Loss Aversion, Endowment Effect & Sunk Costs Psychology 466: Judgment & Decision Making Instructor:...

Loss Aversion,

Endowment Effect & Sunk Costs

Psychology 466: Judgment & Decision Making

Instructor: John Miyamoto 11/19/2015: Lecture 08-2

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Outline

• Experimental demonstration of loss aversion

• Is loss aversion due to pain of loss or change in attractiveness when you own something.

• Affective forecasting

Psych 466, Miyamoto, Aut '15 2Table Comparing EU Theory to Prospect Theory

3Psych 466, Miyamoto, Aut '15

Expected Utility Theory Prospect Theory

The basic objects of preference are states of wealth (including non-monetary resources like health).

The basic objects of preference are changes from a neutral reference point (gains and losses).

The utility function is risk averse everywhere. (Most theorists)

The value function is risk averse for gains, risk seeking for losses.

Loss aversion cannot be defined (EU theory does not identify a status quo.)

The value function implies loss aversion.

People evaluate probabilities linearly. People evaluate probabilities nonlinearly.

Problem description should have no effect as long as the problem is logically the same.

Problem description can change the reference level; hence the definition of gains & losses can change.

All outcomes are evaluated with respect to one big account.

People evaluate gains and losses with respect to mental accounts.

How Prospect Theory (PT) Differs From Expected Utility (EU) Theory

Value Function in Prospect Theory

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Probability Weighting Functionin 1979 Prospect Theory

Next: Focus on Loss Aversion
















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Graph Showing Loss Aversion


Loss Aversion

• Loss aversion –

the pain of losing X is greater

than the pleasure

of gaining X.o Example: Compare the pleasure

of unexpectedly finding $100 to the pain of unexpectedly losing $100.

Credit Cards: Cash Discount versus Credit Card Surcharge

Val

ue

GainsLosses

-xx

Loss Aversion: A loss has greater impactthan an objectively equal gain.

+


The Wine Example (for Endowment Effect)

Kahneman, D., Knetsch, J. L., & Thaler, R. H. (1991). The endowment effect, loss aversion, and status quo bias. Journal of Economic Perspectives, 5, 193-206.

A wine-lover bought wine for $10/bottle, but now it is worth

$200/bottle at auction.

• This wine-lover is not willing to pay $190/bottle

for more bottles of this wine.

• This wine-lover would not sell any of his wine for $200/bottle.

• Is this behavior odd?

Endowment Effect & Loss Aversion


Endowment Effect (Definition)

Definition: The incentive to have something that one does not have is less than the incentive not to lose the same thing if one has it.

Example: Suppose that Mr. A and Mr. B have identical values except that:

o Suppose Mr. A owns an X. o Mr. B doesn’t own an X, but he

could acquire one.

Then, Mr. A has a stronger incentive

to avoid losing X than Mr. B has for

gaining X.

Experimental Demonstration of Endowment Effect


Experimental Demonstration of Endowment EffectsKahneman, D., Knetsch, J. L., & Thaler, R. H. (1991). The endowment effect, loss aversion, and status quo bias. Journal of Economic

Perspectives, 5, 193-206.

Three conditions (between subjects)o Sellers were given a mug, and were asked for their minimum selling prices.o Buyers were shown a mug and were asked for the maximum buying prices.o Choosers were not given the mug. They were asked to set an amount

of cash so that they would be indifferent between receiving the cash and receiving the mug.

Contrasting: Pain of Loss Versus Change in Attractiveness

Gain Lose

Sellers $selling price

Mug

Buyers Mug $buying price

Choosers $ Mug ---


Predictions

EU theory predicts same average price for all three groups.

Loss Aversion Hypothesis:

o Sellers should set a high selling price to compensate for loss of mug.

o Buyers should set a lower buying price because they have less incentive to gain a mug and they lose the cash when they buy the mug.

o Choosers suffer no loss aversion. Their responses should be intermediate.

Contrasting: Pain of Loss Versus Change in Attractiveness

Gain Lose


Mug


Choosers $ Mug ---


Results

Sellers: $7.12; Buyers: $2.87; Choosers: $3.12

Sellers' Price > Choosers' Price > Buyers' Price: o Demonstrates occurrence of an endowment effect.o Violates EU theory.

