Suppose somebody offered you a choice between two different vacations:

·        A 50 percent lottery of winning a three-week European tour.

·        A 100 percent guaranteed one-week tour of Europe.

Empirically, the vast majority of survey takers on this and related questions preferred the second option – take the one-week tour for sure. 

After that choice is made and fresh on your mind, suppose you get to choose an additional, follow up tour:

·        A 5 percent lottery of winning a three-week European tour.

·        A 10 percent lottery of winning a one-week European tour.

Empirically, the vast majority of survey takers preferred the first option – a chance at a longer three-week tour.

This is the basic Allais Paradox, a famous challenge to existing, broadly used Utility Theory. 

Backing up, Utility Theory is a mathematical economic function that describes how rational, numerically derived people consistently behave.  If psychology is the study of how people behave, economics is a subset of psychology that reframes and constrains the vast idiosyncrasies of human behavior into an incentivized norm.  Using this norm – that people have incentives to do what is best for them – then people should attempt to maximize their benefits.  Framing this in terms of numerical plots, the average person as the first moment or location parameter of the population will seek equilibrium at the peak utility where the derivative of the curve is zero.  i.e. Given a choice, most people would prefer to holdout and receive 100 dollars rather than 95 or 90 if those were the only possible utilities. 

Applying Utility Theory to the vacations, we can numerically translate the first vacation thusly:

·        (50%)(3 weeks) = 1.5 weeks expected

·        (100%)(1 week) = 1 week expected

Making the vast majority selecting the 1-week guaranteed tour as incorrectly non-optimal.  The second vacation also translates into:

·        (5%)(3 weeks) = 0.15 weeks expected

·        (10%)(1 week) = 0.1 week expected

Making the vast majority selecting the 3-week lottery as correctly optimal. 

The empirical results do not support this Utility Theory for two reasons.  The first vacation results are clearly inconsistent with empirical findings.  Also, the people are not consistent with themselves by switching on the second vacation preferences. 

This finding partly inspired later work on Prospect Theory, which adds more variables to better fit the utility curve to the empirical findings.  Namely, Prospect Theory applies a non-linear preference curve such that the difference between a 100% probability and a 99% probability is far greater than the difference between a 50% and a 49% one.  The preferences at the extremes (near 0% or near 100%) shift exponentially while the preferences at the center (from 10-90%) shift only slightly.  Translated into the vacations, Prospect Theory would state something like the following:

First vacation choice

·        (1)(50%)(3 weeks) = 1.5 weeks equivalent

·        (2)(100%)(1 week) = 2 weeks equivalent

i.e. “One in the hand is worth two in the bush”

Second vacation choice

·        (0.9)(5%)(3 weeks) = 1.35 weeks equivalent

·        (1)(10%)(1 week) = 1 week equivalent

Making the empirical choices near optimal under Prospect Theory. 

It sounds nice to have human nature so neatly wrapped up in a series of numbers.  Only except that according to Kahneman himself, economists and decision scientists still often use the basic Utility Theory.  Utility Theory is simpler and acts well as a rule of thumb, especially in an uncertain world where the majority of probabilities are near the center rather than at 0% or 100%.  Viewing the equations above, Utility Theory has only 2 factors.  Prospect Theory translates into 3. 

In basic modeling, the presence of an additional term or factor requires sufficient justification.  On a favored model, additional terms or factors require massive justification.  Utility is a favored model of rationality.  It relies on the assumption that the mean of a population as the first moment taken en masse is rational.  While it may not capture all behavior, there is an (overly?) simplistic underlying rationality model that derives into a 2-factor equation.

Prospect Theory is an irrationality patch to a model of rationality.  It relies on the assumption that the people en masse are not rational, that a non-linear term must modify the equivalency to fit the empirical behavior.  While it captures the empirical behavior better, there is technically a lack of an underlying model that derives the 3^rd factor.  How does one model irrationality?

