Prospect Theory in Real Life OR How Losing Feels Bad More than Winning Feels Good

I’m going to do a magic trick with a number. I’m going to take a number 1700 and by doing nothing more than raising and lowering it, I’m to show how the interpretation of the number can dramatically change.  Let’s see how that can happen and then I’ll explain how that works.

When my wife was pregnant with our second son, we had a test for Downs Syndrome. This test had three parts:

  1. A “Nucal” sonogram that measured some key ratios. This was the most important test and sets the baseline.
  2. A blood test that measured blood proteins in the mother.
  3. A test of “soft markers” that refined the initial estimates based on other sonogram features.

So we had the initial test. The chance of an issue was 1 in 1700.

“Is that good?” We asked the doctor. “It sounds good to us.”

“Well, in order to be certain, you’d need to have an amniocentesis which has a 1 in 400 chance of serious problems,” said the doctor.

So 1 in 1700 is pretty darn good. Then we got the blood test back. The numbers were even better. Our chances now were 1 in 6800. That was 4 times better than we’d had before!

So we’d finished 2 or the 3 tests. Then, things got tough. We went in for a sonogram and the technician stopped at one point and said, “I need to get the doctor.” That’s never a good sign.

When the doctor came back he said, “Well, your child had 2 soft markers for Downs.”

“What does that mean?” we asked.

“Well, it means that your child has a higher chance of having Downs Syndrome. Maybe you should see a genetic counselor,” he said.

“Before we go down that route, how does this really alter our chances?” we asked.

“Well, we’re not really sure. One soft marker could double the chance of having Downs Syndrome. So 2 soft markers might increase the chance by as much as 4 times but it’s probably less than that,” he said.

“So you’re saying our chances are back to 1 in 1700.”

“Yes.”

See. Magic.

How did this happen? Behavioral Economics has an answer. In contrast to typical economic theory, Behavioral Economics looks at situations and sees how people really react — not how they would react in theory. The situation above is an example of Prospect Theory — the finding that losing something causes about twice as much pain as the pleasure you get from gaining something. So gaining and then losing the same amount still feels like a net loss.

“Saving Money” by Paying More for Netflix

In an earlier piece, I talked about how NetFlix’s move to a subscription model. Why was this subscription model so important?  It made me think of some research that I did on how people think about money about 10 years ago.

One of the big findings was that people have good and bad ways to spend money. For instance, spending money on the house and paying it off every month is a good thing. Having credit card debt every month is a bad thing. But you can get people to make credit cards bills into good payments when you show them how many airline miles they have “earned.” Notice how credit card companies use the word “earned” as opposed to “purchased.”

Getting back to NetFlix, I remember talking to a middle class couple about their finances about 10 years ago. We were in suburban Chicago and sitting on their back porch on a warm spring day. We talked about how they were saving money. They started with normal things like eating out less and spending less money on clothes. But then they said, “We have Netflix so we’re saving money that way too..”

So I asked, “Do you watch a lot of movies?” figuring that they had calculated the cost of renting from Blockbuster vs. their Netflix subscription. This was before streaming. You got one DVD at a time but you could exchange it as many times as you wanted over a month.

“No. Not really,” they said. “But having Netflix means that we don’t have to rent DVDs anymore so that saving money.”

That always stuck with me because I bet they paid a lot more for their Netflix subscription than they ever paid renting videos at Blockbuster. But to them, this was saving money.