Chooser's Price & Buyers' Price are similar.o Endowment effect much bigger for loss of mug than for loss of cash.

What Causes Loss Aversion: Pain of Loss Versus Change in Attractiveness

Gain Lose


Mug


Choosers $ Mug ---

What Causes the Endowment Effect?

• Pain of Loss Hypothesis: The endowment effect results from loss aversion.

• Change in Perception Hypothesis:Once you own something, youperceive it as more desirable than before owning it.

• Possibly possessing an object changeshow people evaluate an object.

Psych 466, Miyamoto, Aut '15 11

Val

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GainsLosses

-xx

Loss Aversion: A loss has greater impactthan an objectively equal gain.

Experimental Test of Pain of Loss Versus Change in Perception


Is Endowment Effect Due to Pain of Loss or Change in Perceived Value?

Loewenstein & Kahneman (1991):

o Half the subjects received a pen (Owners).o Half the subjects received a token that could be redeemed later

for a prize (Non-owners)o All subjects rated the attractiveness of 6 possible prizes (the pen was among

them).o In the end, all subjects were then allowed to choose between the pen

and 2 candy bars.

Results for Owners and Non-Owners

Rate Attractivenessof Pen

Choose Pen or Candy Bars

Owners Rating of Pen % Choosing Pen

Non-Owners Rating of Pen % Choosing Pen


Predictions

Pain of Loss Hypothesis Predicts:

Owners' Ratings of Pen = Non-Owners Ratings of Pen

% Owners Keep Pen > %Non-Owners Keep Pen

Change in Value (of Pen) Hypothesis Predicts:

Owners' Ratings of Pen > Non-Owners Ratings of Pen


Same Slide w-o Colored Brackets





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Predictions

Loss Aversion Hypothesis Predicts:



Change in Value (of Pen) Hypothesis Predicts:



Results for Owners and Non-Owners






Results for Owners and Non-Owners of the Pen

Key Finding: Attractiveness ratings for the pen were

the same in the two groups.

Conclusion: Endowment effect occurs because

of pain of loss, not change in attractiveness.

Choice response replicates previous findings for endowment effect.

• 56% of owners chose to keep the pen.

44% chose the candy bars.

• 24% of non-owners chose the pen.

76% chose the candy bars.

Real World Example – Auto Insurance Example


The Auto Insurance Example

• Described in KK&T and in Hammond, Keeney & Raiffa (1998: The hidden traps in decision making, Harvard

Business Review, 76, 47-8).

Two auto insurance policies: o Cheaper policy restricts the right to sue;

o More expensive policy retains the unrestricted right to sue.

• 1988: New Jersey made the cheaper policy the default option,

but citizens could buy the more expensive policy at a higher price.

• 1990: Pennsylvania made the more expensive policy the default option, but

citizens switch to the cheaper policy at a lower price.

• Approximately 80% of the New Jersey citizens kept the cheaper policy (did

not change to the expensive one) but only 25% of the Pennsylvania citizens

chose the cheaper policy (changed away from the expensive one).

Wine Example - Table Showing the Transaction


The Wine Example (Again)

KK&T: Kahneman, D., Knetsch, J. L., & Thaler, R. H. (1991). The endowment effect, loss aversion, and status quo bias. Journal of Economic Perspectives, 5, 193-206.

• A wine-lover bought wine for $10/bottle, but now it is worth

$200/bottle at auction.

• This wine-lover is not willing to pay $200/bottle

for more bottles of this wine.

• This wine-lover would not sell any of his wine for $200/bottle.

Endowment Effect - Conclusions

Gain Lose

Sell One Bottle $200 1 Bottle

Don't Sell & Don’t Buy

nothing nothing

Buy One More Bottle

1 Bottle $200


Endowment Effect - Conclusions

• Endowment effects appear to be due to a difference between willingness to

give something up and incentive to receive something new.o It does not appear to be due to a change in the evaluations

of the outcomes.

• The endowment effect tends to promote a status quo bias.

