## 16 February 2016

### Prospect Theory on Valentine's Day

Flip writes*

When applied to the right kind of problems, economic thinking can actually yield very valuable insights. On the Saturday before Valentine’s Day, I was drinking coffee in a busy shopping street in The Hague (the Netherlands). Honestly, up until the moment I saw all the hearts and Valentine’s sales in the shops, I had actually forgotten about V-Day. This, because I have a girlfriend, was quite problematic (understatement). Seeing all these people on the street hurrying in and out of shops to get the best gifts for their beloved made me wonder what I should do. If ‘everyone’ was buying gifts, should I just buy them too?[1]

 Image 1. Source: K & T p 279
Until Kahneman and Tversky’s 1979 paper in which they introduced prospect theory [2], the expected utility theory was the main descriptive model of economic behaviour (refresh your memory about expected utility theory). The most important of the many insights of Kahneman and Tversky’s paper was that losses affect utility stronger negatively, than gains do in a positive way. As can be seen in image 1, the utility function for losses is much steeper than that for gains.

 Image 2. The V-Day shift
Under normal circumstances not receiving a gift is equal to the status quo, and you neither gain nor lose any utility (see image 1). Valentine’s day, however, changes this status quo (image 2), because there is the widespread notion that you need to do something special for your partner. Not getting a gift or receiving special attention suddenly becomes the exception and would result in negative utility. Depending on the expectations your partner has (affected by the amount of TV programmes you watch in which people are getting spoiled because of Valentine and the non-stop Valentine related commercial breaks) his or her hypothetical utility function is transformed (moved) by x. The size of x depends on the expectation of the time, money and thought put into the gift.

Taking another sip of my coffee, I saw two options. First, take my losses for this Valentine’s Day and surprise my girlfriend when she didn’t expect it at another time. Hoping to achieve some positive utility then. Or, second, try to reach the status quo by giving her the best gift I could find under limited time and money I had (I couldn’t buy her a trip around the world, for instance). Kahneman and Tversky made me realise that the utility lost with not getting a gift, outweigh the gains of giving a gift at another time. So I had to buy a gift.[3]

V-Day had me cornered. I took a last sip of my coffee, got up and moved in with the Valentine shopping crowd, looking for a Valentine’s gift.

* Please comment on these posts from my microeconomics students, to help them with unclear analysis, other perspectives, data sources, etc.
1. It is important to note that all the people on the street give a very biased view of the attention being given to Valentine’s Day. Just like the ads and shows being shown on TV.
2. Kahneman, D. and A. Tversky. 1979. “Prospect Theory: An Analysis of Decision Under Risk.” Econometrica 47: 263 – 292.