An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk

by Allison Schrager

Amateur poker player Bob’s total wealth is $1 million. Phil’s total wealth is $10 million. Both are offered a gamble that changes the value of their net worth: A: a 50 percent chance to end up with $1 million or a 50 percent chance to end up with $10 million, or B: end up with $5 million for sure Kahneman and Tversky argue that Bob will happily take option B because there’s A: a 50 percent chance Bob gets nothing, and a 50 percent chance of increasing his wealth tenfold, or B: a 100 percent chance of increasing his wealth fivefold Just like Bernoulli predicted, the incremental value of another $5 million once Bob already has $5 million isn’t worth taking the risk; he is risk averse to this menu of possible gains. But when Phil, who has ten times what Bob has, is offered the same bet, he views it differently. From Phil’s perspective, his options are A: a 50 percent chance of losing $9 million and a 50 percent chance of losing nothing, or B: a 100 percent chance of losing half his net worth Faced with the possibility of certain loss or a 50 percent chance of losing nothing, Phil will take the risky bet. Prospect theory argues that humans are risk seeking, or willing to take a chance on even bigger losses and forgo certainty when offered a menu of loss scenarios.