Diminishing sensitivity

What is diminishing sensitivity?

Diminishing sensitivity describes a smaller subjective difference between equal-sized changes farther from a reference point. In prospect theory, this helps characterize the shape of the value function for gains and losses.

Example

For a fixed reference point, the difference between gains of $20 and $30 might feel larger than the difference between gains of $1,020 and $1,030. Both differences are $10. The example illustrates the proposed pattern; it need not describe every person’s response.

Diminishing sensitivity in prospect theory

Kahneman and Tversky (1979) proposed a value function that is generally concave for gains and convex for losses: successive increments have smaller subjective effects farther from the reference point. They explicitly allowed exceptions when particular amounts have important consequences.

How value curvature can affect risk choices

Consider two hypothetical choices, with no gain or loss as the reference point:

• Gains: receive $50 for certain, or have a 50% chance of receiving $100 and a 50% chance of receiving nothing.
• Losses: lose $50 for certain, or have a 50% chance of losing $100 and a 50% chance of losing nothing.

The probabilities match across the gain and loss versions, and each pair has the same monetary expected value. If we temporarily weight outcomes using their stated probabilities, a concave value function for gains favors the sure gain: the subjective value of $50 can exceed half the value of $100. A convex value function for losses can favor the loss gamble: the subjective impact of losing $50 can exceed half the impact of losing $100.

This isolates what diminishing sensitivity contributes. Prospect theory also assigns decision weights to probabilities, so curvature alone is not the whole prediction. The person’s reference point and the importance of particular amounts can also change the comparison.

Diminishing sensitivity versus loss aversion

The reference point must be specified. Comparing people with different wealth is not the same test as comparing gains for one person. Diminishing sensitivity also differs from loss aversion, which compares losses with corresponding gains. Price reactions and risk choices require consideration of other factors as well.