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decision to make—whether to refinance my mortgage or invest in a new business—I would aim to make the decision in accordance with expected utility theory, just as I would use the Pythagorean theorem to estimate the altitude of our railroad triangle. Expected utility is the right way to make decisions.
    With prospect theory, Kahneman and Tversky set out to offer an alternative to expected utility theory that had no pretense of being a useful guide to rational choice; instead, it would be a good prediction of the actual choices real people make. It is a theory about the behavior of Humans.
    Although this seems like a logical step to take, it is not one that economists had ever really embraced. Simon had coined the term “bounded rationality,” but had not done much fleshing out of how boundedly rational people differ from fully rational ones. There were a few other precedents, but they too had never taken hold. For example, the prominent (and for the most part, quite traditional) Princeton economist William Baumol had proposed an alternative to the traditional (normative) theory of the firm (which assumes profit maximization). He postulated that firms maximize their size, measured for instance by sales revenue, subject to a constraint that profits have to meet some minimum level. I think sales maximization may be a good descriptive model of many firms. In fact, it might be smart for a CEO to follow this strategy, since CEO pay oddly seems to depend as much on a firm’s size as it does on its profits, but if so that would also constitute a violation of the theory that firms maximize value.
    The first thing I took from my early glimpse of prospect theory was a mission statement: Build descriptive economic models that accurately portray human behavior.
    A stunning graph
    The other major takeaway for me was a figure depicting the “value function.” This too was a major conceptual change in economic thinking, and the real engine of the new theory. Ever since Bernoulli, economic models were based on a simple assumption that people have “diminishing marginal utility of wealth,” as illustrated in figure 2.
    This model of the utility of wealth gets the basic psychology of wealth right. But to create a better descriptive model, Kahneman and Tversky recognized that we had to change our focus from levels of wealth to changes in wealth. This may sound like a subtle tweak, but switching the focus to changes as opposed to levels is a radical move. A picture of their value function is shown further below, in figure 3.
    Kahneman and Tversky focus on changes because changes are the way Humans experience life. Suppose you are in an office building with a well-functioning air circulation system that keeps the environment at what we typically think of as room temperature. Now you leave your office to attend a meeting in a conference room. As you enter the room, how will you react to the temperature? If it is the same as that of your office and the corridor, you won’t give it a second thought. You will only notice if the room is unusually hot or cold relative to the rest of the building. When we have adapted to our environment, we tend to ignore it.
    FIGURE 3
    The same is true in financial matters. Consider Jane, who makes $80,000 per year. She gets a $5,000 year-end bonus that she had not expected. How does Jane process this event? Does she calculate the change in her lifetime wealth, which is barely noticeable? No, she is more likely to think, “Wow, an extra $5,000!” People think about life in terms of changes, not levels. They can be changes from the status quo or changes from what was expected, but whatever form they take, it is changes that make us happy or miserable. That was a big idea.
    The figure in the paper so captured my imagination that I drew a version of it on the blackboard right next to the List. Have another look at it now. There is an enormous amount of wisdom about human nature captured in that S-shaped curve.