Introduction

Opportunity
Costs

Sunk Costs

Menu
Decision-Making under Certainty
Dependence
and Decoy
Effect

Endowment
Effect and
Loss Aversion Manoogian College of Business and Economics
Anchoring
and
Adjustment

Discussion

1 / 48
2019-08-30
Decision-Making under Certainty

Manoogian College of Business and Economics

Next time around, when teaching this class, consider David Just’s Intro to
Behavioral Econ chapter on Status Quo Bias and Default Options, he has
a bit more in depth exposition than Angner.
 Decision-Making under Certainty

1 Introduction
Introduction

Opportunity
Costs 2 Opportunity Costs
Sunk Costs

Menu 3 Sunk Costs

Dependence
and Decoy
Effect 4 Menu Dependence and Decoy Effect
Endowment
Effect and
Loss Aversion 5 Endowment Effect and Loss Aversion
Anchoring
and
Adjustment 6 Anchoring and Adjustment
Discussion
7 Discussion

2 / 48
 Introduction

• Although the theory of rational choice is based on a small

Introduction
number of weak assumption, its implications can be
Opportunity
Costs challenged both on descriptive and normative grounds.
Sunk Costs • In this module, we confront the theory with data. We
Menu
Dependence
explore some of the phenomena that behavioral
and Decoy
Effect
economists argue are inconsistent with the theory of
Endowment choice under certainty.
Effect and
Loss Aversion • Moreover, we will discuss how behavioral economists deal
Anchoring with such phenomena. In particular, we will discuss some
and
Adjustment of the building blocks of prominent behavioral alternatives
Discussion to the rational choice theory, including prospect theory
and the heuristics-and-biases program.

3 / 48
 Introduction

Introduction
2019-08-30 • Although the theory of rational choice is based on a small
number of weak assumption, its implications can be
challenged both on descriptive and normative grounds.
• In this module, we confront the theory with data. We
explore some of the phenomena that behavioral

Introduction economists argue are inconsistent with the theory of

choice under certainty.
• Moreover, we will discuss how behavioral economists deal
with such phenomena. In particular, we will discuss some
of the building blocks of prominent behavioral alternatives
to the rational choice theory, including prospect theory
and the heuristics-and-biases program.

For the last bullet point it proabbly makes sence to start expalaining a little
bit the different approaches that deal with the normative and descriptive
inadequacy of the conventional model.
• First, we can say that the rational model is fundamentally wrong
and that’s the reason why it is not descritively and normatively
adequate. The prospect theory is one of the most prominent
theories that pursue that line of reasonong.
• Second, we may say that while the model is fundamentally right,
there can be certain circumstances in life when people don’t act in
accordance with the rational model. Sometimes, we form mental
shortcuts, or heuristics, that help us navigate the complexities of
our daily lives. Those heuristics may work very well under some
circumstances but horribly in other circumstances. In the latter case
they lead to persisten irrationalities, biases. The
heuristics-and-biases program lists and investigates all these
heuristics and biases.
 Costs

• Rational behavior requires sober comparison of benefits as

well as costs. It turns out that we are terrible at
Introduction
evaluating both. The first two section of the chapter deal
Opportunity
Costs with our inability to accurately evaluate costs.
Sunk Costs • Explicit cost: What you have to pay (e.g., in dollars) to
Menu
Dependence get something.
and Decoy
Effect • Opportunity (Implicit) Cost: The value of the best
Endowment option forgone.
Effect and
Loss Aversion • When you face a menu of choices and end up choosing
Anchoring
and
one item, your second best alternative on the menu is your
Adjustment
opportunity cost.
Discussion
• Example: If you watch a movie with friends, the explicit
cost is the price of the ticket; the opportunity cost is the
time that could be spent studying.
4 / 48
 Calculating Gains

Introduction

Opportunity
Costs
• Economic profit: Net Benefit (=total benefit minus
Sunk Costs

Menu
explicit costs) of your choice minus the opportunity cost.
Dependence – Suppose watching a movie gives you 10 units of net utility
and Decoy
Effect (after paying for the ticket) while studying gives you 7
Endowment units of utility. When going to the movies, your economic
Effect and
Loss Aversion profit is 10 − 7 = 3 units of utility.
Anchoring
and
Adjustment

Discussion

5 / 48
 Calculating Gains

Introduction

Opportunity
Costs

Sunk Costs

Menu
Dependence
and Decoy
Effect

Endowment
Effect and
Loss Aversion

Anchoring
and
Adjustment • When making rational choices, opportunity costs must
Discussion
never exceed the benefits.

6 / 48
 More Formally

Introduction

Opportunity
Definition of Opportunity Cost
Costs
c(ai ) = max{u(a1 ), u(a2 ), . . . , u(ai−1 ), u(ai+1 ), . . . , u(an )}
Sunk Costs

Menu
Dependence
and Decoy
Effect where
Endowment – a1 , a2 , . . . , an denote n different acts,
Effect and
Loss Aversion – u(a1 ), u(a2 ), . . . , u(an ) denote the utilities of those acts,
Anchoring – u(ai ) utility of act ai ,
and
Adjustment
– c(ai ) is the opportunity cost of act i = the utility of the
Discussion
best forgone alternative.

7 / 48
 Rational Choice

Proposition on Rational Choice

Introduction
Act ai is rational ⇔ (if and only if) u(ai ) ≥ c(ai )
Opportunity
Costs

Sunk Costs

Menu Proof (needs to be done both ways):

Dependence
and Decoy 1. Assume that ai is the rational choice.
Effect
2. Given our definition of rationality u(ai ) ≥ u(aj ) for all
Endowment
Effect and i 6= j.
Loss Aversion
3. If so, u(ai ) ≥
Anchoring max{u(a1 ), u(a2 ), . . . , u(ai−1 ), u(ai+1 ), . . . , u(an )} =
and
Adjustment c(ai ) by definition of opportunity cost.
Discussion 4. ∴ u(ai ) ≥ c(ai )
5. The second (reverse) part can be proven in the same way,
except reversed.

8 / 48
 Rational Choice

Opportunity Costs
2019-08-30 Proposition on Rational Choice
Act ai is rational ⇔ (if and only if) u(ai ) ≥ c(ai )

Proof (needs to be done both ways):

Rational Choice 1. Assume that ai is the rational choice.

2. Given our definition of rationality u(ai ) ≥ u(aj ) for all
i 6= j.
3. If so, u(ai ) ≥
max{u(a1 ), u(a2 ), . . . , u(ai−1 ), u(ai+1 ), . . . , u(an )} =
c(ai ) by definition of opportunity cost.
4. ∴ u(ai ) ≥ c(ai )
5. The second (reverse) part can be proven in the same way,
except reversed.

