The fight between normative and descriptive… What does neuroeconomics have to do with it?

Individuals often make irrational decisions. We force ourselves to finish our meals, even if we’ve eaten too much and our stomachs hurt. We hold onto new sweaters bought in the wrong size because we’ve already paid for them. 

This irrationality poses a challenge to standard economics, specifically, the normative theory of Expected Utility which aims to explain what individuals should do, and what choices they should make, to maximize their self-interest. This irrationality is so prominent, that economists took matters into their own hands and created an entirely new field, behavioral economics, to try and collate empirical evidence explaining descriptive observations that directly contradict normative forecasts. 

Within behavioral economics, it was only natural for economists Daniel Kahneman and Amos Tversky, to provide their take; Prospect Theory. By challenging traditional theories on the basis that individuals don’t always make rational decisions, they introduced the role of systematic biases and preferences in evaluating potential outcomes. Such evaluations are explained by perceived gains and losses relative to a reference point. This notion differs from the classical one because outcomes are weighed relative to an interchangeable point, and not an absolute value. Such evaluations have created the need for phenomena like loss aversion, diminishing sensitivity to gains and losses, and framing effects, to explain the ‘irrational’ behavior observed on the daily. 

Prospect Theory was a cornerstone of economics when working with decision-making, but now, economists wish to understand the biology behind why our brains differ in operation from what seems to be a common-sense rationale; stop eating if your stomach hurts. A trip to the doctor will cost more than the 7 euros you spent on this burger. This is where neuroeconomics comes in.  

Neuroeconomics is a fairly infant interdisciplinary study, which amalgamates neuroscience, psychology, and economics. Using neuroeconomics enables a deeper understanding of decision-making under uncertainty. To begin this short article, we must first differentiate between risk and uncertainty, however trivial this may seem, it is vital to apply the correct axioms of decision-making under uncertainty; probability, order, equivalence, substitution, and choice.

Uncertainty differs from risk concerning the availability of probabilities. Risk is applicable when the probabilities of possible outcomes/gambles are known, whereas uncertainty regards the randomness of outcomes, which cannot be expressed in terms of specific known probabilities. And so the central question remains; how do individuals incorporate probability in their assignment of outcome values? This is divided into two schools of thought one being Expected Utility as supported by standard economics, the other being Prospect Theory, put forth by behavioral economists. 

In expected utility theory, the valuation of a prospect (an action with uncertain rewards), is clearly defined as the sum of the value of individual outcomes, weighted by their objective probability. Observe the use of objective probabilities assigned to the outcomes: there is no uncertainty about the success of the outcomes, or whatever rewards they bear. The only unpredictable aspect of this theory is the risk involved, which standard economics categorizes into three based on the nature of the attitude towards risk, them being risk-seeking, neutral, and averse. 

Such an approach is utilized in financial markets for example, because the EU general formula ends up narrowing down to a weighted sum of the expected value and variance of prospects. EU in the past has been especially appealing due to its plausible consistency with the traditional normative axioms of decision-making: completeness, transitivity, independence of irrelevant alternatives, and continuity, also considered to be the Von Neumann and Morgenstern Expected Utility Representation Axioms. 

Repeated instances where EU theory doesn’t explain observed behavior have deemed it too static, thus turning over a new leaf where Prospect Theory plays a role.

Under PT, the value of the prospect depends on a reference point and is weighted by a non-linear function of the objective probabilities. Reference dependence has aided in explaining why some outcomes are valued over others, irrespective of their expected values. This is mostly due to framing effects where individuals react differently to an outcome depending on how it is presented, for example, whether is positive or negative - the decision is influenced by how the information is presented. 

A second aspect of PT remains to be loss aversion. This assumption is psychologically explained by the concept of diminishing marginal sensitivity to gains and losses, relative to reference points. This loss aversion reduces to a cognitive bias which describes why the pain of losing, is twice as powerful as the pleasure of gaining. With this phenomenon, losses loom larger than gains, creating a kink in the traditional value function which causes individuals to over-weigh small probabilities and under-weigh large probabilities - also referred to as probability weighting. 

The above biases are more subconsciously prominent than initially realized, and what better way to tackle one’s subconscious, than to use insights from the scientific study of the brain, in other words, neuroscience. 

Neuroeconomics provides a neuroscientific lens through which the neural foundation of PT can be scrutinized. This is experimented with using imaging techniques such as functional magnetic resonance imaging (fMRI) which demonstrates activity in specific parts of the brain, as well as electroencephalography (EEG) which measures electrical activity in the brain using electrodes attached to the scalp. These tools are implemented during decision-making tasks so researchers can analyze brain activity in real time. 

Coming back to this idea of framing effects, neuroeconomic research has identified that manipulating the framing of choices activates distinct neural networks concerned with emotional processing and cognitive control. Strong emotions can impair our judgment when decision-making, which makes it challenging to think objectively, especially concerning decision-making in short periods. Cognitive control is also triggered as it is the intentional selection of thoughts, emotions, and behaviors based on current task demands and choice selection. 

The emotional processing part of our brain differs drastically from normative predictions and can cloud our cognitive control especially when provided reference points are intensively negative, thus, this neuroeconomic finding sheds light on how our brains integrate contextual information (provided values of outcomes) with biases in decision making (framing effects). 

Neuroeconomics has also provided valuable insights into the brainpower behind loss aversion. Imagings have identified neural circuits (a population of neurons interconnected by synapses to carry out a specific function when activated) associated with loss aversion, such circuits involve the amygdala, insula, and ventromedial prefrontal cortex. 

The amygdala is a region that processes fear and anxiety, it plays a crucial role in loss aversion. Studies using fMRI have shown increased activity in the amygdala when individuals anticipate, or experience losses rather than gains, which intuitively makes sense. The heightened emotional response observed in this area to potential losses reflects the aversive nature most individuals experience in decision-making. Activity observations were also visible in the insula during real-time decision-making, which enabled neuroeconomics to identify further neural correlates associated with loss aversion. 

By uncovering the neural mechanisms utilized during decision-making in real-time, neuroeconomists can elucidate how individuals evaluate risks, weigh potential gains and losses, and make choices in uncertain environments. The contemporary field of neuroeconomics informs us of drivers of behavioral phenomena, all the more aiding us in promoting rational decision-making.

About this article

Written by:
  • Daria Haidar
| Published on: May 10, 2024