Prospect Theory as Efficient Perceptual Distortion

In rational choice theory, individuals are assumed always to choose the option that will provide them maximum utility. But actual choices must be based on subjective perceptions of the attributes of the available options, and the accuracy of these perceptions will always be limited by the information-processing capacity of one’s nervous system. In recent work (Woodford 2011), I propose a theory of valuation errors under the hypothesis that perceptions are as accurate as possible on average, given the statistical properties of the environment to which they are adapted, subject to a limit on processing capacity. The capacity limit requires that choice be based on a compressed representation of the choice situation; the data compression inevitably introduces distortions, but the resulting behavioral biases are actually efficient, when one takes account of the information-processing constraint. The theory is related to the “rational inattention” hypothesis of Sims (2003) but modified for closer conformity with psychophysical and neurobiological evidence regarding perceptual accuracy. This hypothesis can explain a variety of anomalous aspects of economic choice in experimental settings. Here I discuss the explanation that it provides for choices over lotteries of the kind captured by the prospect theory of Kahneman and Tversky (1979). Attention And ChoiCe ‡