• Exercise on Opportunity costs: What is the opportunity cost of

(a) staying in an unfulfilling relationship,
(b) pursuing a course of study that does not excite you, and
(c) sleeping until noon?
The concept of opportunity cost has considerable explanatory power.
• Exercise on Opportunity costs, cont. Using the language of
opportunity cost, explain why highly paid people are less likely than
poor people to mow their own lawns, clean their own houses,
maintain their own cars, and so on.
 Rational Choice

Opportunity Costs
2019-08-30 Proposition on Rational Choice
Act ai is rational ⇔ (if and only if) u(ai ) ≥ c(ai )

Proof (needs to be done both ways):

Rational Choice 1. Assume that ai is the rational choice.

2. Given our definition of rationality u(ai ) ≥ u(aj ) for all
i 6= j.
3. If so, u(ai ) ≥
max{u(a1 ), u(a2 ), . . . , u(ai−1 ), u(ai+1 ), . . . , u(an )} =
c(ai ) by definition of opportunity cost.
4. ∴ u(ai ) ≥ c(ai )
5. The second (reverse) part can be proven in the same way,
except reversed.

Do we take our opportunity costs into consideration?

Example on Gangnam Style: By mid-2014, the goofy music video ‘Gang-
nam Style’ became the most watched YouTube clip of all time. According
to a review by The Economist, in the amount of time people spent watch-
ing the clip, they could instead have built three of the largest type of
aircraft carrier, four Great Pyramids of Giza, six Burj Khalifas (the world’s
tallest building in Dubai), or 20 Empire State Buildings. As this example
shows, opportunity costs can be huge.
 Opportunity Cost Fallacy

• It is always irrational to ignore opportunity costs.

• However, individuals do not always consider opportunity costs.
Introduction Comparison of the best and second best alternatives can
Opportunity sometimes be a challenge.
Costs • People are particularly likely to ignore the opportunity cost of
Sunk Costs spending a windfall, that is, an unexpectedly large or unforeseen
Menu
Dependence
profit.
and Decoy • People often think in terms of ratios. In such instances, it is
Effect
easy to ignore opportunity cost. For example, asking questions
Endowment
Effect and such as “What’s another $10,000 when I’m already spending
Loss Aversion $100,000 on a new house?” is one way to ignore the opportunity
Anchoring
and
costs of spending $10,000 that way.
Adjustment • Another example is unpaid work. John washes his car for an
Discussion hour instead of working. If John makes $20/hour and he would
be charged $7 to wash his car, the opportunity cost of washing
his car himself is $7 − $20 = −$13. (This assumes he takes no
pleasure in washing his car, etc.)
9 / 48
 Opportunity Cost Fallacy

Opportunity Costs • It is always irrational to ignore opportunity costs.

2019-08-30 • However, individuals do not always consider opportunity costs.

Comparison of the best and second best alternatives can
sometimes be a challenge.
• People are particularly likely to ignore the opportunity cost of
spending a windfall, that is, an unexpectedly large or unforeseen
profit.

Opportunity Cost Fallacy • People often think in terms of ratios. In such instances, it is
easy to ignore opportunity cost. For example, asking questions
such as “What’s another $10,000 when I’m already spending
$100,000 on a new house?” is one way to ignore the opportunity
costs of spending $10,000 that way.
• Another example is unpaid work. John washes his car for an
hour instead of working. If John makes $20/hour and he would
be charged $7 to wash his car, the opportunity cost of washing
his car himself is $7 − $20 = −$13. (This assumes he takes no
pleasure in washing his car, etc.)

• For the third bullet point in the previous slide use the following
example
Example Imagine that after visiting your parents in Montana a few
times, you earn a voucher that can be exchanged for a free
airplane ticket anywhere in the country. You decide to go to
Las Vegas. You would not actually have bought a ticket to
Vegas, but because it was free you figured you might as well.
Now, after few months, you would like to visit your parents in
Montana, and wish you did not have to pay so much money
for the ticket.
• for the fourth bullet point in the previous slide use the following
example.
Example Suppose that you are staying at an expensive hotel that offers
in-room dining for $60. Ordinarily you would not pay that kind
of money for a meal, but you say to ourself: “I already paid
$220 for this room, so what’s $60 more?” Explain in what way
 Why People May Ignore Opportunity Costs?

• In order to remain consistently rational, people must never

choose an alternative whose opportunity cost is higher than
Introduction utility. This is hard to achieve.
Opportunity – Example of Marriage. One not only must have complete
Costs and transitive preferences over different potential spouse
Sunk Costs choices, but also must make sure that her choice is not
Menu inferior to any other alternative. But in one lifetime, we
Dependence
and Decoy get to know only so many alternatives.
Effect • But the fact that considering all possible alternatives is so very
Endowment
Effect and
demanding means that there can be legitimate disagreement
Loss Aversion about whether failing to consider opportunity costs under those
Anchoring conditions is irrational or not.
and
Adjustment • On the other hand, paying too much, rather than too little,
Discussion attention to opportunity costs can make us unhappy.
Psychologist Barry Schwartz calls this phenomenon ”the
paradox of choice.” The more alternatives there are, the greater
our experience of the opportunity costs will be and the less
satisfaction we will derive from our chosen alternative... 10 / 48
 Why People May Ignore Opportunity Costs?

Opportunity Costs • In order to remain consistently rational, people must never

2019-08-30 choose an alternative whose opportunity cost is higher than

utility. This is hard to achieve.
– Example of Marriage. One not only must have complete
and transitive preferences over different potential spouse
choices, but also must make sure that her choice is not
inferior to any other alternative. But in one lifetime, we

Why People May Ignore Opportunity Costs? get to know only so many alternatives.
• But the fact that considering all possible alternatives is so very
demanding means that there can be legitimate disagreement
about whether failing to consider opportunity costs under those
conditions is irrational or not.
• On the other hand, paying too much, rather than too little,
attention to opportunity costs can make us unhappy.
Psychologist Barry Schwartz calls this phenomenon ”the
paradox of choice.” The more alternatives there are, the greater
our experience of the opportunity costs will be and the less
satisfaction we will derive from our chosen alternative...

• Sunk-costs fallacy is another reason why people may ignore

opportunity costs. Menu dependence, loss aversion, and the
endowment effects are yet two other explanations why people
often ignore opportunity costs, those effects will be discussed later
in the chapter.
• This is a good time to distribute the experiment Behavioral
Economics: Handout Section 3.3 (1 of 2) and (2 of 2). Divide
students into two groups. Ask group 1 to fill out handout 1 and
group 2 to fillout handout 2.
 Sunk-Cost Fallacy

Introduction

Opportunity
Costs Definition of Sunk Cost
Sunk Costs A cost that cannot be recovered at the time when the decision
Menu
Dependence
is made.
and Decoy
Effect

Endowment
• Sunk costs must not affect rational decisions. If you honor
Effect and
Loss Aversion
sunk costs, you are acting irrationally and committing the
Anchoring sunk-cost fallacy.
and
Adjustment

Discussion

11 / 48
 Sunk-Cost Fallacy: an Example

• Imagine that you paid $200 to participate in a networking

Introduction
trip organized by the PBC at the University of Scranton.
Opportunity
Costs This money is not refundable. You have to get up at
Sunk Costs 5:00AM to join the trip. On the day of the trip, you wake
Menu up with migraine. Would you go on the trip?
Dependence
and Decoy • Now, imagine that you haven’t paid anything for the trip.
Effect

Endowment
Would you be more or less likely to go on the trip?
Effect and
Loss Aversion • If you chose different answers to these two questions then
Anchoring you are irrational.
and
Adjustment • Thus, rational choices are completely forward-looking:
Discussion
things that happened in the past matter only insofar as
they affect future outcomes.

