3.2 Chapter 3 - Decision-Making Under Certainty - Lecture 5 - Loss Aversion and Endowment Effect

Previous lecture • Plan for today
Chapter 3: Decision-Making under Chapter 3: Decision-Making under

Certainty Certainty
• Sunk cost • The endowment effect
• Menu dependence • Loss aversion
• Decoy effect • Value function and Prospect
Theory
• Applications of loss aversion
• Determination of Reference point
• Own endowments
• Expectations
Join: vevox.app ID: 151-454-623 POLL OPEN
A student has invested three years in a degree program but realizes it's not the right
fit. Despite the realization, the student continues with the program, thinking it's too
late to change. What is influencing this decision?
1. Rational decision-making
2. Confirmation bias
3. Opportunity cost consideration
✓ 4. Sunk cost fallacy
Angner – A Course in Behavioral Economics (3rd Edition)

Macmillan International Higher Education
Behavioral economics suggests that rational

decision-making should:
1. Always consider sunk costs
2. Ignore both sunk costs and opportunity costs
✓ 3. Evaluate opportunity costs when making decisions
4. Prioritize sunk costs over opportunity costs

How can individuals avoid falling prey to the

sunk cost fallacy?
1. By prioritizing sunk costs over opportunity costs
2. By considering only future costs
✓ 3. By evaluating decisions based on present circumstances
4. By ignoring all past costs

The endowment effect
• In neoclassical economics, preferences independent of
your endowment
• Meaning what you have at the time of decision does not effect
the decision.
• Example: preferences for coffee mugs
• Assuming you prefer more money to less,
• you prefer $1 to $0, and $2 to $1
• There must be a dollar amount p (not necessarily in
whole dollars and cents) such that you are indifferent
between p and the mug
• If p is one dollar
Angner – A Course in Behavioral Economics (3rd Edition) Macmillan International Higher Education
• If you have the mug, and somebody asks you what it would take to
give it up
• Answer: No less than $1 OR willingness-to-accept (WTA) equals $1
• If you do not have a mug, and somebody asks you what you would
pay in order to get one
• Answer: No more than $1 OR willingness-to pay (WTP) equals $1 too
• Your preference between the mug and the dollar bill does not depend
on whether or not you already have a mug.
• WTA equals your WTP.
• Your preference for a second mug
might depend, however, on
whether you already have a mug
• the utility of the first mug is
independent of your endowment
• People do not in general behave this way.
• People require a lot more to give up a cup when they already have
one than they would be willing to pay when they do not.
• Experiment Cornell University coffee mugs, the median owner asked
for $5.25 when selling a mug
• while the median buyer was only willing to pay $2.25 to $2.75 to
purchase one
• This phenomenon is referred to as the endowment effect
• Because people’s preferences appear to depend on their endowment
or what they already possess
Reference-point phenomena
• people assess various options might depend on a reference point – in this
case, their current endowment
• Phenomena like these are sometimes referred to as reference-point
phenomena.
• Instances of framing effects
• Which occur when people’s preferences depend on how the options are framed.
• In 2007, the Associated Press reported that Irishman David Clarke was
likely to lose his license after being caught driving 180 km/h (112 mph) in a
100 km/h (62 mph) zone.
• However, the judge reduced the charge, “saying the speed [in km/h]
seemed ‘very excessive,’ but did not look ‘as bad’ when converted into
miles per hour.” The judge’s assessment appears to depend on whether
Clarke’s speeding was described in terms of km/h or mph.
Reference-point phenomena
• Similarly, people traveling to countries with a different currency
sometimes fall prey to what is called money illusion.
• Even if you know that one British pound equals about one and a half
US dollars,
• paying two OMR for a drink might strike you as better than paying
four pounds.
How much is your happiness if you gifted

1000 OMR
1. 1 (least happy)
0%
2. 2
0%
✓ 3. 3
0%
4. 4
9.09%
5. 5
27.27%
6. 6 (maximum happiness)
63.64%
Angner – A Course in Behavioral Economics (3rdEdition)
Macmillan International
Higher Education
How much is your unhappiness if you lost

