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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

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Loss Aversion & Endowment Effect

  1. 1. Loss Aversion and the Endowment Effect<br />Dr. Russell James III<br />University of Georgia<br />
  2. 2. Our choices and our satisfaction are driven by the comparisons we make <br />Nearby additional<br />Alternative<br />Future<br />Past<br />Expected<br />Current<br />Multiple Alternative<br />Relevant Observed<br />
  3. 3. Behavioral Economics Concepts<br />Loss Aversion; Endowment Effect; Status Quo Bias<br />Availability Effects<br />Endogenous Determination of Time Preference<br />Nearby additional<br />Alternative<br />Future<br />Past<br />Expected<br />Current<br />Hedonic Adaptation<br />Placebo Effect; Stereotypes<br />Multiple Alternative<br />Anchoring; Paradox of Choice <br />Peer Effects; Relative Standing<br />Relevant Observed<br />
  4. 4. Two behavioral economics principles<br />1. The endowment effect<br />“Ownership creates satisfaction”<br />2. Loss aversion<br />“People are more motivated by avoiding a loss than acquiring a similar gain”<br />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<br />
  5. 5. The endowment effect<br />People value a thing more once it becomes theirs <br />Ownership increases utility <br />Term originated by Richard Thaler(U. of Chicago)<br />Thaler, R. (University of Chicago), 1980, Toward a positive theory of consumer choice. Journal of Economic Behavior and Organization, March, 39-60.<br />
  6. 6. Students who did not get a mug reported the price they would be willing to pay to get one.<br />Students in every other seat were given university mugs. Then reported how much they would be willing to sell the mug for.<br />What happened?<br />The students with mugs priced them higher.<br />The students with no mugs priced them higher.<br />Both sets of students priced them about the same<br />
  7. 7. Students with no mugs were willing to buy them, on average, for <br />$2.25<br />Students with the mugs were willing to sell them, on average, for <br />$4.50<br />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.<br />
  8. 8. Class B<br />Students given a chocolate bar. At the end, given option to trade for a coffee mug.<br />Class C<br />At the beginning, offered a choice between a chocolate bar or coffee mug. <br />Class A<br />At the beginning, students given a coffee mug. At the end, given option to trade for a bar of Swiss chocolate.<br />?<br />?<br />?<br />
  9. 9. Class B<br />Students given a chocolate bar. At the end, given option to trade for a coffee mug.<br />Class C<br />At the beginning, offered a choice between a chocolate bar or coffee mug. <br />Class A<br />At the beginning, students given a coffee mug. At the end, given option to trade for a bar of Swiss chocolate.<br />?<br />?<br />Which class was most likely to choose the coffee mug?<br />?<br />
  10. 10. Class B<br />10% <br />chose coffee mug<br />Class C<br />59% <br />chose coffee mug<br />Class A<br />89% <br />chose coffee mug<br />?<br />?<br />?<br />J. Knetsch (Simon Fraser U.), 1989, The endowment effect and evidence of nonreversible indifference curves. American Economic Review, 79, 1277-1284.<br />
  11. 11. 33 chimpanzees given frozen-juice popsicle or tube of peanut butter (both familiar items) and then an opportunity to trade.<br />?<br />?<br />When initially given peanut butter <br />89% <br />Chose peanut butter<br />When initially given popsicle<br />42% <br />Chose peanut butter<br />Brosnan, S. (Emory), et al (Texas, Vanderbilt), 2007, Endowment effects in chimpanzees. Current Biology, 17, 1704-1707.<br />
  12. 12. Endowment effect in basketball tickets?<br />Dr. Dan Ariely, Duke University<br />http://www.youtube.com/watch?v=drEVExtrUgQ<br />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.<br />
  13. 13. The endowment effect in art<br />Dr. Dan Gilbert, Harvard University<br />http://www.youtube.com/watch?v=LTO_dZUvbJA8:25-13:57<br />
  14. 14. Students in a non-credit photography class at Harvard picked two photos to develop then chose one to keep.<br />Group 2<br />If you change your mind within four days, you can swap it. I’ll call at the end to double-check.<br />Group 1<br />“pick your favorite, … you won’t be able to change your mind.”<br />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<br />
  15. 15. 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)<br />Group 2<br />Change in satisfaction with picture<br />-1.8<br />Group 1<br />Change in satisfaction with picture<br />+1.3<br />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<br />
  16. 16. “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”<br />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<br />
  17. 17. 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. <br />Group A: “if … any time in the next month, you can just let me know and we will exchange it for you.”<br />Group B: Final choice, no exchanges.<br />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<br />
  18. 18. Change in ranking of the art poster before and after they chose to take it home.<br />-.07<br />+.71<br />Group A: “if … any time in the next month, you can just let me know and we will exchange it for you.”<br />Group B: Final choice, no exchanges.<br />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<br />
  19. 19. When allowed to pick their type of choice (changeable or unchangeable), people preferred:<br />66.3%<br />33.7%<br />Group A: “if … any time in the next month, you can just let me know and we will exchange it for you.”<br />Group B: Final choice, no exchanges.<br />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<br />
  20. 20. When asked which type of choice the typical student would prefer, they believed:<br />84.3%<br />15.7%<br />Group A: “if … any time in the next month, you can just let me know and we will exchange it for you.”<br />Group B: Final choice, no exchanges.<br />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<br />