12 / 48
 Sunk-Cost Fallacy: Another Example

– You drive to the mall thinking that there is a sale (you wouldn’t shop
unless there is a sale) and once you get there you realize that there
Introduction are no sales. You still buy something because if you do not, you feel
Opportunity as though you would have wasted time driving to the mall.
Costs – If you are rational, you’d think that whether or not you buy anything,
Sunk Costs you have already spent that time.
Menu – To show mathematically, imagine that you would like to buy an item
Dependence
and Decoy that gives you $11 worth of satisfaction. Buying the item will cost
Effect
$12. Driving to the mall costs you (explicitly or implicitly) $2. You
Endowment
Effect and
initially think that there is a 50% sale and by driving to the mall you
Loss Aversion can get the item for $6. Thus, you expect to experience net benefit
Anchoring equal to: $11 − $6 − $2 = $3
and
Adjustment – But once you get to the mall, you realize that there is no sale and if
Discussion you buy the item you’ll be getting net benefit equal to:
$11 − $12 − $2 = −$3
– if you act rationally and decide not to buy it, your net benefit will be:
−$2. Thus not buying leads to smaller net loss than buying it, never
the less, many people would go for a buy. 13 / 48
 Sunk Cost Fallacy

• Sunk Cost Fallacy can easily be understood from the

perspective of the multistage nature of a decision process.
Introduction

Opportunity
For example:
Costs

Sunk Costs

Menu
Dependence
and Decoy
Effect

Endowment
Effect and
Loss Aversion

Anchoring
and
Adjustment

Discussion

• Your choice between Coke and Pepsi should not depend on

whether you go to Walmart or Target.
14 / 48
 Sunk-Cost Fallacy

• However, sometimes actual human choices fail to go on with the

same ultimate choice irrespective how the first stage in the decision
Introduction process evolved. It often happens when sunk costs are present.
Opportunity • Consider the following example that is very similar to the one before.
Costs
Here you have to decide whether to invest $1M in a project that, you
Sunk Costs
know, is going to fail.
Menu
Dependence
and Decoy
Effect

Endowment
Effect and
Loss Aversion

Anchoring
and
Adjustment

Discussion

• In the first case, an initial investment of $9M has already been made,
while in the second case it has not.
15 / 48
 Sunk-Cost Fallacy

Sunk Costs
2019-08-30
• However, sometimes actual human choices fail to go on with the
same ultimate choice irrespective how the first stage in the decision
process evolved. It often happens when sunk costs are present.
• Consider the following example that is very similar to the one before.
Here you have to decide whether to invest $1M in a project that, you
know, is going to fail.

Sunk-Cost Fallacy
• In the first case, an initial investment of $9M has already been made,
while in the second case it has not.

Next time do an example with cutting the cable cord and

how people consider internet costs as part of the equation:
http://www.usatoday.com/story/tech/talkingtech/2017/03/08/cutting-
cord-could-cost-much-cable/98894132/
 Escalation of Sunk Costs

• The sunk-cost fallacy can start a vicious cycle sometimes

referred to as an escalation situation.
Introduction

Opportunity
• Once a project – whether an R&D effort, a marriage, a
Costs
financial investment, or whatever – is beginning to go
Sunk Costs
downhill, the sunk-cost fallacy encourages people
Menu
Dependence irrationally to make additional investments in the project.
and Decoy
Effect • Once the additional investment has been made, unless it
Endowment
Effect and
turns the project around, people find themselves with an
Loss Aversion even greater sunk cost, which is even harder to ignore,
Anchoring
and
thereby encouraging even greater investments.
Adjustment
• As one of the founders of Lyft, John Zimmer, once
Discussion
remarked, if you want to be successful then ”you often
have to ask yourself, if I were to start it all over again,
would I do things differently.”
16 / 48
 Escalation of Sunk Costs

• Understanding of the sunk-cost fallacy and its escalation

Introduction can be useful not only in business but also in personal
Opportunity relationships.
Costs

Sunk Costs
• If a friend refuses to ditch her current boyfriend, even
Menu though she realizes that he is an utter loser, on the basis
Dependence
and Decoy that leaving him would mean that she would have wasted
Effect
some of the best years of her life, she would be honoring
Endowment
Effect and the sunk cost of the time and effort that she has already
Loss Aversion
committed to him. But the more she stays with him, the
Anchoring
and harder it will be to make the rational choice.
Adjustment

Discussion
• If you are the loser’s girlfriend, it might help to remind
yourself that the wasted years in your past are no reason
to stay with him.

17 / 48
 Escalation of Sunk Costs

Sunk Costs
2019-08-30
• Understanding of the sunk-cost fallacy and its escalation
can be useful not only in business but also in personal
relationships.
• If a friend refuses to ditch her current boyfriend, even
though she realizes that he is an utter loser, on the basis

Escalation of Sunk Costs that leaving him would mean that she would have wasted
some of the best years of her life, she would be honoring
the sunk cost of the time and effort that she has already
committed to him. But the more she stays with him, the
harder it will be to make the rational choice.
• If you are the loser’s girlfriend, it might help to remind
yourself that the wasted years in your past are no reason
to stay with him.

• Decoy effect and menu dependence are another reason why people
may not be able to rank their preferences on the menu correctly.
• It is a good time to distribute the experiment Behavioral Economics:
Handout Section 3.4 (1 of 2) and (2 of 2). Again half class fills out
experiment 1 and the other half fills out the other half.
 Decoy Effect

• Menu dependence occurs when people’s preferences change

when the menu expands.
Introduction
• Example: Economist.com offers 3 subscription options presented
Opportunity in the following table. Which one would you prefer?
Costs

Sunk Costs

Menu
Dependence
and Decoy
Effect

Endowment
Effect and
Loss Aversion
• When presented with options 1 and 3 only, 68% of respondents
Anchoring
and chose option 1 and 32% chose option 3.
Adjustment
• When presented with options 1, 2, and 3, 0% chose option 2.
Discussion
But only 16% chose option 1 whereas 84% chose option 3.
• The inclusion of an option that nobody in their right mind
would choose can affect people’s preferences over the remaining
options.
18 / 48
 Decoy Effect