1000 OMR
1 1 (least unhappy)
25%
2 2
0%
✓3 3
8.33%
4 4
0%
5 5
0%
6 6 (maximum unhappiness)
66.67%
Angner – A Course in Behavioral Economics (3rdEdition)
Macmillan International
Higher Education
loss aversion
• People dislike losses more than they like commensurate gains
• Brad Pitt character in Moneyball says “I hate losing more than I even
wanna win,” that is loss aversion.
• It is reflected in the fact that many people are more upset when they
lose something than pleased when they find the same thing.
• Adam Smith noted this very phenomenon when he wrote
• “Pain … is, in almost all cases, a more pungent sensation than the
opposite and correspondent pleasure.”
loss aversion
• In the language of framing, we will say that how much you value a
$10 bill depends on whether it is framed as
• a (potential) loss, or
• as a (potential) gain
WTA vs. WTP
• In the presence of loss aversion: Your willingness-to-accept (WTA) does
not in general equal your willingness to-pay (WTP)
• WTA ≠ WTP
• willingness-to-accept (WTA): you are asked to imagine that you have some
good and to state what dollar amount you would be willing to accept in
order to give the good up, meaning that the good will be evaluated in the
loss frame.
• willingness to-pay (WTP): you are asked to imagine that you do not have
some good and to state what dollar amount you would be willing to pay in
order to acquire the good, meaning that the good will be evaluated in the
gain frame.
• WTA > WTP
WTA vs. WTP
• loss aversion has radical implications for the practice of cost— benefit
analysis
• It is quite common to assess the value of goods by eliciting people’
willingness-to-accept (WTA) or willingness-to-pay (WTP).
• Particularly common in the case of public goods, like nature
preserves, and other goods that are not traded on an open market.
Value function
• Behavioral economists capture loss aversion by means of a value
function v(·)
• The value function is an essential part of prospect theory, which is
one of the most prominent theories to emerge from behavioral
economics (e.g., in Sections 7.2, 7.3 and 7.6).
• Utility function, which ranges over total endowments,
• Value function ranges over changes relative to some reference point.
• the value function has a kink at the reference point
• In this case, the current endowment – in such a way that the curve is
steeper to the left of the origin
Value function
• the vertical distance between the
origin and v(−1)
• the vertical distance between the
origin and v(+1).
• |v(−1)| > | v(+1) |.
• this captures the fact that losses
loom larger than gains
• people dislike losses more than
they like the commensurate gains
Another implication:
• Consider that if you gain something and
then lose it,
• you may feel worse off even though you find
yourself where you started
• Suppose your parents promise to buy you
a car if you graduate with honors, but
after you do they reveal that they were
lying
• Example 3.34 Toy Yoda In 2001, a Florida waitress working for an
establishment sued her employer for breach of contract, alleging that
she had been promised a new car for winning a sales contest. The
manager had promised her a “new Toyota” but when she claimed her
prize, she found out that she had won a “new Toy Yoda” – meaning a
Star Wars figure. She was understandably upset. Loss aversion
explains why: being subjected to that kind of prank leaves a person
worse off than she was before, even if her total endowment remains
unchanged.
Losses and gains:
• How the value function can be used in practice
• What is the increase in value you would experience if you found $10?
• What is the decrease in value you would experience if you lost $10?
• In absolute terms, which is the greater number?
• https://www.youtube.com/watch?v=D9U5EdFP9EI
• Endowment Effect: Trying To Buy People's Lottery Tickets | Why Are
We All So Stupid?
Exercise 3.37: Having and losing
• It is possible to be worse off in value terms even if you are better off in
dollar terms.
• gaining 6: V(6) = 6/3 = 2

