In prospect theory, the pseudocertainty effect is people’s tendency to perceive an outcome as certain while in fact it is uncertain. It is observed in multi-stage decisions, in which evaluation of outcomes in previous decision stage is discarded when making an option in subsequent stages.
Kahneman and Tversky (1986) illustrated the pseudocertainty effect by the following examples.
First, consider this problem:
Which of the following options do you prefer?
- C. 25% chance to win $30 and 75% chance to win nothing
- D. 20% chance to win $45 and 80% chance to win nothing
In this case, 42% of participants chose option C while 58% chose option D.
Now, consider this problem:
Consider the following two stage game. In the first stage, there is a 75% chance to end the game without winning anything, and a 25% chance to move into the second stage. If you reach the second stage you have a choice between:
- E. a sure win of $30
- F. 80% chance to win $45 and 20% chance to win nothing
Your choice must be made before the outcome of the first stage is known.
This time, 74% of participants chose option E while only 26% chose option F.
In fact, the actual probability of winning money in option E (25% x 100% = 25%) and option F (25% x 80% = 20%) is the same as the probability of winning money in option C (25%) and option D (20%) respectively. In the second problem, since individuals have no choice on options in the first stage, individuals tend to discard the first option when evaluating the overall probability of winning money, but just to consider the options in the second stage that individuals have a choice on. This is also known as cancellation, meaning that possible options are yielding to the same outcome thus ignoring decision process in that stage.