• The decoy effect occurs when the introduction of a subpar

option causes individuals to change their preferences.
Introduction
• Why are menu dependence and decoy effect irrational?
Opportunity
Costs • The theory of rational choice implies something we call
Sunk Costs expansion condition.
Menu
Dependence
and Decoy Expansion Condition
Effect

Endowment
If x is chosen from the menu {x, y}, assuming that you are not
Effect and indifferent between x and y, you must not choose y from the menu
Loss Aversion
{x, y, z}.
Anchoring
and
Adjustment
• The proposition simply says that an introduction of an inferior
Discussion
product should not change your choice.
• Yet there is evidence that people’s preferences do change when
the menu expands.
19 / 48
 Decoy Effect

Introduction

Opportunity • Suppose that you market a product, which we call the

Costs
target.
Sunk Costs

Menu
• Another company markets a similar product, the
Dependence
and Decoy
competitor.
Effect
• Both the target and the competitor are on the budget line,
Endowment
Effect and thus the consumer can afford each of these.
Loss Aversion

Anchoring
• Consumers preferences are such that the consumer prefers
and
Adjustment
the competitor.
Discussion

20 / 48
 Decoy Effect

Introduction

Opportunity
Costs

Sunk Costs

Menu
Dependence
and Decoy
Effect

Endowment
Effect and
Loss Aversion

Anchoring
and
Adjustment

Discussion

21 / 48
 Decoy Effect

• It turns out that you can manipulate the consumer’s choices by

introducing a product that is in every respect inferior to the
Introduction target.
Opportunity
Costs Definition
Sunk Costs One product x dominates another y just in case x is better than y
Menu in every possible respect.
Dependence
and Decoy
Effect • Thus, the target dominates every product in boxes B and C and
Endowment
Effect and
the competitor dominates every product in boxes A and B.
Loss Aversion • Now the menu includes a third item, which we call the decoy.
Anchoring • For the decoy to be effective, it should be asymmetrically
and
Adjustment dominated by the target.
Discussion
Definition
A product y is asymmetrically dominated by x just in case y is
dominated by x but not by any other member of the menu.
22 / 48
 Decoy Effect

• Thus for the decoy to work, it should be dominated by the

target but not by the competitor ⇒ it should fall in box
Introduction
marked C.
Opportunity
Costs

Sunk Costs

Menu
Dependence
and Decoy
Effect

Endowment
Effect and
Loss Aversion

Anchoring
and
Adjustment

Discussion

23 / 48
 Decoy Effect

Menu Dependence and Decoy Effect

2019-08-30
• Thus for the decoy to work, it should be dominated by the
target but not by the competitor ⇒ it should fall in box
marked C.

Decoy Effect

• To make it more concreet, do an example with Target= Ferrari and

Competitor=Volvo. For the decoy work, it should be slower and less
safe than Ferrari but faster than volvo. Even though noone will buy
the decoy, it will rotate the indifference curves towards Ferrari.
• Exercise, Real-estate sales: Suppose that you are a real-estate
agent showing two properties to potential customers. The one is in
very good shape but far from the clients’ office; the other is only in
decent shape but close to the office.
(a) If you want the customers to choose the former, what third
property should you show?
(b) If you want the customers to choose the latter, what third
property should you show?
 Decoy Effect

Menu Dependence and Decoy Effect

2019-08-30
• Thus for the decoy to work, it should be dominated by the
target but not by the competitor ⇒ it should fall in box
marked C.

Decoy Effect

• Exercise, Wingmen and wingwomen: To improve your chances

on the dating scene, you have decided to recruit a wingman or
wingwoman.
(a) How, in general terms, should you choose your wingman or
wingwoman?
(b) Imagine that your attractiveness and intelligence are both
rated 9 on a 10-point scale. You have two competitors: one
whose attractiveness is 10 and intelligence 8; and another
whose attractiveness is 8 and intelligence 10. In what range
would you want your wingman or wingwoman’s attractiveness
and intelligence to fall?
(c) If somebody asks you to be his or her wingman or wingwoman,
what does this analysis suggest he or she thinks about your
attractiveness and intelligence?
 Other Forms of Menu Dependence

• There are other known forms of menu dependence.

Introduction

Opportunity
Costs Compromise Effect (or extremeness aversion)
Sunk Costs
People’s tendency to choose an alternative that represents a
Menu
Dependence compromise or middle option in the menu.
and Decoy
Effect

Endowment E.g. A high-end brand might try to drive business to their

Effect and
Loss Aversion expensive products by introducing a super-expensive
Anchoring product; although the super-expensive product might
and
Adjustment never sell, it could make the expensive product stand out
Discussion as an attractive compromise between the cheap and the
super-expensive one.

24 / 48
 How Does One Explain the Decoy Effect?

Introduction • Perhaps consumers look for a reason to pick one option

Opportunity
Costs
over another, or to reject one of the options, in order to
Sunk Costs
feel better about their decision.
Menu • The search for reasons for action – or reason-based
Dependence
and Decoy choice – may actually be responsible for making us
Effect
behave irrationally.
Endowment
Effect and
Loss Aversion
• This is interesting, because having reasons for actions is
Anchoring
otherwise frequently seen as the hallmark of rationality.
and
Adjustment • Notice that there are cases that look like menu dependence
Discussion but which may be better described as something different.

25 / 48
 How Does One Explain the Decoy Effect?

Menu Dependence and Decoy Effect

2019-08-30 • Perhaps consumers look for a reason to pick one option
over another, or to reject one of the options, in order to
feel better about their decision.
• The search for reasons for action – or reason-based

How Does One Explain the Decoy Effect? choice – may actually be responsible for making us
behave irrationally.
• This is interesting, because having reasons for actions is
otherwise frequently seen as the hallmark of rationality.
• Notice that there are cases that look like menu dependence
but which may be better described as something different.

• For the last bullet point, consider the following example: Suppose
you enter a restaurant in a part of town you do not know very well
and are offered the choice between fish, veal, and nothing at all.
You choose the fish. Suppose, next, that the waiter returns to tell
you that the menu also includes crack-cocaine. It would be perfectly
possible, at this point, to decide you would rather not have anything
at all without violating rational-choice theory. Why? When the
waiter comes back, he does not just expand your menu, he also tells
you something about the establishment – and also that you do not
want to eat any of their food.
• before going to the next slide it makes sense to mention that one
other reason why people may ignore opportunity costs is the the
Endowment effect.
• it is a good time to distribute the next experiment: Behavioral
Economics: Handout Section 3.5 (1 of 2) and (2 of 2). Again, half
of the class must complete part 1 and another half part 2. Also
 Endowment Effect

Introduction • The endowment effect occurs when a person’s preferences

Opportunity
Costs
depend upon what they already possess.
Sunk Costs
– Example: You might pay $1 for a coffee mug at the
Menu
bookstore, but will only accept $2 or more if someone
Dependence wants to buy that mug from you.
and Decoy
Effect • This implies that a person’s preferences depend upon a
Endowment
Effect and certain reference point, perhaps determined by the
Loss Aversion
person’s possessions.
Anchoring
and • This also implies that you are irrational. Why? The next
Adjustment

Discussion
slide explains.

