Loss Aversion & Endowment Effect
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Loss Aversion & Endowment Effect

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A summary of research dealing with two concepts from prospect theory: loss aversion and the endowment effect by Dr. Russell James III, University of Georgia

A summary of research dealing with two concepts from prospect theory: loss aversion and the endowment effect by Dr. Russell James III, University of Georgia

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Loss Aversion & Endowment Effect Loss Aversion & Endowment Effect Presentation Transcript

  • Loss Aversion and the Endowment Effect
    Dr. Russell James III
    University of Georgia
  • Our choices and our satisfaction are driven by the comparisons we make
    Nearby additional
    Alternative
    Future
    Past
    Expected
    Current
    Multiple Alternative
    Relevant Observed
  • Behavioral Economics Concepts
    Loss Aversion; Endowment Effect; Status Quo Bias
    Availability Effects
    Endogenous Determination of Time Preference
    Nearby additional
    Alternative
    Future
    Past
    Expected
    Current
    Hedonic Adaptation
    Placebo Effect; Stereotypes
    Multiple Alternative
    Anchoring; Paradox of Choice
    Peer Effects; Relative Standing
    Relevant Observed
    View slide
  • Two behavioral economics principles
    1. The endowment effect
    “Ownership creates satisfaction”
    2. Loss aversion
    “People are more motivated by avoiding a loss than acquiring a similar gain”
    Kahneman and Tversky’s “Prospect Theory” describes how people evaluate gains and losses; it includes concepts such as status quo bias, loss aversion, and the endowment effect
    View slide
  • The endowment effect
    People value a thing more once it becomes theirs
    Ownership increases utility
    Term originated by Richard Thaler(U. of Chicago)
    Thaler, R. (University of Chicago), 1980, Toward a positive theory of consumer choice. Journal of Economic Behavior and Organization, March, 39-60.
  • Students who did not get a mug reported the price they would be willing to pay to get one.
    Students in every other seat were given university mugs. Then reported how much they would be willing to sell the mug for.
    What happened?
    The students with mugs priced them higher.
    The students with no mugs priced them higher.
    Both sets of students priced them about the same
  • Students with no mugs were willing to buy them, on average, for
    $2.25
    Students with the mugs were willing to sell them, on average, for
    $4.50
    Kahneman, D. (UC Berkley), Knetsch, J. (Simon Fraser U), Thaler, R. (Cornell), 1990, Experimental tests of the endowment effect and the Coase theorem. Journal of Political Economy, 98(6), 1325-1348.
  • Class B
    Students given a chocolate bar. At the end, given option to trade for a coffee mug.
    Class C
    At the beginning, offered a choice between a chocolate bar or coffee mug.
    Class A
    At the beginning, students given a coffee mug. At the end, given option to trade for a bar of Swiss chocolate.
    ?
    ?
    ?
  • Class B
    Students given a chocolate bar. At the end, given option to trade for a coffee mug.
    Class C
    At the beginning, offered a choice between a chocolate bar or coffee mug.
    Class A
    At the beginning, students given a coffee mug. At the end, given option to trade for a bar of Swiss chocolate.
    ?
    ?
    Which class was most likely to choose the coffee mug?
    ?
  • Class B
    10%
    chose coffee mug
    Class C
    59%
    chose coffee mug
    Class A
    89%
    chose coffee mug
    ?
    ?
    ?
    J. Knetsch (Simon Fraser U.), 1989, The endowment effect and evidence of nonreversible indifference curves. American Economic Review, 79, 1277-1284.
  • 33 chimpanzees given frozen-juice popsicle or tube of peanut butter (both familiar items) and then an opportunity to trade.
    ?
    ?
    When initially given peanut butter
    89%
    Chose peanut butter
    When initially given popsicle
    42%
    Chose peanut butter
    Brosnan, S. (Emory), et al (Texas, Vanderbilt), 2007, Endowment effects in chimpanzees. Current Biology, 17, 1704-1707.
  • Endowment effect in basketball tickets?
    Dr. Dan Ariely, Duke University
    http://www.youtube.com/watch?v=drEVExtrUgQ
    Carmon, Ziv and Dan Ariely (2000), “Focusing on the Forgone: How Value Can Appear So Different to Buyers and Sellers,” Journal of Consumer Research, 27 (December), 360–70.
  • The endowment effect in art
    Dr. Dan Gilbert, Harvard University
    http://www.youtube.com/watch?v=LTO_dZUvbJA8:25-13:57
  • Students in a non-credit photography class at Harvard picked two photos to develop then chose one to keep.
    Group 2
    If you change your mind within four days, you can swap it. I’ll call at the end to double-check.
    Group 1
    “pick your favorite, … you won’t be able to change your mind.”
    Gilbert, D. (Harvard) & Ebert, J. (MIT), 2002, Decisions and revisions: The affective forecasting of changeable outcomes. Journal of Personality and Social Psychology, 82, 503-514