• Loosing 4: V(4) = 2*4 = 8 Value loss of 6
• If you do not incorporate the $6 gain into your endowment, and therefore
do not change your reference point before losing the $4
• V(+6-4) = v(2) = 1
Exercise 3.38: The bond market
• An ill-fated investment of yours in the junk bond
market just decreased from $1 to $0. Your value
function is
• v(x) = x/2 for gains and
• v(x) = 2x for losses.
a) Suppose, first, that your reference point is $0.
In value terms, how large is the loss you just
experienced?
In terms of deviations from a reference point of $0, the
drop in price corresponds to a drop from +1 to 0. In
value terms, that corresponds to a drop from v(+1) =
0.5 to v(0) = 0.
So the change in value is v(0) − v(+1) = 0 − 0.5 = −0.5.
Exercise 3.38: The bond market
• Suppose, instead, that your reference point is $1. In value terms, how large
is the loss you just experienced?
• In terms of deviations from a reference point of $1, the drop in price
corresponds to a drop from 0 to −1.
• In value terms, that corresponds to a drop from v(0) = 0 to v(−1) = −2. So
the change in value is v(−1) − v(0) = −2 − 0 = −2.
• With a reference point of $0, you experience a loss of 0.5 units of value;
• With a reference point of $1, you experience a loss of 2 units of value.
Since a loss of 2 is worse than a loss of 0.5, using a reference point of $1
makes you feel worse than a reference point of $0.
Exercise 3.40 Thievery
• A thief steals $100 from a victim. Let us suppose that the thief and victim
have the same value function over money:
• How much, in value terms, does the thief gain as a result of his robbery?
• V(100) = 100/2 = 50
• How much, in value terms, does the victim lose as a result of the robbery?
• V(100) = 100*2 = 200
• Assuming that it makes sense to compare the thief ’s gain and the victim’s
loss, and ignoring any other consequences of the crime, what is the total
effect of the robbery in value terms?
• Value loss = 50 – 200 = -150
Exercise 3.41 The tax cut (understand yourself)
• Suppose Alex and Bob are loss averse, so that their value function is
• politician R promises a tax cut which would give each citizen an additional $2 in his or her
pocket every day
• Politician D opposes the tax cut.
• Ultimately D wins the election. Neither Alex nor Bob receives the additional $2
per day.
• Bob was sure that R would win the election, and started thinking of the $2 as part
of his endowment. He thinks of the $2 as an actual loss. What would he say D’s
election cost him in terms of value?
• Bob thought of the $2 as a loss, so for him the absolute value of the $2 was 4.
Mathematically, the change in value can be computed as v(−2) − v(0) = −4 − 0 =
−4.
Exercise 3.41 The tax cut (understand yourself)
• Suppose Alex and Bob are loss averse, so that their value function is v(x) = x/2 for
gains and v(x) = 2x for losses.
• politician R promises a tax cut which would give each citizen an additional $2 in his or her
pocket every day
• Politician D opposes the tax cut.
• Ultimately D wins the election. Neither Alex nor Bob receives the additional $2
per day.
• Alex thought D would win the election and never thought of the additional $2 as
part of her endowment. She thinks of the $2 as a forgone gain. What would she
say D’s election cost her in terms of value?
• Alex thought of the $2 as a forgone gain, so for her the absolute value of the $2
was 1. Mathematically, the change in value can be computed as v(0) − v(+2) = 0 −
2/2 = −1.
• Who is likely to be more disappointed, Alex or Bob?
Loss aversion can explain a wide range of phenomena.
• Why many companies have 30-day no-questions-asked return
policies.
1. Once taken home, however, the product becomes part of the
customer’s endowment and loss aversion kicks in,
2. Loss aversion helps explain why politicians argue about whether
cancelling tax cuts amounts to raising taxes.
• Voters find the forgone gain associated with a cancelled tax cut easier to
stomach than they do the loss associated with a tax increase
• Consequently, politicians favoring higher taxes will talk about “cancelled tax
cuts”
• whereas politicians opposing higher taxes will talk about “tax increases.”
4. 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 (hard to come by)
5. Loss aversion can also explain why the volume of real-estate sales
decreases in an economic downturn.
Sellers may find it so hard to sell their house at a loss, relative to the price at
which the property was purchased, that they would rather not sell it at all.
Loss aversion and opportunity cost
• If people treat out-of-pocket costs as losses
• opportunity costs as forgone gains,
• loss aversion entails that out-of-pocket costs will loom larger than
opportunity costs
Loss aversion and Sunk Cost
• Loss aversion may also help explain why people are so prone to
honoring sunk costs
• Since a sunk cost is often experienced as a loss,
• loss aversion entails that such costs will loom large, which in turn
might drive people to honor sunk costs.
Determination of Reference point
• Determined by a person’s current endowment.
• A person’s reference point can be determined by her aspirations and
expectations
• Explains how people who get a five percent raise can feel cheated if
they expected a ten percent raise,
• but be absolutely overjoyed if they did not expect a raise at all.
Exercise 3.44 Exam scores
• Assume that Alysha and Billy have the following value function over
exam scores:
• Both of them use the expected exam score as their reference point.
• Alysha expects to score 75 out of 100 on her upcoming midterm
exam. She does better than expected. What is her gain, in terms of
value, if her final score is 93?
• v(+93 − 75) = v(+18) = 9
Exercise 3.44 Exam scores
• 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?
• v(+67 − 75) = v(−8) = −16
• What does the 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?
Barry Bond’s Salary
• When Pittsburgh Pirate outfielder Barry Bonds’
• salary was raised from $850,000 in 1990 to $2.3 million in 1991, instead of the $3.25
million he had requested,
• Bonds sulked, “There is nothing Barry Bonds can do to satisfy Pittsburgh. I’m so sad
all the time.”
• Behavioral economists use the term aspiration treadmill to refer to a
process where increasing endowments lead to rising aspirations
• people like Barry Bonds are no where near as happy with their $2.3 million
salary when they have it as they thought they would be before they started
making that kind of money
• Aspiration treadmill is often invoked to explain the fact that the marginal
happiness of money is sharply diminishing
Taxes on rich and poor
• Traditional economic theory suggest:
• Rich person who loses money would experience a much smaller loss in utility
than a poor person would.
• Many affluent people dislike, e.g., paying taxes no less than poor
people do.
• aspiration treadmill
https://www.youtube.com/watch?v=SdJSjj2A710

3.2 Chapter 3 - Decision-Making Under Certainty - Lecture 5 - Loss Aversion and Endowment Effect

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

3.2 Chapter 3 - Decision-Making Under Certainty - Lecture 5 - Loss Aversion and Endowment Effect

Uploaded by

Copyright:

Available Formats

Previous lecture • Plan for today

Chapter 3: Decision-Making under Chapter 3: Decision-Making under

3. Opportunity cost consideration

✓ 4. Sunk cost fallacy

Angner – A Course in Behavioral Economics (3rd Edition)

Behavioral economics suggests that rational

2. Ignore both sunk costs and opportunity costs

✓ 3. Evaluate opportunity costs when making decisions

4. Prioritize sunk costs over opportunity costs

Angner – A Course in Behavioral Economics (3rd Edition)

How can individuals avoid falling prey to the

2. By considering only future costs

✓ 3. By evaluating decisions based on present circumstances

4. By ignoring all past costs

Angner – A Course in Behavioral Economics (3rd Edition)

How much is your happiness if you gifted

How much is your unhappiness if you lost

• gaining 6: V(6) = 6/3 = 2

You might also like