26 / 48
 More Formal Discussion of the Endowment Effect

• Because of completeness, if you are rational, there must

Introduction be a dollar amount p such that you are indifferent between
Opportunity p and the mug. Let p = $1
Costs

Sunk Costs
• If you have the mug, and somebody asks you what it
Menu would take to give it up, your answer would be “No less
Dependence
and Decoy
than $1,” ⇒ your willingness-to-accept (WTA) equals $1.
Effect
• If you do not have a mug, and somebody asks you what
Endowment
Effect and you would pay in order to get one, your answer would be
Loss Aversion
“No more than $1,” ⇒ willingness-to-pay (WTP) equals
Anchoring
and $1 too.
Adjustment

Discussion
• Thus, your preference between the mug and the dollar bill
should not depend on whether or not you already have a
mug, and your WTA equals your WTP.

27 / 48
 Endowment Effect Through the Lens of Utility

• Imagine your utility

Introduction
function over different
Opportunity
number of mugs (x) √ is
Costs given by u(x) = 3 x
Sunk Costs • Regardless of how many
Menu
Dependence
mugs you initially have,
and Decoy the amount of utility
Effect
received from acquiring
Endowment
Effect and another mug = the
Loss Aversion amount of utility lost when
Anchoring
and
giving it up.
Adjustment • Therefore, the utility of
Discussion gaining or loosing a mug
must be independent of
your endowment.

28 / 48
 Endowment Effect Through the Lens of Utility

Endowment Effect and Loss Aversion

2019-08-30
• Imagine your utility
function over different
number of mugs (x) √ is
given by u(x) = 3 x
• Regardless of how many
mugs you initially have,

Endowment Effect Through the Lens of Utility the amount of utility

received from acquiring
another mug = the
amount of utility lost when
giving it up.
• Therefore, the utility of
gaining or loosing a mug
must be independent of
your endowment.

Loss aversion must not be confused with diminishing marginal utility. If

people would be willing to pay less for a mug that they do not own than
they would accept in return for the mug that they do own, this may reflect
diminishing marginal utility for mugs. Going back to the figure on the
previous slide, notice that the utility derived from the second mug (that
is, the marginal utility of the second mug) is much lower than the utility
derived from the first mug. It is important not to attribute loss aversion to
agents whose behavior is better explained in terms of diminishing marginal
utility.
 Endowment Effect

• In reality, however, people require a lot more to give up a cup

when they already have one than they would be willing to pay
Introduction when they do not.
Opportunity • In one Cornell study found that the median owner asked for
Costs
$5.25 when selling a mug, while the median buyer was only
Sunk Costs
willing to pay $2.25 to $2.75 to purchase one.
Menu
Dependence • People’s preferences appear to depend on their endowment, or
and Decoy
Effect what they already possess; thus the endowment effect.
Endowment • Endowment effect and other reference-point-phenomena (such
Effect and
Loss Aversion as money illusion) are instances of the framing effects, which
Anchoring occur when people’s preferences depend on how the options are
and
Adjustment
framed.
Discussion
• Is there an explanation of the endowment effect and other
reference-point phenomena?
• Yes, loss aversion (discussed next) is one of the most prominent
explanations.
29 / 48
 Loss Aversion

Definition of Loss Aversion

The apparent fact that people dislike losses more than they like
Introduction

Opportunity
commensurate gains.
Costs

Sunk Costs • In the presence of loss aversion, your willingness-to-accept

Menu
Dependence
(WTA) does not necessarily need to be equal your
and Decoy willingness-to-pay (WTP).
Effect
• Given that losses loom larger than gains, we should expect your
Endowment
Effect and WTA to exceed your WTP.
Loss Aversion

Anchoring
• Loss aversion has radical implications for the practice of
and cost–benefit analysis. For example when deciding on whether a
Adjustment
given public good (such as a national park, highway, or else)
Discussion
must be provided, we often base out analysis on WTP.
• This reliance on WTP implies equality between WTP and WTA.
However, in reality the two should not be the same.
30 / 48
 Loss Aversion

Introduction

Opportunity
Costs
• Behavioral economists capture loss aversion by the means
Sunk Costs

Menu
of a value function v(·), which represents how a person
Dependence evaluates a change.
and Decoy
Effect • The value function is an essential part of the prospect
Endowment
Effect and theory, one of the most prominent theories to emerge
Loss Aversion
from behavioral economics.
Anchoring
and
Adjustment

Discussion

31 / 48
 Value Function

The value function has two

critical features.
Introduction
1 Unlike the utility
Opportunity
Costs function, which ranges
Sunk Costs over total endowments,
Menu the value function ranges
Dependence over changes in the
and Decoy
Effect endowment.
Endowment
Effect and
2 The value function has a
Loss Aversion kink at the reference
Anchoring point – in this case, the
and
Adjustment current endowment – in
Discussion such a way that the curve
is steeper to the left of
the origin.

32 / 48
 Value Function

• One important
Introduction implication of the value
Opportunity
function is
Costs disappointment: if you
Sunk Costs think you gain something
Menu and then think you lose
Dependence
and Decoy it, you may feel worse off
Effect
even though you find
Endowment yourself where you
Effect and
Loss Aversion started, which makes little
Anchoring sense from a traditional
and
Adjustment economic perspective.
Discussion • Imagine, I promise to give
everyone in this class an
A and then renege.

33 / 48
 Value Function: An Example of Exam Scores

Assume that Alysha and Billy have the following value function
over exam scores: v(x) = x/2 for gains and v(x) = 2x for
Introduction losses. Both of them use the expected exam score as their
Opportunity reference point.
Costs

Sunk Costs (a) Alysha expects to score 75 out of 100 on her upcoming
Menu midterm exam. She does better than expected. What is
Dependence
and Decoy her gain, in terms of value, if her final score is 93?
Effect
(b) Billy also expects to score 75 out of 100 on his upcoming
Endowment
Effect and midterm exam. He does worse than expected. What is his
Loss Aversion
loss, in terms of value, if his final score is 67?
Anchoring
and
Adjustment
(c) Insofar as you use your expectation as a reference point,
Discussion
what does value theory seem to say about maximizing
value in your life: should you perform well or poorly in
exams? Should you set high or low expectations for
yourself?
34 / 48
 Value Function: An Example of Exam Scores

Endowment Effect and Loss Aversion Assume that Alysha and Billy have the following value function

2019-08-30 over exam scores: v(x) = x/2 for gains and v(x) = 2x for
losses. Both of them use the expected exam score as their
reference point.
(a) Alysha expects to score 75 out of 100 on her upcoming
midterm exam. She does better than expected. What is

Value Function: An Example of Exam Scores her gain, in terms of value, if her final score is 93?
(b) Billy also expects to score 75 out of 100 on his upcoming
midterm exam. He does worse than expected. What is his
loss, in terms of value, if his final score is 67?
(c) Insofar as you use your expectation as a reference point,
what does value theory seem to say about maximizing
value in your life: should you perform well or poorly in
exams? Should you set high or low expectations for
yourself?