  21. 21. Diversification Bias <br />Endowment Effect<br />v.<br />“Our studies show that people prefer to have the opportunity to change their outcomes, …” <br />“but that, in fact, these opportunities inhibit the psychological processes that would otherwise have helped them manufacture satisfaction.”<br />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<br />
  22. 22. Dr. Dan Gilbert, Harvard University<br />Summary<br />http://www.youtube.com/watch?v=LTO_dZUvbJA 14:19-19:05<br />
  23. 23. -<br />+<br />Loss Aversion<br />
  24. 24. People are more motivated to avoid a loss than to acquire a similar gain. <br />
  25. 25. Loss aversion and endowment effect<br />Once I own something, not having it becomes more painful, because it is a loss.<br />If I don’t yet own it, then acquiring it is less important, because it is a gain.<br />
  26. 26. Loss aversion and framing<br />If the same choice is framed as a loss, rather than as a gain, different decisions will be made.<br />
  27. 27. 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.<br />A: 200 people will be saved<br />B: 1/3 chance that 600 people will be saved. 2/3 chance that no people will be saved.<br />
  28. 28. 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.<br />72%<br />A: 200 people will be saved<br />B: 1/3 chance that 600 people will be saved. 2/3 chance that no people will be saved.<br />28%<br />Tversky, A. & Kahneman, D., 1981, The framing of decisions and the psychology of choice. Science, 211, 453-458.<br />
  29. 29. 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.<br />A: 400 people will die.<br />B: 1/3 chance that nobody will die.2/3 chance that 600 people will die.<br />
  30. 30. 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.<br />A: 400 people will die.<br />B: 1/3 chance that nobody will die.2/3 chance that 600 people will die.<br />22%<br />78%<br />Tversky, A. & Kahneman, D., 1981, The framing of decisions and the psychology of choice. Science, 211, 453-458.<br />
  31. 31. Only the framing changed<br />600 people expected to die…<br />1/3 chance that nobody will die. <br />2/3 chance that 600 people will die.<br />600 people expected to die…<br />1/3 chance that 600 people will be saved. 2/3 chance that no people will be saved.<br />=<br />78%<br />28%<br />≠<br />We will take great risks to avoid a loss. Reframing the same option as a loss changes the choices.<br />Tversky, A. & Kahneman, D., 1981, The framing of decisions and the psychology of choice. Science, 211, 453-458.<br />
  32. 32. Choose<br />A sure gain of $240<br />25% chance to gain $1000, and 75% chance to gain nothing<br />We are less likely to risk to get an extra gain<br />We are more likely to risk to avoid a loss<br />84%<br />16%<br />Choose<br />A sure loss of $750 <br />75% chance to lose $1000, and 25% chance to lose nothing<br />13%<br />87%<br />Tversky, A. & Kahneman, D., 1981, The framing of decisions and the psychology of choice. Science, 211, 453-458.<br />
  33. 33. Framing a gamble as a loss or a gain<br />http://www.youtube.com/watch?v=Ng9V2JneJ68 start – 5:54<br />
  34. 34. When an investor sells a losing stock, she is committing to the loss. <br />Does loss aversion cause investors to hold losing stocks longer than winning stocks?<br />
  35. 35. Study: Tracking 10,000 brokerage accounts from 1987-1993 including 162,948 trades.<br />In any one year…<br />What share of losing stocks were sold?<br />What share of gaining stocks were sold?<br />
  36. 36. Study: Tracking 10,000 brokerage accounts from 1987-1993 including 162,948 trades.<br />In any one year…<br />What share of losing stocks were sold?<br />What share of gaining stocks were sold?<br />Note the strong opposing tax incentives <br />9.8%<br />14.8%<br />Odean, T. (UC-Davis), 1998, Are investors reluctant to realize their losses? Journal of Finance, 53, 1775-1798.<br />
  37. 37. Would investors have been better off to hold the winners and sell the losers?<br />Average 252-day gain after winners sold<br />Average 252-day gain after other stocks sold, but losing stocks held<br />
  38. 38. Would investors have been better off to hold the winners and sell the losers?<br />Average 252-day gain after winners sold<br />Average 252-day gain after other stocks sold, but losing stocks held<br />+2.35% (better than market)<br />-1.06% (worse than market)<br />Odean, T. (UC-Davis), 1998, Are investors reluctant to realize their losses? Journal of Finance, 53, 1775-1798.<br />
  39. 39. Why losses hurt more<br />Is there a conflict between the core “elephant” side of the brain and the rational pre-frontal cortex “rider”. Why?<br />http://www.youtube.com/watch?v=GGQLO_iXKlU 3:06-end<br />
  40. 40. Using prospect theory to pursue your goals<br />Make it a habit (status quo bias) <br />Own it (endowment effect)<br />Fear its loss (loss aversion)<br />
  41. 41. 1. Make it a habit (Goal pursuit becomes the status quo)<br />“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.”<br />H. Keane (Australian National University), 2000, Setting yourself free: Techniques of recovery. Health, 4, 324-346.<br />
  42. 42. 2. Own it <br />Ownership creates satisfaction (endowment effect). By completely identifying yourself with a future goal, you become more attached to it<br />I claim my future<br />
  43. 43. 3. Fear its loss<br />By “owning” a future goal, immediate temptations which put that future at risk can be framed as a potential loss.<br />
  44. 44. Application question<br />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?<br />
  45. 45. Slides by: <br />Russell James III, J.D., Ph.D.<br />Asst. Professor, Department of Housing & <br />Consumer Economics, University of Georgia<br />Please use these slides! <br />If you think you might use anything here in a classroom, please CLICK HEREto let me know. Thanks!<br />The outline for this behavioral economics<br />series is at rjames.myweb.uga.edu/outline.htm<br />

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