Value Function

In one of the most cited papers in Economics, Kahneman & Tversky present the Value Function:

Possible Value Function, made with GeoGebra

It was created to explain how humans make decisions, based on data collected from people's day-to-day lives.

Reference Point

The gains and losses are relative. Meaning they reset at the beginning of each day, week, month, etc.

This means that what you do is more influenced by what happened to you recently!

Value and Decisions

From the shape of the value function, we can extract a few general rules for human behavior:

Concave Down → Diminishing returns

The more money you make, the less you Value every additional dollar.
If you make a lot of money, an extra 100$ won't increase your happiness by a lot. But, if your total wealth was very low, those same 100$ would have a lot more Value to you!

Losses hurt more than Gains

As you can see in the image above, the pain of losing 5$ is greater than the pleasure of making 5$.
This means that most people don't like small gambles, since the possible pain is much higher than the possible pleasure, even if the payout and losses are the same!

And, if you've already lost some money, there is a higher chance that you'll take more risk, in the hopes of ending the day, month, or year 'In the Green'!

Conclusion

We can use the Value function to help us understand why humans act like they do, and use this knowledge about our behavior to correct ourselves and better predict the future.

Have you ever noticed any of these ways of thinking in yourself or the people around you?

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