Kahneman &Tversky (1979) published their prospect theory at the same time that other economists were also working on generalisations of expected utility theory. There was something different about Kahneman and Tversky’s theory. There was something very eye-catching about it. And it caught the eye of Richard Thaler, the person who more than anyone else would be responsible for turning behavioural economics into a distinct field within economics (Barberis 2018). According to Thaler’s (2016) account of the early history of behavioural economics, Kahneman and Tversky’s ‘stunning graph’ was the thing that he first noticed when reading some of their early work. The stunning graph he refers to is the S-shaped utility function.
In economics, a utility function plots the relationship between utility (satisfaction) and goods or money. Orthodox utility functions are concave to depict
FIGURE 1.1 A regular shaped concave utility function.
risk aversion and diminishing marginal utility. One of these ordinary functions is shown in Figure 1.1. The details are not important for now. What is important is how interesting the S-shaped function looks when compared to the regular shaped utility function.There is something about the S-shape that is much more intriguing.
Kahneman &Tversky (1979) drew an S-shaped utility function inflecting about a reference point.This S-shaped utility function was something entirely new to this part of economics, though undulating utility functions had been used much earlier by Friedman & Savage (1948) and Markowitz (1952). We have drawn an S-shaped utility' function in Figure 1.2.
Kahneman &Tversky’s (1979) prospect theory' could have been just one of many generalisations of expected utility' published during the late 1970s and early 1980s (Schoemaker 1982; Machina 1987). Richard Thaler was persistent. Throughout the 1980s and 1990s, he gradually built behavioural economics by enticing new researchers into the field and by teaming up with established researchers who held similar interests in human behaviour (Thaler 2016; Barberis 2018). He used prospect theory and Kahneman and Tversky’s heuristics and biases research as a core theoretical foundation to provide deeper explanations for puzzling pieces of human behaviour. For example, when De Bondt & Thaler (1985) decided to see whether the stock market overreacts to new information—that is, whether prices tend to move too drastically in response to news—they found their benchmark against which to test their hypothesis in Kahneman and Tversky’s study of violations of
FIGURE 1.2 The famous (and much more exciting) S-shaped utility function
Bayes’ rule and their rationale for doing so in Kahneman and Tversky’s representativeness heuristic. By the turn of the century, behavioural economics was firmly established within economics. There was now a long list of results that could be used as building blocks for deeper narratives about human decision-making (Rabin 1998; Dellavigna 2009).