Penalties & Prospect Theory: When the Sting of Loss Trumps the Joy of Gain
Last week I mentioned the PQRS kick-off calls. At the beginning of those calls, Dr. Dan Green with CMS mentioned several anecdotes regarding the penalty phase of the eRx program. A common thread was that physicians were substantially more concerned about the penalty phase of the program in comparison to the (positive) incentives available during the program’s early years. I think what Dan has discovered during this experience is a manifestation of Prospect Theory.
Classic economic theory is based on a fictitious individual commonly referred to as the “economic man.” Imagine a person who makes every decision with the unwavering logic Star Trek fans expect from Mr. Spock. If Spock were a gambling man (okay, a reach, but bear with me) and he was offered a bet in which he would either win or lose $100, he would always take that bet if his chances of winning were the tiniest fraction greater than his chances of losing. That is to say, from a utility perspective he is indifferent. He would feel the pain of losing $100 with the same magnitude as he would experience the joy of winning $100 (if Vulcans had emotions of course).
A substantial amount of economic theory is built on this fundamental assumption: that we are guided by logic in our decisions based on expected utility theory, and therefore we place an equal magnitude of value on losses and gains, of course always preferring the later. This idea was the gospel for many years. Then in the late 1970’s, a couple of psychologists by the names of Daniel Kahneman and Amos Tversky came up with a better idea. In a series of elegant experiments they made the case that people do not make decisions or choices in a vacuum of logic, and when it comes to comparing losses and gains, we feel the pain of losing more than we experience the joy of a gain. In fact, the differential approximates 2:1.
Let me be clear, I am taking liberties and cutting corners to explain a concept that is not easy to wrap your brain around. To put this in perspective, ask yourself the following: Suppose I have a coin I am going to toss one time. If the coin-toss results in tails, I lose $100. How much would I need to win for heads in order to play this game? Mr. Spock is all in if he wins $100.01. Most of us, however, need a larger incentive to play this game. This is displayed graphically in one of the most important images created in economics over the past 100 years:
Notice how much steeper the utility curve is on the left (loss) compared to the right (gain). Because the value function for losses is steeper than that for gains, losses “loom larger” than gains. For example, a loss of 1% of your part B allowable is felt more than a gain of 1%. The recognition of this difference creates a behavioral pattern commonly referred to as loss aversion. Prospect theory paved the way for the development of the field of Behavioral Economics and Kahneman went on to share the Nobel Prize in Economics in 2002. Think about that for just a moment. A psychologist won the Nobel Prize in Economics. That probably ruffled a feather or two.
Another intriguing result of prospect theory is captured in Thayer Watkins’ description of risk-aversion and risk-seeking behavior. Watkins writes, “One very important result of Kahneman and Tversky’s work is demonstrating that people’s attitudes toward risks concerning gains may be quite different from their attitudes toward risks concerning losses. For example, when given a choice between getting $1000 with certainty or having a 50% chance of getting $2500 they may well choose the certain $1000 in preference to the uncertain chance of getting $2500 even though the mathematical expectation of the uncertain option is $1250. This is a perfectly reasonable attitude that is described as risk-aversion. But Kahneman and Tversky found that the same people when confronted with a certain loss of $1000 versus a 50% chance of no loss or a $2500 loss do often choose the risky alternative. This is called risk-seeking behavior. This is not necessarily irrational but it is important for analysts to recognize the asymmetry of human choices.”
Why bring this up in a blog about health IT and nephrology? Perhaps the author was out in the sun too much this weekend, but I think prospect theory describes why Dan Green is hearing so much about the penalty phase of the eRx program. Sure it’s only 1% of the doc’s Part B Allowable, but the “sting” is much greater than that. Next year heralds the arrival of the payment adjustment period for the upcoming penalty phase of both the PQRS and Meaningful Use programs. Failing to successfully participate in both in 2013 could result in sustaining two penalties in 2015. Many providers did not see the eRx penalty coming. Now that it is here, most are preparing to avoid it in the future. I suspect we will see the same thing with PQRS and Meaningful Use, and prospect theory suggests providers will avoid the penalties with substantially more vigor.