Loss Aversion, Endowment Effect & Sunk Costs Psychology 466: Judgment & Decision Making Instructor: John Miyamoto 11/16/2017: Lecture 08-2 Note: This Powerpoint presentation may contain macros that I wrote to help me create the slides. The macros aren’t needed to view the slides. You can disable or delete the macros without any change to the presentation.

Lecture probably ends here Outline Loss aversion What is loss aversion? How is loss aversion different from risk aversion? Is loss aversion due to pain of losing something or a change in attractiveness when you own something? Framing effects that result from loss aversion Endowment effect Sunk costs Affective forecasting Lecture probably ends here Psych 466, Miyamoto, Aut '17 Table Showing Differences Between Prospect Theory and EU Theory

How Prospect Theory (PT) Differs From Expected Utility (EU) Theory 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 but not all 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 shape of 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. Psych 466, Miyamoto, Aut '17 Same Slide with Focus on Loss Aversion

How Prospect Theory (PT) Differs From Expected Utility (EU) Theory 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 but not all 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 shape of 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. Psych 466, Miyamoto, Aut '17 Graph Showing Loss Aversion

A loss has greater impact than an objectively equal gain. Loss Aversion A loss has greater impact than an objectively equal gain. Loss aversion – the pain of losing X is greater than the pleasure of gaining X. Example: the pleasure of unexpectedly finding $200 is less intense than ... the pain of unexpectedly losing $200. Psych 466, Miyamoto, Aut '17 Credit Cards: Cash Discount versus Credit Card Surcharge

Gasoline Price: Cash Discount or Credit Card Surcharge During 1979 oil crisis, the oil companies wanted to charge a fee for using a credit card to buy gasoline. Federal Regulatory Issue: How should prices be labeled? Labeling Solution 1: The gas price should be labeled 94¢ / gallon for cash with a 3¢ / gallon credit card surcharge. Labeling Solution 2: The gas price should be labeled 97¢ / gallon on a credit card with a 3¢ / gallon cash discount. Question: Assuming that the oil companies wanted to encourage the use of credit cards, which solution will cause more consumers to use credit cards? Why? This is a practical example of how framing can influence consumer behavior. * Labeling the 3 cents per gallon difference as a cash discount will result in greater use of the credit cards. Why? Because people will be less motivated to “gain” 3 cents per gallon than motivated to avoid “losing” 3 cents per gallon. Calling the 3 cents difference a “credit card surcharge” makes it feel like you are losing an additional 3 cents for each gallon of gas. Psych 466, Miyamoto, Aut '17 Wine Owner Example

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? Is it illogical or irrational? Psych 466, Miyamoto, Aut '17 Endowment Effect & Loss Aversion

Endowment Effect (Definition) Definition: The incentive to have something that one does not have is less than the incentive not to lose the same thing if one has it. Example: Suppose that Mr. A and Mr. B have identical values and they both regard X as a desirable object. If .... Mr. A owns an X. 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. A loss has greater impact than an objectively equal gain. Psych 466, Miyamoto, Aut '17 Experimental Demonstration of Endowment Effect

Experimental Demonstration of Endowment Effects $ = dependent variable Gain Lose Sellers $ min selling price Mug Buyers $ max buying price Choosers $  Mug --- 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. Three conditions (between subjects). $ = dependent variable Sellers were given a mug, and were asked for their minimum selling prices. Buyers were shown a mug and were asked for the maximum buying prices. 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. Predictions Psych 466, Miyamoto, Aut '17

Predictions Gain Lose Sellers $ min selling price Mug Buyers $ = dependent variable Gain Lose Sellers $ min selling price Mug Buyers $ max buying price Choosers $  Mug --- EU theory predicts same average price for all three groups. Loss Aversion Hypothesis: Sellers should set a high selling price to compensate for loss of mug. 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. Choosers suffer no loss aversion. Their responses should be intermediate. Contrasting: Pain of Loss Versus Change in Attractiveness Psych 466, Miyamoto, Aut '17