Example: Assume your value function is given by the following function

(
x/2 for gains (x ≥ 0)
v(x) =
2x for losses (x < 0)

(a) What is the increase in value you would experience if you found $10?
(b) What is the decrease in value you would experience if you lost $10?
(c) In absolute terms, which is the greater number?
(d) In fact, it is possible to be worse off in value terms even if you are
better off in dollar terms. Working with the same value function,
compute the net effect in value terms of gaining $6 and
subsequently losing $4. Assume that you incorporate the $6 into
your endowment immediately. What if you do not incorporate the
$6 gain into your endowment before losing $4
 Value Function: An Example of Exam Scores

Endowment Effect and Loss Aversion Assume that Alysha and Billy have the following value function

2019-08-30 over exam scores: v(x) = x/2 for gains and v(x) = 2x for
losses. Both of them use the expected exam score as their
reference point.
(a) Alysha expects to score 75 out of 100 on her upcoming
midterm exam. She does better than expected. What is

Value Function: An Example of Exam Scores her gain, in terms of value, if her final score is 93?
(b) Billy also expects to score 75 out of 100 on his upcoming
midterm exam. He does worse than expected. What is his
loss, in terms of value, if his final score is 67?
(c) Insofar as you use your expectation as a reference point,
what does value theory seem to say about maximizing
value in your life: should you perform well or poorly in
exams? Should you set high or low expectations for
yourself?

Example, stock market: Alicia, Benice, and Charlie own stock in the
same company. When they bought the stock, it was worth $10. It later
rose to $17, but then dropped to $12 before they sold it. The three are
loss averse and have the same value function: v(x) = x/2 for gains and
v(x) = 2x for losses.
(a) Alicia uses the selling price ($12) as her reference point. If you ask
her, how much would she say that she lost in terms of value when
the price dropped from $17 to $12?
(b) Benice uses the peak price ($17) as her reference point. If you ask
her, how much would she say that she lost in terms of value when
the price dropped from $17 to $12?
(c) Charlie uses the buying price ($10) as her reference point. If you ask
her, how much would she say that she lost in terms of value when
the price dropped from $17 to $12?
(d) Who was more disappointed when the price dropped?
 Value Function: An Example of Exam Scores

Endowment Effect and Loss Aversion Assume that Alysha and Billy have the following value function

2019-08-30 over exam scores: v(x) = x/2 for gains and v(x) = 2x for
losses. Both of them use the expected exam score as their
reference point.
(a) Alysha expects to score 75 out of 100 on her upcoming
midterm exam. She does better than expected. What is

Value Function: An Example of Exam Scores her gain, in terms of value, if her final score is 93?
(b) Billy also expects to score 75 out of 100 on his upcoming
midterm exam. He does worse than expected. What is his
loss, in terms of value, if his final score is 67?
(c) Insofar as you use your expectation as a reference point,
what does value theory seem to say about maximizing
value in your life: should you perform well or poorly in
exams? Should you set high or low expectations for
yourself?

The key is to see that Alicia and Charlie evaluate the change as a foregone
gain, whereas Benice evaluates the change as an actual loss. Given that
losses loom larger than gains, Benice suffers more.
 Loss Aversion

Loss aversion can explain a wide range of phenomena.

Introduction

Opportunity
• Many companies have no-questions-asked return policies.
Costs
• It explains why credit-card companies permit merchants to
Sunk Costs
offer ”cash bonuses” but prevent them from imposing
Menu
Dependence ”credit-card surcharges.”
and Decoy
Effect • Loss aversion also helps explain why politicians are more
Endowment
Effect and
likely to talk about canceling tax cuts than raising taxes,
Loss Aversion
even though both amount to the same phenomenon.
Anchoring
and • Loss aversion can also explain why so many negotiations
Adjustment
end in stalemate, even in the presence of potential,
Discussion
mutually beneficial agreements.

35 / 48
 Loss Aversion

Endowment Effect and Loss Aversion

2019-08-30 Loss aversion can explain a wide range of phenomena.
• Many companies have no-questions-asked return policies.
• It explains why credit-card companies permit merchants to
offer ”cash bonuses” but prevent them from imposing
”credit-card surcharges.”

Loss Aversion • Loss aversion also helps explain why politicians are more
likely to talk about canceling tax cuts than raising taxes,
even though both amount to the same phenomenon.
• Loss aversion can also explain why so many negotiations
end in stalemate, even in the presence of potential,
mutually beneficial agreements.

• For the first bullet: Although costly in other ways, such policies may serve to
convince a customer who otherwise would not make the purchase to take the
product home and try it out. Once taken home, however, the product becomes
part of the customer’s endowment and loss aversion kicks in, meaning that the
cus- tomer is unlikely to return the product.

• Second bullet point: Clients find it easier to forego a cash bonus than to suffer
the loss of a surcharge, so they are more likely to use a credit card in the
presence of the former than of the latter.

• Third bullet point: Voters find the foregone gain associated with a can- celled
tax cut easier to stomach than they do the loss associated with a tax increase.

• Fourth bullet point: Suppose two partners are negotiating the division of a pie
and that both partners think they are owed two-thirds of the pie. Any division
that strikes an outside observer as fair (including a 50–50 split) will feel like a
loss to both partners, and an agreement might be hard to come by.
 Loss Aversion

Introduction Loss aversion can also can account for the sunk-cost and
Opportunity
Costs
opportunity-costs fallacies studied earlier.
Sunk Costs • Opportunity Costs Fallacy: If people treat out-of-pocket
Menu costs as losses and opportunity costs as foregone gains,
Dependence
and Decoy loss aversion entails that out-of-pocket costs will loom
Effect
larger than opportunity costs.
Endowment
Effect and • Sunk Cost Fallacy: Since a sunk cost is often
Loss Aversion

Anchoring
experienced as a loss, loss aversion entails that such costs
and
Adjustment
will loom large, which in turn might drive people to honor
Discussion sunk costs.

36 / 48
 Microeconomic Implications of Loss Aversion

Introduction

Opportunity
Costs Loss aversion has deeper microeconomic implications.
Sunk Costs
• The standard theory presupposes that preferences are
Menu
Dependence independent of endowments. This means that that
and Decoy
Effect indifference curves are also independent of endowments.
Endowment
Effect and
• Let’s consider what would loss aversion mean in terms of
Loss Aversion representing preferences using indifference curves.
Anchoring
and
Adjustment

Discussion

37 / 48
 Loss Aversion and Indifference Curves

• Traditional indifference curves are

reversible, in the sense that they
Introduction
describes indifference between X,
Opportunity
Costs
Y, and Z independently of the
Sunk Costs
consumer endowment.

