5. Subjective Probability

Economic models often assume that we know the objective probability of an uncertain event and risk can be defined by means of numerical probabilities. In reality, we rarely know the underlying, true distribution of uncertain events and even then, we typically do not engage in data collection to estimate objective probabilities. In some cases, there is simply no data to estimate empirical probabilities, especially in the case of rare events such as natural disasters. In dealing with risk in our daily life, we rely on our subjective judgments and beliefs about how likely an uncertain event is and our beliefs are not necessarily expressible in numerical terms. Subjective probability refers to the likelihood an individual attributes to an event based on the individual’s own experience or personal judgement. It differs from person to person.

The human tendency to overestimate our actual ability to perform a task successfully is termed overconfidence by cognitive psychologists. Drivers are not the only ones who fall prey to overconfidence. Studies show that people tend to be unrealistically optimistic about their health, believing themselves to be at a significantly lower risk for a wide range of physical diseases and health outcomes (e.g., cancer or heart disease) relative to their peers. Students, employers, and CEOs have been shown to routinely overestimate their performance. In general, psychologists find low correlation between our subjective beliefs about abilities and actual or objective performance.

There are many factors that affect one’s subjective probability such as age, gender, experience, and education. More often than not, we make decisions based on our subjective beliefs rather than objective probabilities, which has real economic consequences for us and the society as a whole.