Results Gain Lose Sellers $ min selling price Mug Buyers $ max buying price Choosers $  Mug --- Sellers: $7.12; Buyers: $2.87; Choosers: $3.12 Sellers' Price > Choosers' Price > Buyers' Price: Demonstrates occurrence of an endowment effect. Violates EU theory. Chooser's Price & Buyers' Price are similar. Endowment effect much bigger for loss of mug than for loss of cash. Psych 466, Miyamoto, Aut '17 What Causes Loss Aversion: Pain of Loss Versus Change in Attractiveness

What Causes the Endowment Effect? Pain of Loss Hypothesis: The endowment effect results from loss aversion. Change in Perception Hypothesis: Once you own something, you perceive it as more desirable than before owning it. Possibly possessing an object changes how people evaluate an object. Psych 466, Miyamoto, Aut '17 Experimental Test of Pain of Loss Versus Change in Perception

Rate Attractiveness of Pen Choose Pen or Candy Bars Is Endowment Effect Due to Pain of Loss or a Change in Perceived Value? Loewenstein & Kahneman (1991): Half the subjects received a pen (Owners). Half the subjects received a token that could be redeemed later for a prize (Non-owners) All subjects rated the attractiveness of 6 possible prizes (the pen was among them). In the end, all subjects were then allowed to choose between the pen and 2 candy bars. Rate Attractiveness of Pen Choose Pen or Candy Bars Owners Rating of Pen % Choosing Pen Non-Owners Psych 466, Miyamoto, Aut '17 Predictions Based on Hypotheses of Pain of Loss and Change in Value

Rate Attractiveness of Pen Choose Pen or Candy Bars Predictions Rate Attractiveness of Pen Choose Pen or Candy Bars Owners Rating of Pen % Choosing Pen Non-Owners Loss Aversion Hypothesis Predicts: (A) Owners' Ratings of Pen = Non-Owners Ratings of Pen (B) % Owners Keep Pen > % Non-Owners Choose Pen Change in Value (of Pen) Hypothesis Predicts: (A') Owners' Ratings of Pen > Non-Owners Ratings of Pen (B') % Owners Keep Pen > % Non-Owners Choose Pen Different Same Psych 466, Miyamoto, Aut '17 Same Slide w-o Colored Brackets

Rate Attractiveness of Pen Choose Pen or Candy Bars Predictions Rate Attractiveness of Pen Choose Pen or Candy Bars Owners Rating of Pen % Choosing Pen Non-Owners Loss Aversion Hypothesis Predicts: (A) Owners' Ratings of Pen = Non-Owners Ratings of Pen (B) % Owners Keep Pen > % Non-Owners Choose Pen Change in Value (of Pen) Hypothesis Predicts: (A') Owners' Ratings of Pen > Non-Owners Ratings of Pen (B') % Owners Keep Pen > % Non-Owners Choose Pen Psych 466, Miyamoto, Aut '17 Results for Owners and Non-Owners

Results for Owners and Non-Owners of the Pen Key Finding: Attractiveness ratings for the pen were the same in the two groups. Result supports loss aversion hypothesis (supports Prediction (A)) Result contradicts change in value hypothesis (contradicts Prediction (A') Conclusion: Endowment effect occurs because of pain of loss, not change in attractiveness. Secondary Result: Owners Non-Owners % who chose to keep the pen 56% > 24% Same prediction, (B) and (B') for loss aversion hypothesis and for change of value hypothesis. Psych 466, Miyamoto, Aut '17 Real World Example – Auto Insurance Example

The Auto Insurance Example Described in KK&T and in Hammond, Keeney & Raiffa (1998: The hidden traps in decision making, Harvard Business Review, 76, 47-8). Two auto insurance policies: Cheaper policy restricts the right to sue; 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. 80% of the New Jersey citizens kept the cheaper policy (did not change from the cheaper to the expensive policy) 25% of the Pennsylvania citizens chose the cheaper policy (changed from the expensive to the cheaper policy). Psych 466, Miyamoto, Aut '17 Wine Example - Table Showing the Transaction