  • Both before and two days after their choice, participants asked how much they liked their photograph from 1 (not at all) to 9 (very much)
    Group 2
    Change in satisfaction with picture
    -1.8
    Group 1
    Change in satisfaction with picture
    +1.3
    Gilbert, D. (Harvard) & Ebert, J. (MIT), 2002, Decisions and revisions: The affective forecasting of changeable outcomes. Journal of Personality and Social Psychology, 82, 503-514
  • “The ratio of fructose to cellulose is an objective and unchanging property of apples, of course, but the experience of sweetness is a subjective property that increases when an apple becomes my apple”
    Gilbert, D. (Harvard) & Ebert, J. (MIT), 2002, Decisions and revisions: The affective forecasting of changeable outcomes. Journal of Personality and Social Psychology, 82, 503-514
  • Students ranked 6 art posters. Next, allowed to take home either 3rd or 4th ranked poster. 15 minutes later, they rated their chosen poster again.
    Group A: “if … any time in the next month, you can just let me know and we will exchange it for you.”
    Group B: Final choice, no exchanges.
    Gilbert, D. (Harvard) & Ebert, J. (MIT), 2002, Decisions and revisions: The affective forecasting of changeable outcomes. Journal of Personality and Social Psychology, 82, 503-514
  • Change in ranking of the art poster before and after they chose to take it home.
    -.07
    +.71
    Group A: “if … any time in the next month, you can just let me know and we will exchange it for you.”
    Group B: Final choice, no exchanges.
    Gilbert, D. (Harvard) & Ebert, J. (MIT), 2002, Decisions and revisions: The affective forecasting of changeable outcomes. Journal of Personality and Social Psychology, 82, 503-514
  • When allowed to pick their type of choice (changeable or unchangeable), people preferred:
    66.3%
    33.7%
    Group A: “if … any time in the next month, you can just let me know and we will exchange it for you.”
    Group B: Final choice, no exchanges.
    Gilbert, D. (Harvard) & Ebert, J. (MIT), 2002, Decisions and revisions: The affective forecasting of changeable outcomes. Journal of Personality and Social Psychology, 82, 503-514
  • When asked which type of choice the typical student would prefer, they believed:
    84.3%
    15.7%
    Group A: “if … any time in the next month, you can just let me know and we will exchange it for you.”
    Group B: Final choice, no exchanges.
    Gilbert, D. (Harvard) & Ebert, J. (MIT), 2002, Decisions and revisions: The affective forecasting of changeable outcomes. Journal of Personality and Social Psychology, 82, 503-514
  • Diversification Bias
    Endowment Effect
    v.
    “Our studies show that people prefer to have the opportunity to change their outcomes, …”
    “but that, in fact, these opportunities inhibit the psychological processes that would otherwise have helped them manufacture satisfaction.”
    Gilbert, D. (Harvard) & Ebert, J. (MIT), 2002, Decisions and revisions: The affective forecasting of changeable outcomes. Journal of Personality and Social Psychology, 82, 503-514
  • Dr. Dan Gilbert, Harvard University
    Summary
    http://www.youtube.com/watch?v=LTO_dZUvbJA 14:19-19:05
  • -
    +
    Loss Aversion
  • People are more motivated to avoid a loss than to acquire a similar gain.
  • Loss aversion and endowment effect
    Once I own something, not having it becomes more painful, because it is a loss.
    If I don’t yet own it, then acquiring it is less important, because it is a gain.
  • Loss aversion and framing
    If the same choice is framed as a loss, rather than as a gain, different decisions will be made.
  • Imagine that the US is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Choose a program to address the problem.
    A: 200 people will be saved
    B: 1/3 chance that 600 people will be saved. 2/3 chance that no people will be saved.
  • Imagine that the US is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Choose a program to address the problem.
    72%
    A: 200 people will be saved
    B: 1/3 chance that 600 people will be saved. 2/3 chance that no people will be saved.
    28%
    Tversky, A. & Kahneman, D., 1981, The framing of decisions and the psychology of choice. Science, 211, 453-458.
  • Imagine that the US is preparing for the outbreak of an unusual Asian disease which is expected to kill 600 people. Choose a program to address the problem.
    A: 400 people will die.
    B: 1/3 chance that nobody will die.2/3 chance that 600 people will die.
  • Imagine that the US is preparing for the outbreak of an unusual Asian disease which is expected to kill 600 people. Choose a program to address the problem.
    A: 400 people will die.
    B: 1/3 chance that nobody will die.2/3 chance that 600 people will die.
    22%
    78%
    Tversky, A. & Kahneman, D., 1981, The framing of decisions and the psychology of choice. Science, 211, 453-458.
  • Only the framing changed
    600 people expected to die…
    1/3 chance that nobody will die.
    2/3 chance that 600 people will die.
    600 people expected to die…
    1/3 chance that 600 people will be saved. 2/3 chance that no people will be saved.
    =
    78%
    28%

