Loss Aversion, Framing, and Bargaining: The Implications of Prospect Theory for International Conflict

Prospect theory deviates from expected-utility theory by positing that how people frame a problem around a reference point has a critical influence on their choices and that people tend to overweight losses with respect to comparable gains, to be risk-averse with respect to gains and riskacceptant with respect to losses, and to respond to probabilities in a nonlinear manner. This study examines these and related observed anomalies in expected-utility theory, summarizes how prospect theory integrates these anomalies into an alternative theory of risky choice, and explores some of the implications of prospect theory for international conflict and for bargaining and coercion in particular. One hypothesis is that political leaders of adversarial states behave differently when they are bargaining over gains than when they are bargaining over losses. Another is that crisis behavior may be more destabilizing than commonly predicted by rational choice theories because leaders are less willing to make concessions and more willing to risk large losses in the hope of eliminating small losses altogether. Prospect theory was developed in the late 1970s by Kahneman and Tversky (1979) in response to accumulating evidence of systematic behavioral violations of expectedutility theory. It is now a leading alternative to expected utility as a theory of choice under conditions of risk.1 Prospect theory is best known for its claims that people tend to overweight losses with respect to comparable gains, that they are generally risk-averse with respect to gains and risk-acceptant with respect to losses, that they respond to probabilities in a non-linear manner, and that how they frame a problem around a reference point has a critical influence on their choices. The theory generates a rich and intriguing set of hypotheses about international relations, but attempts to apply the theory outside the highly controlled environment of the experimental laboratory are plagued by a number of difficult methodological problems (Jervis, 1992; Levy 1992b; Stein, 1992). 0192-5121 96/02 179-17 ? 1996 International Political Science Association Loss Aversion, Framing, and Bargaining In this study I examine some of the primary anomalies in expected-utility theory that emerge from experimental research in social psychology, summarize how prospect theory incorporates these anomalies, and explore some of the implications of prospect theory for international conflict in general and for bargaining and coercion in particular. One important theme is that the bargaining behavior of political leaders is different when the issue is the distribution of losses from that when the issue is the distribution of gains. Another is that crisis bargaining behavior is more destabilizing than rational choice theories predict because political leaders are less likely to make concessions and more likely to gamble and risk large losses in the hope of eliminating smaller losses altogether. Descriptive Anomalies in Expected-Utility Theory The expected-utility principle posits that actors aim to maximize their expected utility by weighting the utility of each possible outcome of a given course of action by the probability of its occurrence, summing over all possible outcomes for each strategy, and selecting that strategy with the highest expected utility. Expectedutility theory assumes that an actor's utility for a particular good is a function of net asset levels of that good, so that the marginal utility of changes in assets is a function of existing levels of assets. Most applications of the theory in the social sciences add the auxiliary assumption (Simon, 1984) that individuals have diminishing marginal utility for most goods, which is reflected by a concave utility function. This assumption is descriptively accurate for many types of behavior and enhances the analytical power and elegance of the theory, but diminishing marginal utility is not an essential component of expected-utility theory and violations of the former are not necessarily inconsistent with the latter. An actors's attitude or orientation toward risk is defined in terms of the shape of an actor's utility function. An actor is risk-averse if l,is utility function is concave, risk neutral if his utility function is linear, and risk-acceptant if his utility function is convex. Given a choice between two options, one involving a certain outcome of utility x and the other involving a lottery or gamble with the equivalent expected utility x, a risk-averse actor will prefer the certain outcome, a risk-acceptant actor will prefer the gamble, and a risk-neutral actor will be indifferent between the two. I now turn to experimental evidence of the various ways in which individual behavior deviates from the predictions of expected-utility theory.2 Reference Dependence One finding is that people are more sensitive to changes in assets than to net asset levels. They think in terms of gains and losses rather than levels of wealth and welfare. Thus Kahneman and Tversky (1979: 273) argue that "the carriers of value or utility are changes of wealth, rather than final asset positions that include current wealth." These changes in assets are defined around a reference point (which is usually but not always identified with current assets). This reference dependence (Tversky and Kahneman, 1991: 1039) runs contrary to the standard expectedutility postulate of an individual utility function that is defined over levels of wealth and draws support from a variety of experimental studies (Tversky and Kahneman, 1986: S258; 1991). There is also evidence that the marginal value of both gains and losses is a decreasing function of their magnitude, which Tversky and Kahneman (1991: 1048-1050) refer to as diminishing sensitivity. 180