The Wine Example (Again) KK&T: Kahneman, D., Knetsch, J. L., & Thaler, R. H. (1991). The endowment effect, loss aversion, and status quo bias. Journal of Economic Perspectives, 5, 193-206. A wine-lover bought wine for $10 / bottle, but now it is worth $200 / bottle at auction. This wine-lover is not willing to pay $200 / bottle for more bottles of this wine. This wine-lover would not sell any of his wine for $200 / bottle. Gain Lose Comment Sell One Bottle $200 1 Bottle Gain of $200 is less valued than loss of 1 bottle. Don't Sell & Don’t Buy nothing No gains, no losses. Buy One More Bottle Gain of 1 bottle is less valued than loss of $200. Psych 466, Miyamoto, Aut '17 Endowment Effect - Conclusions

Endowment Effect - Conclusions Endowment effects appear to be due to a difference between willingness to give something up and incentive to acquire something new. 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. Psych 466, Miyamoto, Aut '17 Sunk Costs

Sunk Costs – Football Ticket Example Sunk Cost Fallacy: Continue to invest in something because you have already invested a large amount in this thing. EXAMPLE: 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: if you didn't already have tickets and someone offered to take you to the game for free, you wouldn't go; .... but if you have already paid for the tickets, you feel that you should go to the game; so you go. I.e., are you prone to honor sunk costs in this situation? Analysis of the Football Ticket Example Using Mental Accounting and Loss Aversion Psych 466, Miyamoto, Aut '17

Analysis of Football Ticket Example 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!) 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 '17 Another Sunk Cost Example – Government Spending on Projects

When Do We Feel We Should Honor Sunk Costs? Example: Government has spent $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 analysis of this choice: 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”.) Option 2: We “lose” $1.5 B (the initial cost). We "gain" the opportunity to use the $1 B that we didn't spend, or we leave it in the tax payers' pockets. Psych 466, Miyamoto, Aut '17 How to Avoid Sunk Cost Fallacies

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. Return to the Table that Compares EU Theory to Prospect Theory Psych 466, Miyamoto, Aut '17

Observed Preference Behavior, Prospect Theory & EU Theory Expected Utility Theory Prospect Theory Evidence 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). Framing effects. Reflection effect when probabilities are not small. The utility function is risk averse everywhere. (Not all theorists) The value function is risk averse for gains, risk seeking for losses. Reflection effect. People buy lottery tickets. Loss aversion cannot be defined (EU theory does not identify a status quo.) The shape of the value function implies loss aversion. Endowment effect. Sunk cost fallacy. People evaluate probabilities linearly. People evaluate probabilities nonlinearly. Allais paradox Small probabilities are overweighted. 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. Framing effects, e.g., mental accounting and effects of shifts in the status quo. All outcomes are evaluated with respect to one big account. People evaluate gains and losses with respect to mental accounts. Mental accounting. Psych 466, Miyamoto, Aut '17 Same Slide without Emphasis Rectangle

Observed Preference Behavior, Prospect Theory & EU Theory Expected Utility Theory Prospect Theory Evidence 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). Framing effects. Reflection effect when probabilities are not small. The utility function is risk averse everywhere. (Not all theorists) The value function is risk averse for gains, risk seeking for losses. Reflection effect. People buy lottery tickets. Loss aversion cannot be defined (EU theory does not identify a status quo.) The shape of the value function implies loss aversion. Endowment effect. Sunk cost fallacy. People evaluate probabilities linearly. People evaluate probabilities nonlinearly. Allais paradox Small probabilities are overweighted. 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. Framing effects, e.g., mental accounting and effects of shifts in the status quo. All outcomes are evaluated with respect to one big account. People evaluate gains and losses with respect to mental accounts. Mental accounting. Psych 466, Miyamoto, Aut '17 Outline of Affective Forecasting Topic

Outline of Affective Forecasting Topic Affective forecasting - what is it? Examples of affective forecasting Focusing illusion Impact bias Duration bias Lecture ends here Psych 466, Miyamoto, Aut '17 Why Do People Have Difficulty with Affective Forecasting?

Thursday, 16 November, 2017: The Lecture Ended Here Psych 466, Miyamoto, Aut '17