Sunk Costs


Sunk Costs – Football Ticket Example (same as ski ticket example from earlier in quarter)

Suppose that 6 months previously, you bought season tickets

to Husky football game. As the next game approaches, you catch a cold that

makes you feel miserable.

Could it happen that:

a) if you didn't already have tickets and someone offered to take you to the game for free, you wouldn't go; and ....

b) since you have already paid for the tickets, you feel that you should go to the game; so you go.

I.e., are you prone in this situation to honor sunk costs?

Analysis of the Football Ticket Example Using Mental Accounting and Loss Aversion

Analysis of Football Ticket Example

• Option 1 avoids the “loss” of the price of the ticket. You suffer the loss due to experience of an unpleasant day.

• Option 2 feels like you “lose” the price of the ticket because you keep the ticket cost in a separate mental account from other costs and benefits.

• Sunk cost fallacy can be explained by a combination of mental accounting and loss aversion.

Psych 466, Miyamoto, Aut '15 20

Option 1 Option 2

• Go to football game.

• Have an unpleasant day because you feel sick.

• You do not “lose” the price of the ticket because it has been compensated for by attendance at the game. (mental accounting)

• Stay at home.

• Have a reasonably enjoyable day.

• You “lose” the price of the ticket.

(mental accounting)

Another Sunk Cost Example – Government Spending on Projects


When Do We Feel We Should Honor Sunk Costs?

• Example: Government expends $1.5 B(illion) on a subway line that is still

incomplete. Should we spend an additional $1 B to finish the subway line?

Option 1: Government has spent $2.5 B. We have a complete subway line.

Option 2: Government has spent $1.5 B. We have an incomplete subway line. We have the option to spend $1 B on something else, or leave the money in the tax payers pockets.

Mental accounting and loss aversion:o Option 1: We “lose” $1 B (the additional cost).

We gain a completed subway line. (With Option 1, we do not see the initial $1.5 B as a “loss”.)

o Option 2: We “lose” $1.5 B (the initial cost). Of course, we retain the power to use the $1 B that we didn't spend.

Return to Table that Contrasts EU Theory with Prospect Theory

How to Avoid Sunk Cost Fallacies

• Ask yourself: Is the additional cost worth what you will get for that expense?

• Your past expenses are usually irrelevant to whether you spend this additional investment.

Psych 466, Miyamoto, Aut '15 22Return to the Table that Compares EU Theory to Prospect Theory
















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New Topic: Affective Forecasting

Outline

• Affective forecasting - what is it?

• Examples of affective forecasting♦ Focusing illusion

♦ Impact bias

♦ Duration bias

Psych 466, Miyamoto, Aut '15 24Affective Forecasting

Lecture ends here


Why Do People Have Difficulty With Affective Forecasting?

• People have incomplete or inaccurate self-theories?

• Response to novel experiences is hard to anticipate?

• Affect set point – overall happiness/unhappiness is determined by internal

personal factors? People sometimes fail to take this into account.

• People are unaware of the influence of cognitive processes:

Focusing illusion & impact bias

Duration neglect

Focusing Illusion


Focusing Illusion

Focusing illusion – if attention is focused on some but not all of the attributes

(aspects/issues) of an option, these attributes are likely to be overweighted in

predictions of affect.o Changes in attribute levels tend to be focused on, and hence, overweighted.

Example: Schwarz et al. asked 2 questions to college students:

(i) How happy are you?

(ii) How many dates did you have last month?

• Correlation between answers was .12 when asked in the

order (i), then (ii).

• Correlation between answers was .66 when asked in the

order (ii), then (i) .

Anticipated quality of life in midwest or California

P 466, Miyamoto, Aut '15 27

Focusing Illusion

• Focusing illusion – if attention is focused on some but not all of the

attributes (aspects/issues) of an option, these attributes are likely to be

overweighted in predictions of affect.o Changes in attribute levels tend to be focused on, and hence, overweighted.

• Focalism: The tendency to exaggerate the effect of circumstances when we

predict the effect of these circumstances. .

Anticipated quality of life in midwest or California


Is Life Better in California (or Does It Just Look That Way)?

• Schkade & Kahneman (1998): S&K

Subjects were 992 students at midwestern universities

and 1,002 students at southern California universities.

