### Grant McDermott

Assistant Professor
Dept. of Economics
University of Oregon

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# McDermott and Shleifer double-team Taleb and Kahneman

Not really. But I did enjoy reading the following passage from Andrei Shleifer's review of Daniel Kahneman's (superb) Thinking, Fast and Slow. To give context, he is talking about a key assumption of Prospect Theory (which Kahneman pioneered together with Amos Tversky); namely that individuals attach weights to objective probabilities in a way that causes them to overweight low probability events and underweight high probability ones. Shleifer writes:
The evidence used to justify this assumption is the excessive weights people attach to highly unlikely but extreme events: they pay too much for lottery tickets, overpay for flight insurance at  the airport, or fret about accidents at nuclear power plants. Kahneman and Tversky use probability weighting heavily in their paper, adding several functional form assumptions (subcertainty, subadditivity) to explain various forms of the Allais paradox. In the book, Kahneman does not talk about these extra, assumptions, but without them Prospect Theory explains less.

To me, the stable probability weighting function is problematic. Take low probability events. Some of the time, as in the cases of plane crashes or jackpot winnings, people put excessive weight on them, a phenomenon incorporated into Prospect Theory that Kahneman connects to the availability heuristic. Other times, as when investors buy AAA-rated mortgage-backed securities, they neglect low probability events, a phenomenon sometimes described as black swans (Taleb 2007). Whether we are in the probability weighting or the black swan world depends on the context: whether or not people recall and are focused on the low probability outcome. [Emphasis mine.]
This is precisely the issue I was trying to point out here. Sometimes people greatly overweight the risks of low probability events (as suggested by Prospect Theory)... and yet at other times they completely underestimate them (as suggested by Taleb's black swan metaphor). As a result, we should be cautious in trying to make generalisable statements about human behaviour from either one of these theories alone.

You may also recall that $$-$$ for my temerity in pointing out this apparent tension between Kahneman and Taleb's theories $$-$$ I was labelled an "idiot" by none other than Taleb himself. As I coyly suggested at the time, Taleb's knee-jerk tendency to accuse anyone who disagrees with him of idiocy meant that I was likely to be in good company at least. I am sure of that now having read Shleifer's article.