the research program which systematically identified the biases people have when making decisions was started by two psychologists in Israel named Daniel Kahneman and Amos diversky after Decades of research these two guys completely changed the way psychology and economics looks at human behavior they changed how we think about thinking in 2002 Daniel Kahneman was given the Nobel prize in economics for these insights but sadly Amos taversky died in the 1990s from cancer and the Nobel is never awarded posthumously by conducting clever experiments Kahneman and taversky were able to uncover some of the systematic ways in which people make decisions and then assemble a theory which explains them first people are loss averse meaning that we prefer avoiding a loss to acquiring a gain people are generally willing to do more to avoid losing one hundred dollars than they are to earning an additional one hundred dollars this is one of the irrationalities the economy and diversky identified through their research second people are reference dependent meaning that their decisions can be influenced if something is presented as a loss or a gain we saw this in the previous video with framing effects third people overweight small probabilities an underweight large probabilities if something has a 10 percent chance of happening people tend to make decisions as if that probability were zero percent and if something has a 90 chance of happening they tend to make decisions as if it was a sure thing and fourth there's diminishing sensitivity to gains and losses meaning that the marginal utility of gains or losses is diminishing as they get larger if you take a look at this graph you can see these principles in action we can see that gaining five cents gives us 17 or 18 units of value or utility but losing five cents reduces our utility by 40. a much bigger amount that exemplifies loss aversion that since the disutility of a loss is much bigger than the utility of a gain but it also shows that our utility depends on whether this is framed as a gain or a loss and as we increase the gains or losses the value function flattens out we become less sensitive to it here's an example of how we all have diminishing sensitivity to gains or losses imagine you go to a store to buy a nice pen the pen costs 15 but when you bring it up to the register the cashier says hey I'm not really supposed to do this but the shop Three Doors Down is selling this exact same pen for eight dollars so you might want to buy it there instead would you thank the cashier and go to the other store or would you shrug it off and pay almost double for this pen most people respond that they would go to the other store to save the money okay well now imagine you're at a store and you want to buy a really nice camera this camera costs one thousand and fifteen dollars but when you bring it up to the register the cashier tells you that Three Doors Down they're selling the camera for one thousand and eight dollars would you go to the other store then most say no they would just pay the 1015 since saving seven dollars on that price just isn't that much but this is totally irrational in both cases the marginal cost of going to the other store is walking Three Doors Down and in both cases the marginal benefit is saving seven dollars but people aren't really thinking on the margin they're reference dependent and they have diminishing sensitivity keep this in mind when you go to buy a house or a car where sales people will know how insensitive you are at a very large changes in the price because they're small relative to the total price why are we like this why do we make systematic mistakes like this in economics we assume that people behave rationally but behavioral economics shows us that it is a bounded rationality with limits Daniel Kahneman offers this explanation we have two systems or modes of thinking system one and system two system one is fast automatic frequent emotional stereotypic and subconscious system one is filled with our heuristics our rules of thumb which means that it often gets decisions right but misses things on the edges and behaves poorly in unusual circumstances but it's really cheap to run system one system one doesn't even feel like thinking the odds are good that you're using system one right now to watch this video just trying to catch important parts for quizzes and stuff system two is slow effortful infrequent logical in its calculation and conscious system two requires you to focus your whole mind on the problem and it's expensive in terms of effort and energy so we don't use it very much but system two is what allows us to recognize those visual Illusions and to see that it's illogical to go to the other store for the pen but not for the camera honestly my guess is that from most of you you use system one when you take the quizzes and exams for this class but really you should use system two system one isn't bad though system one is our brains economizing on resources and finding shortcuts in cognition that still reach the right answer most of the time but this framework helps us see why we have so many cognitive biases and helps us figure out what we can do about them