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
GainsLossesV
alu
e
0.0 0.2 0.4 0.6 0.8 1.0
0.0
0.2
0.4
0.6
0.8
1.0
Stated Probability
Pro
ba
bili
ty W
eig
ht
Probability Weighting Functionin 1979 Prospect Theory
Next: Focus on Loss Aversion
4Psych 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
GainsLossesV
alu
e
0.0 0.2 0.4 0.6 0.8 1.0
0.0
0.2
0.4
0.6
0.8
1.0
Stated Probability
Pro
ba
bili
ty W
eig
ht
Probability Weighting Functionin 1979 Prospect Theory
Graph Showing Loss Aversion
5Psych 466, Miyamoto, Aut '15
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.
+
6Psych 466, Miyamoto, Aut '15
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
7Psych 466, Miyamoto, Aut '15
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
8Psych 466, Miyamoto, Aut '15
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 ---
9Psych 466, Miyamoto, Aut '15
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
Sellers $selling price
Mug
Buyers Mug $buying price
Choosers $ Mug ---
10Psych 466, Miyamoto, Aut '15
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
Sellers $selling price
Mug
Buyers Mug $buying price
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
ue
GainsLosses
-xx
Loss Aversion: A loss has greater impactthan an objectively equal gain.
Experimental Test of Pain of Loss Versus Change in Perception
12Psych 466, Miyamoto, Aut '15
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
13Psych 466, Miyamoto, Aut '15
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
% Owners Keep Pen > %Non-Owners Keep Pen
Same Slide w-o Colored Brackets
Rate Attractivenessof Pen
Choose Pen or Candy Bars
Owners Rating of Pen % Choosing Pen
Non-Owners Rating of Pen % Choosing Pen
Dif
fere
nt
Sa
me
14Psych 466, Miyamoto, Aut '15
Predictions
Loss Aversion 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
% Owners Keep Pen > %Non-Owners Keep Pen
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
15Psych 466, Miyamoto, Aut '15
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
16Psych 466, Miyamoto, Aut '15
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
17Psych 466, Miyamoto, Aut '15
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
18Psych 466, Miyamoto, Aut '15
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
19Psych 466, Miyamoto, Aut '15
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
21Psych 466, Miyamoto, Aut '15
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
23Psych 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
GainsLossesV
alu
e
0.0 0.2 0.4 0.6 0.8 1.0
0.0
0.2
0.4
0.6
0.8
1.0
Stated Probability
Pro
ba
bili
ty W
eig
ht
Probability Weighting Functionin 1979 Prospect Theory
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
25Psych 466, Miyamoto, Aut '15
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
26Psych 466, Miyamoto, Aut '15
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
P 466, Miyamoto, Aut '15 28
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
P 466, Miyamoto, Aut '15 29
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
P 466, Miyamoto, Aut '15 30
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
P 466, Miyamoto, Aut '15 31
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.
Women’s Predictions About the Impact of Wealth on Mood
UW Psych 466, Miyamoto, Aut '10 32
Women’s Predictions About the Impact of Wealth on Mood
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
UW Psych 466, Miyamoto, Aut '10 33
Women’s Predictions About the Impact of Wealth on Mood
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
UW Psych 466, Miyamoto, Aut '10 34
Women’s Predictions About the Impact of Wealth on Mood
• 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
UW Psych 466, Miyamoto, Aut '10 35
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
36Psych 466, Miyamoto, Aut '15
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