Dependent Variables:

• Rate importance of a series of dimension for yourself and for “someone like

you” who attends University X.o X = a California university for a midwestern student

and a midwestern university for a California student. o Dimensions: Job prospects, academic opportunities, financial situation, personal

safety, outdoor activities, weather, .... o These ratings are used to determine the students’ theory of what determines life

satisfaction.

• Rate overall quality of life for self and for “someone like you” who attends

University X.

Graph of Importance of Dimensions


Results for Importance

of Dimensions

Schkade & Kahneman,

Figure 2

o Midwestern and California students had similar importance ratings.o Notice: “Job Prospects” & “Academic Opportunity” rated much more important for

well-being than weather.

Results for Michigan/California Quality of Life on Various Dimensions


Results for Quality of Life on Various Dimensions

Schkade & Kahneman (1998): S&K

• Rated Quality of Non-Weather Dimensions:

Cal – Midwest differences were small or zero o Non-Weather Dimensions: Job prospects, academic opportunity, financial situation,

personal safety, social life, outdoor activities, natural beauty, cultural opportunities

• Rated Quality of Weather Dimension:

Cal – Midwest difference was very large, i.e., both Cal and

midwest students agreed that Cal had much better weather. o Weather Dimensions: Overall climate, summer weather, winter weather

Women’s Predictions About the Impact of Wealth on Mood


Results for Actual & Predicted Satisfaction

Schkade & Kahneman (1998): S&K

• Actual Satisfaction:

Cal and midwest students were equally satisfied with life;

• Predicted Satisfaction for “Someone like Them” in

the Other Region: Both groups predict that "someone like them" would be

more satisfied if living in California. o Mediation analysis shows that weather accounts for rated difference in life quality

in midwest and California.

• S&K’s Interpretation: People suffer from a focusing illusion;o Cal versus midwest difference in weather is salient;

its true impact is much less than its predicted impact.


UW Psych 466, Miyamoto, Aut '10 32


Kahneman, D., Krueger, A. B., Schkade, D., Schwarz, N., & Stone, A. A. (2006). Would you be happier if you were richer?

A focusing illusion. Science, 312, 1908-1910.

Participants were working women. Between subjects design.

Participants ....

(a) stated the percentage of time they were in a bad mood on the preceding day, and ....

(b) predicted the percentage of time in a bad mood experienced by a woman similar to themselves who had high or low incomes. (Similar question for married/single, health insurance/no health insurance, ...)

• Since some of the women did have income < $20,000 or

> $100,000, or were alone or married, etc., we also have the actual self-rating

of time in a bad mood.

How Would You Feel If You Were ____? - Results



Results for Household Income

Actual Difference = 32.0 - 19.8 = 12.2

Predicted Difference = 57.7 - 25.7 = 32.0

Same Slide with Sample Sizes Added to It

N > 59 in all cases



• In general, ACTUAL difference < PREDICTED differenceo The contrast between good and bad circumstances was exaggerated.

(Good and bad circumstances do have an effect, but not as much as predicted.)o Result explained by focalism – we exaggerate the predicted effects of variables that we

focus on.

Same Slide with Sample Sizes Added to It

N > 59 in all cases


A Note re Sample Sizes for this Study

• Sample sizes were large enough to produce reliable results.

Focusing Illusion – Summary - END

N > 59 in all cases

Sample SizesActual Predicted

64 83 59 83 75 84 237 84 96 83 211 85 82 85 221 87


Focusing Illusion - Summary

• Focusing on any one aspect of a larger situation exaggerates its impact on

the hedonic response to the situation.

"Nothing in life is quite as important

as you think it is while you are thinking about it." Schkade and Kahneman (1998)

• We often focus on changes.

Hence, we often exaggerate the impact of changes.o Distinguish between the short-term and long-term impact of changes.o Long-term impact of changes is the experience of a stable, non-changing state

(more or less).

• Focusing illusion is relevant when we attempt to anticipate

the value of a change in circumstance.

END

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Loss Aversion, Endowment Effect & Sunk Costs Psychology 466: Judgment & Decision Making Instructor:...

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