    We will take great risks to avoid a loss. Reframing the same option as a loss changes the choices.
    Tversky, A. & Kahneman, D., 1981, The framing of decisions and the psychology of choice. Science, 211, 453-458.
  • Choose
    A sure gain of $240
    25% chance to gain $1000, and 75% chance to gain nothing
    We are less likely to risk to get an extra gain
    We are more likely to risk to avoid a loss
    84%
    16%
    Choose
    A sure loss of $750
    75% chance to lose $1000, and 25% chance to lose nothing
    13%
    87%
    Tversky, A. & Kahneman, D., 1981, The framing of decisions and the psychology of choice. Science, 211, 453-458.
  • Framing a gamble as a loss or a gain
    http://www.youtube.com/watch?v=Ng9V2JneJ68 start – 5:54
  • When an investor sells a losing stock, she is committing to the loss.
    Does loss aversion cause investors to hold losing stocks longer than winning stocks?
  • Study: Tracking 10,000 brokerage accounts from 1987-1993 including 162,948 trades.
    In any one year…
    What share of losing stocks were sold?
    What share of gaining stocks were sold?
  • Study: Tracking 10,000 brokerage accounts from 1987-1993 including 162,948 trades.
    In any one year…
    What share of losing stocks were sold?
    What share of gaining stocks were sold?
    Note the strong opposing tax incentives
    9.8%
    14.8%
    Odean, T. (UC-Davis), 1998, Are investors reluctant to realize their losses? Journal of Finance, 53, 1775-1798.
  • Would investors have been better off to hold the winners and sell the losers?
    Average 252-day gain after winners sold
    Average 252-day gain after other stocks sold, but losing stocks held
  • Would investors have been better off to hold the winners and sell the losers?
    Average 252-day gain after winners sold
    Average 252-day gain after other stocks sold, but losing stocks held
    +2.35% (better than market)
    -1.06% (worse than market)
    Odean, T. (UC-Davis), 1998, Are investors reluctant to realize their losses? Journal of Finance, 53, 1775-1798.
  • Why losses hurt more
    Is there a conflict between the core “elephant” side of the brain and the rational pre-frontal cortex “rider”. Why?
    http://www.youtube.com/watch?v=GGQLO_iXKlU 3:06-end
  • Using prospect theory to pursue your goals
    Make it a habit (status quo bias)
    Own it (endowment effect)
    Fear its loss (loss aversion)
  • 1. Make it a habit (Goal pursuit becomes the status quo)
    “Creating a good habit requires much conscious effort, but once the groove has been produced the acts which make up a habitual pattern are not consciously willed.”
    H. Keane (Australian National University), 2000, Setting yourself free: Techniques of recovery. Health, 4, 324-346.
  • 2. Own it
    Ownership creates satisfaction (endowment effect). By completely identifying yourself with a future goal, you become more attached to it
    I claim my future
  • 3. Fear its loss
    By “owning” a future goal, immediate temptations which put that future at risk can be framed as a potential loss.
  • Application question
    Suppose you are advising a friend who wants to become a surgeon. What practical suggestions can you give to help her “own” her identity as a future surgeon?
  • Slides by:
    Russell James III, J.D., Ph.D.
    Asst. Professor, Department of Housing &
    Consumer Economics, University of Georgia
    Please use these slides!
    If you think you might use anything here in a classroom, please CLICK HEREto let me know. Thanks!
    The outline for this behavioral economics
    series is at rjames.myweb.uga.edu/outline.htm