., w vs. Δw], (ii) prospect idea permits the utility perform and threat preferences to for beneficial properties relative to losses [i.e., u(w) vs. v(w)] ], and (iii) anticipated utility idea takes possibilities as given whereas prospect idea makes use of choice weights which account for the way people understand these possibilities [i.e., p vs. π(p)].

Whereas Prospect Concept doubtless represents real-world human decision-making processes extra precisely than anticipated utility idea, some criticisms of Prospect Concept can be that (i) with repeated video games, people usually revert to nearer to an anticipated utility framework and (ii) for researchers, figuring out a ‘establishment’ worth for every particular person is usually difficult in apply.

Nonetheless, the Nobel Prize was a lot deserved and the scientific contributions Kahneman (and his collaborator Amos Tversky) will reside on for posterity.