Levy: Prospect theory, rational choice, and international relations

Levy. 1997. Prospect theory, rational choice, and international relations. International Studies Quarterly 41 (March): 87-112.

Rational choice, broadly speaking doesn't assume much more than that actors make maximizing choices based on transitive preferences. Generally speaking, most rational choice scholars use expected-utility logic (which is that we weight our preferences according to the probability of getting a certain outcome). However, a great deal of experimental evidence pokes holes in expected utility. A few of the problems: People value a gain less than they fear a loss of equal size. After a gain is made, people evaluate future gains and losses based on this new reference point; after a loss occurs, however, people continue to evaluate future gains and losses based on the former reference point. People won't take risks in order to gain, but they will take risks to prevent a loss. People overvalue small probabilities and they undervalue large probabilities.

"Kahneman and Tversky (1979) developed prospect theory to integrate these observed patterns into an alternative theory of risky choice. They distinguish two phases in the choice process. In the editing phase the actor identifies the reference point, the available options, the possible outcomes, and the value and probability of each of these outcomes. In the evaluation phase she combines the values of possible outcomes (as reflected in an S-shaped vdlue function) with their weighted probabilities (as reflected in the probability weighting fun,ction) and then maximizes over the product (the "prospective utility")." (page 92)

See page 93 for six hypotheses about IR that are immediately implied by prospect theory--and the conflict with traditional rational choice hypotheses.

Despite early concerns about the internal validity of prospect theory, enough experimental work has been done to satisfy Levy of its internal validity. His main concern is with external validity. Prospect theory has been shown in highly structured laboratory experiments, but it may not really apply in real-life foreign policy decisions. Many experiments take a form similar to this: Participants are given some money (the status quo situation) and asked to make a choice between (a) definitely keeping the status quo and (b) having a 70% probability of winning more money and a 30% probability of losing money. But in real foreign policy decisions, there is rarely a "risk-free" option--even just keeping the status quo involves risk. Prospect theory depends greatly on this "sure-thing" status quo reference point; not having it complicates applications of prospect theory to IR greatly.

Moreover, we aren't talking about the rationality of individuals dealing with money, here, but of aggregate political outcomes (i.e. the state's collective rationality), which is not necessarily the same as the rationality of its members. "The concepts of loss aversion, the reflection of risk orientations, and framing were developed for individual decision making and tested on individuals, not on groups, and we cannot automatically assume that these concepts and hypotheses apply equally well at the collective level." (page 102) It's not that prospect theory can't be make into a theory of collective choice, just that it hasn't been done yet. (Difficulties of doing so are summarized on 103). "This discussion makes it clear that one critically important task for future research involves the theoretical development and empirical validation of linkages between loss aversion, the reflection effect, and framing effects at the individual level and decision making at the collective level." (page 104)

Equally important is the task of moving prospect theory from a mere decision-making theory to a theory about strategic interactions. Prospect theory won't be of much use to IR until it can be used to model bargaining.

Levy ends with a length plea not to let the rivalry between expected utility and prospect theory end up in a paradigmatic debate. He laments that IR is characterized by permanent paradigmatic debate rather than simple normal science. We need to develop all the paradigms (especially expected utility and prospect theory) and see what they can do and lean how well one research program can do when fully developed.