Menu • Thus, if your initial endowment is

Dependence
and Decoy
3 apples and 3 bananas (point Z),
Effect you would give up 1 bananas in
Endowment exchange for 2 apples and end up
Effect and
Loss Aversion with 5 apples and 2 bananas
• Thus, regardless of the initial
Anchoring (point Y, which caries the same
and endowment, moving from Z to Y
Adjustment
amount of utility as Z and X).
or from Y to Z (or between any
Discussion • If your initial endowment is at Y,
two points along the same
you would be willing to give up 2 indifference curve ) involves
apples for 1 bananas and end up symmetric trade offs (in this case
at point Z. 2 apples for 1 banana).
38 / 48
 Loss Aversion and Indifference Curves

• Now suppose you are loss

averse and your value function
is v(x) = x for gains and
Introduction
v(x) = 2x for losses, and that
Opportunity this is true for both apples and
Costs
bananas.
Sunk Costs
• If you start with endowment Z
Menu (3 apples and 3 bananas), and 1
Dependence
and Decoy banana is taken from you, you
Effect will ask for 2 apples in return.
Endowment This will put you on point Y
Effect and with 5 apples and 2 bananas.
Loss Aversion
• But if you start with
Anchoring
and endowment Y, and 2 apples are
Adjustment taken from you, you will ask for
Discussion 4 bananas in return (not 1),
thus you will end up at point • If you are a loss averse, there is
W(6= Z). It follows that trade one indifference curve for each
offs with loss aversion depend initial endowment.
asymmetrically on the initial
endowment. 39 / 48
 Loss Aversion and Indifference Curves

Endowment Effect and Loss Aversion • Now suppose you are loss

2019-08-30
averse and your value function
is v(x) = x for gains and
v(x) = 2x for losses, and that
this is true for both apples and
bananas.
• If you start with endowment Z
(3 apples and 3 bananas), and 1

Loss Aversion and Indifference Curves
• But if you start with
banana is taken from you, you
will ask for 2 apples in return.
This will put you on point Y
with 5 apples and 2 bananas.
endowment Y, and 2 apples are
taken from you, you will ask for
4 bananas in return (not 1),
thus you will end up at point • If you are a loss averse, there is
W(6= Z). It follows that trade one indifference curve for each
offs with loss aversion depend initial endowment.
asymmetrically on the initial
endowment.

Exercise w. a value function: Suppose that you are loss averse, and
that your value function is v(x) = x for gains and v(x) = 3x for losses.
(a) Represent the value function graphically.
(b) Represent your indifference curves graphically, in the same manner
as above, assuming that your initial endowment is 3 apples and 4
bananas.
• Go to the next slide in your notes but keep the previous slide
displayed
 Further Implications of Loss Aversion

• If you begin with endowment X and are offered to trade it

Introduction with endowment Y, you will reject it.
Opportunity
Costs
• Why?
Sunk Costs • This implies that X  Y .
Menu
Dependence
• If you begin with endowment Y and are offered to trade it
and Decoy
Effect
with endowment X, you will reject it.
Endowment • Why?
Effect and
Loss Aversion • This implies that Y  X.
Anchoring
and • The two bullet points above lead to a contradiction.
Adjustment

Discussion
• This phenomenon is sometimes referred to as status quo
bias, because you exhibit a tendency to prefer the existing
state of affairs under any circumstances.

40 / 48
 Implications of the Status Quo Bias

• Implications of the status quo bias are huge. For one, even
Introduction
famous theoretical results that deal with optimality in
Opportunity
Costs general may be challenged.
Sunk Costs • For example, the Coase Theorem, one of the most
Menu
Dependence
fundamental results in public economic that won Dr.
and Decoy
Effect
Ronald Coase a Nobel.
Endowment • Coase Theorem states that in the absence of transaction
Effect and
Loss Aversion costs, bargaining will lead to an efficient allocation even
Anchoring when external costs or benefits are present.
and
Adjustment • But to the extent that people exhibit status quo bias, they
Discussion
may fail to reach an efficient bargaining solution even
when transactions costs are zero.

41 / 48
 Implications of the Status Quo Bias

Introduction

Opportunity
Costs
• Using the notion of loss aversion and status quo bias,
Sunk Costs
explain why it will be very difficult for the Trump
Menu
administration to
Dependence
and Decoy
(a) completely repeal the Affordable Care Act (a.k.a.
Effect Obamacare) without any replacement.
Endowment (b) implement barriers for international trade.
Effect and
Loss Aversion • Again, using the notion of the status quo bias explain why
Anchoring
and
it is so hard to eliminate clutter in closet.
Adjustment

Discussion

42 / 48
 Implications of the Status Quo Bias

Endowment Effect and Loss Aversion

2019-08-30 • Using the notion of loss aversion and status quo bias,
explain why it will be very difficult for the Trump
administration to
(a) completely repeal the Affordable Care Act (a.k.a.

Implications of the Status Quo Bias Obamacare) without any replacement.

(b) implement barriers for international trade.
• Again, using the notion of the status quo bias explain why
it is so hard to eliminate clutter in closet.

• Good time to distribute the last handout of the chapter: Behavioral

Economics: Handout Section 3.6 (1 of 1). The entire class does the
same surve.
 Anchoring and Adjustment

• Why are black pearls more expensive than white pearls?

• Until mid-1970s, there was no market nor demand for Tahitian
Introduction
black pearls.
Opportunity
Costs • After many unsuccessful attempts to sell black pearls, two
Sunk Costs partners persuaded the owner of one the finest fifth-avenue
Menu jewelry stores to exhibit in the window their black-pearl jewelry
Dependence
and Decoy
with an outrageously high price tag attached. Soon after, black
Effect pearls were parading through Manhattan on the necks of the
Endowment most prosperous divas.
Effect and
Loss Aversion • How did two partners succeed in their enterprise? How do we
Anchoring accept the first price that comes before our eyes? Does that
and
Adjustment price (the anchor) have a long-term effect on our willingness to
Discussion pay for the product from then on?
• From the beginning, the sellers of black pearls anchored their
pearls to the finest gems in the world and the prices followed
ever after.
43 / 48
 Anchoring and Adjustment

Anchoring and Adjustment

2019-08-30
• Why are black pearls more expensive than white pearls?
• Until mid-1970s, there was no market nor demand for Tahitian
black pearls.
• After many unsuccessful attempts to sell black pearls, two
partners persuaded the owner of one the finest fifth-avenue
jewelry stores to exhibit in the window their black-pearl jewelry
with an outrageously high price tag attached. Soon after, black

Anchoring and Adjustment pearls were parading through Manhattan on the necks of the
most prosperous divas.
• How did two partners succeed in their enterprise? How do we
accept the first price that comes before our eyes? Does that
price (the anchor) have a long-term effect on our willingness to
pay for the product from then on?
• From the beginning, the sellers of black pearls anchored their
pearls to the finest gems in the world and the prices followed
ever after.