This is not the fault of Prospect Theory.  It is easy to dismiss this as splitting hairs, or as economists playing with numerical models of banking and lottery and vacations.  But we should not.  This is the fault of neuroscience.  When Prospect Theory dives into the “Fear and Greed” motivators of economics and terms it, “Loss Aversion,” it references the amygdala as the locus of quick thinking fear. 

The amygdala is located in the medial temporal lobes of the brain as part of the limbic system.  Simply put, activating the amygdala generates a fear sensation that is so rapid as to be essentially subconscious.  Ever hear about those experiments where a fearful image shows up on a movie screen for a split second and the viewers have no recollection of seeing the image, yet have elevated heart rates and elevated stress hormones?  That is the amygdala speaking.  This is why Kahneman refers to it in his book, Thinking Fast and Slow.  This is part of the fast thinking, fast being the irrational, heuristic, biased judgment portion. 

So why do we have amygdalas?  Is it an evolutionary throw-back to our limbic, lizard-like ancestors?  Is this something wrongly mal-adapted to modern life and thus something to fight against (i.e. suppress our fast thinking amygdalas) so we can better fit rationality?  This is exactly the track economists take, including Kahneman, the Chartered Financial Analysts association, and others. 

This is what happens when neuroscience is playing catch up in the supporting role.  Taking a step back, these vacation choice results are natural human behavior.  These are known, empirical findings on freely behaving humans in vivo.  This is a treasure trove of data.  Why are there not any neuroscience leads?  Why is this still relegated to financial economics?  This is not irrational behavior.  This is human behavior of Social Neuroscience. 

From the perspective Social Neuroscience work, the issue is not that the 2-factor Utility Theory calculates one result and the 3-factor Prospect Theory calculates another to fit the empirical findings.  The issue is that the vacation choices are not static and independent even though Utility Theory and Prospect Theory treat them as if they were.

In a Social Neuroscience setting, nothing is independent.  Everything feeds back into itself contextually, temporally and spatially.  At each step in time, the two spatial choices define each other: a 50% lottery of winning a European tour sounds great, until we hear the alternative of a guaranteed tour elsewhere.  And at each spatial choice, the future and past temporal results define the choices.  Any tour or chance thereof sounds great, until we hear or imagine someone else getting a better tour.  This contextual feedback violates mathematical principles (Glimcher, 2003) and cannot be modeled as such with economic mathematics.  There, individuals are i.i.d., AKA independent and identically distributed.  Each individual acts in isolation to maximize their benefits, creating a population mean that maximizes its benefits.  But in Social Neuroscience, this feedback is a core essential.  If the ecosystem can be designed appropriately, the feedback will factor itself out without leading to runaway additive feedback activity.  In this factored out case, the individuals still seek to maximize their benefits and behave rationally under the 2-factor Utility Theory framework.  The only difference is in what the individuals are attempting to maximize. 

In Social Neuroscience, when translated into numerical terms, the individuals are not trying to get 100 dollars.  They are trying to get 100 followers. 

In Social Neuroscience, the primary brain region activity of focus is not the amygdala of fear.  It is the prefrontal cortex of anticipation and decision-making.

In Social Neuroscience, the translation of the vacation options might be something like:

First vacation choice

·        (50%)(3 weeks) = unnecessary risk, looking stupid in comparison

·        (100%)(1 week) = keeping with the Jones

Second vacation choice

·        (5%)(3 weeks) = necessary risk, hero-like in comparison

·        (10%)(1 week) = keeping with the Jones

The differentiating concept is that both the Utility Theory and Prospect Theory operate on maximizing the tour duration whereas the Social Neuroscience operates on maximizing the relationships with all potential observers and peers.  It requires all individuals to anticipate what everyone else would do and project forward to anticipate how their actions will be perceived.  Technically, under this paradigm, people are rational and will rationally loosely follow Utility Theory while still being consistent with empirical findings.  The only difference is in defining what is the utility.