This story is taken from Predictably Irrational, chapter 2, two partners are
Jean Claude Brouillet (then owner of the blue lagooned paradise in French
Polynesia) and Salvator Assael (The king of pearl back then)
 Anchoring and Adjustment

Introduction

Opportunity • The above phenomenon (and many others) is explained by

Costs

Sunk Costs
what we refer to as ”anchor and adjust.”
Menu • Anchoring and adjustment: a process used when
Dependence
and Decoy forming judgments: first pick an initial estimate (an
Effect
anchor), then adjust up or down as necessary.
Endowment
Effect and • The estimate does not have to be related to the good.
Loss Aversion

Anchoring
Nor does the anchor have to be consciously chosen by the
and
Adjustment
consumer.
Discussion

44 / 48
 Heuristics and Biases

• According to one prominent account of human judgment

Introduction
and decision- making – the heuristics-and-biases
Opportunity
Costs program – we make judgments not by actually computing
Sunk Costs probabilities and utilities but by following heuristics.
Menu • A heuristic is a rule of thumb or mental shortcut that can
Dependence
and Decoy
Effect
be used when forming judgments.
Endowment • Often useful and functional in real life, under certain
Effect and
Loss Aversion circumstances, heuristics are thought to fail in predictable
Anchoring fashion.
and
Adjustment • Because the consistent application of a heuristic can lead
Discussion
to answers that are systematically and predictably wrong,
we say that it can lead to bias.

45 / 48
 Heuristics and Biases

Anchoring and Adjustment

2019-08-30 • According to one prominent account of human judgment
and decision- making – the heuristics-and-biases
program – we make judgments not by actually computing
probabilities and utilities but by following heuristics.
• A heuristic is a rule of thumb or mental shortcut that can

Heuristics and Biases be used when forming judgments.

• Often useful and functional in real life, under certain
circumstances, heuristics are thought to fail in predictable
fashion.
• Because the consistent application of a heuristic can lead
to answers that are systematically and predictably wrong,
we say that it can lead to bias.

The heuristics-and-biases program has been enormously influential, and we

will continue to discuss it. Because it carries so much explanatory power,
we will return to anchoring and adjustment repeatedly
 Anchor and Adjust is a Heuristics

Introduction • Anchoring and adjustment is one of the heuristics

Opportunity
Costs
identified by the heuristics-and-biases program. Like all
Sunk Costs heuristics, anchoring and adjustment is thought to be
Menu functional but at the same time lead to bias under certain
Dependence
and Decoy conditions.
Effect
• The final judgment will be a function of the anchor, which
Endowment
Effect and
Loss Aversion
may be perfectly arbitrary.
Anchoring • If the anchor is very different from the true answer,
and
Adjustment anchoring and insufficient adjustment can generate highly
Discussion inaccurate answers.

46 / 48
 Anchor and Adjust is a Heuristics

Anchoring and Adjustment

2019-08-30 • Anchoring and adjustment is one of the heuristics
identified by the heuristics-and-biases program. Like all
heuristics, anchoring and adjustment is thought to be
functional but at the same time lead to bias under certain

Anchor and Adjust is a Heuristics conditions.

• The final judgment will be a function of the anchor, which
may be perfectly arbitrary.
• If the anchor is very different from the true answer,
anchoring and insufficient adjustment can generate highly
inaccurate answers.

Invention of chess
 Implications of the Anchor-and-adjust Bias

Anchoring and adjustment might affect a wide range of

judgments.
Introduction • Anchor-and-adjust heuristics is irrational because it can be said
Opportunity to violate procedure invariance: the proposition that a stated
Costs preference should not differ depending on the method used to
Sunk Costs elicit it.
Menu • When placing items on sale, retailers often state the original
Dependence
and Decoy
price.
Effect • Manufacturers often post MRSP that tends to be higher than
Endowment the retail price
Effect and
Loss Aversion
• Realtors often publish an asking price that is higher than what
they expect to receive for the property.
Anchoring
and • Retailers rely on anchor-and-adjust to affect quantities sold: “3
Adjustment
for $2,” “Limit of 6 per person,” and “Buy 10 get 2 for free”
Discussion are some examples.
• A German study of experienced judges and prosecutors found
that sentencing decisions reflected irrelevant information
provided to them by the researchers.
47 / 48
 Implications of the Anchor-and-adjust Bias

Anchoring and Adjustment

2019-08-30
Anchoring and adjustment might affect a wide range of
judgments.
• Anchor-and-adjust heuristics is irrational because it can be said
to violate procedure invariance: the proposition that a stated
preference should not differ depending on the method used to
elicit it.
• When placing items on sale, retailers often state the original
price.

Implications of the Anchor-and-adjust Bias
• Manufacturers often post MRSP that tends to be higher than
the retail price
• Realtors often publish an asking price that is higher than what
they expect to receive for the property.
• Retailers rely on anchor-and-adjust to affect quantities sold: “3
for $2,” “Limit of 6 per person,” and “Buy 10 get 2 for free”
are some examples.
• A German study of experienced judges and prosecutors found
that sentencing decisions reflected irrelevant information
provided to them by the researchers.

A German study of experienced judges and prosecutors found that sen-

tencing decisions reflected irrelevant information provided to them by the
researchers. Before handing down their decisions in a realistic but fictional
case of sexual assault, the legal professionals were asked to imagine that
a journalist called to ask if the sentence would be higher or lower than
x years. The call should have no influence on the decision, but the re-
searchers found that it did: when x was 1, the recommended sentence was
25 months; when x was 3, the recommended sentence was 33 months.
Most amazingly, the difference between conditions remained significant
even when the participants in the study were told that the anchor was
generated randomly — and when it was generated randomly right before
their eyes by the rolling of dice.
 Discussion

• In this module we studied how people ignore opportunity costs

but honor sunk costs, exhibit menu dependence, overweight
Introduction losses relative to gains, and permit arbitrary anchors to unduly
Opportunity affect their behavior.
Costs • All these behaviors are inconsistent with the view that people
Sunk Costs actually behave in accordance with rational-choice theory.
Menu • Though far from universal, these deviations from rationality
Dependence
and Decoy appear to be substantial, systematic, and predictable.
Effect
• We have also reviewed some basic building blocks of theories
Endowment
Effect and that behavioral economists have proposed to account for
Loss Aversion
phenomena that cannot be captured within standard economics.
Anchoring
and
Thus, we have studied the value function of prospect theory and
Adjustment the notion of heuristic.
Discussion • We will return to prospect theory and the heuristics-and-biases
program repeatedly. Studying these theories will give you a
better idea of what behavioral economists do, beyond finding
fault with standard theory.
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