Download presentation
Presentation is loading. Please wait.
1
Introduction to Prospect Theory
Psychology 466: Judgment & Decision Making Instructor: John Miyamoto 11/14/2017: Lecture 08-1 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.
2
Lecture probably ends here
Outline Risk attitude & origins of prospect theory The reflection effect Framing effects that result from reflection effects Loss aversion Framing effects that result from loss aversion Endowment effect Sunk costs Lecture probably ends here Psych 466, Miyamoto, Aut '17 Reminder: Concept of Risk Attitude
3
Risk Attitude Risk averse action: A person chooses a sure-thing X over a gamble G where X is less than the expected value of G. A risk averse person prefers a sure win of $500 over a gamble for $1,010 or $0. Risk seeking action: A person chooses a gamble G over a sure thing X where the expected value of G is less than X. A risk seeking person prefers a gamble for $1000 or $0 over a sure win of $505. Expected value of gamble = $505 Sure win of $500 < $505 Expected value of gamble = $500 Sure win of $505 > $505 Same Slide without Screen over Upper Half Psych 466, Miyamoto, Aut '17
4
Risk Attitude Risk averse action: A person chooses a sure-thing X over a gamble G where X is less than the expected value of G. A risk averse person prefers a sure win of $500 over a gamble for $1,010 or $0. Risk seeking action: A person chooses a gamble G over a sure thing X where the expected value of G is less than X. A risk seeking person prefers a gamble for $1000 or $0 over a sure win of $505. Expected value of gamble = $505 Sure win of $500 < $505 Expected value of gamble = $500 Sure win of $505 > $505 Examples of Risk Aversion & Risk Seeking Psych 466, Miyamoto, Aut '17
5
Reminder:. Risk aversion & risk seeking preferences
Reminder: Risk aversion & risk seeking preferences are related to the curvature of the utility function for money. Psych 466, Miyamoto, Aut '17
6
Kahneman & Tversky’s Insights into Risk Attitude
Important Idea #1: People tend to risk averse for gains and risk seeking for losses. Even More Important Idea #2: These concepts, risk aversion and risk seeking, apply to gains and losses, not to states of wealth. Table: The Fourfold Pattern of Risk Attitude Psych 466, Miyamoto, Aut '17
7
The Fourfold Pattern of Risk Attitude (Risk Propensity)
Small Probabilities Medium to Large Probabilities Gains Risk-Seeking Risk Averse Losses Risk-Averse To understand this table, we need to remember how EU theory explains risk attitude. Risk Aversion & Utility Curvature Psych 466, Miyamoto, Aut '17
8
Assuming EU Theory, risk aversion is related to the curvature of the utility function
The certainty equivalent (CE) is the sure-thing that is equally desirable as a gamble. Two 90% Truths*: When the utility function is more concave (bulge in curve on upper side), then choices become more risk averse. When the utility function is more convex (bulge in curve on lower side), then choices become more risk seeking. * "90% Truth" means "regard it as true if you are an undergrad" and "usually true, but there are exceptions" if you are a grad student. Utility Expected Value $ in Thousands Utility Expected Value $ in Thousands Return to Table that Shows the Fourfold Pattern of Risk Propensity Psych 466, Miyamoto, Aut '17
9
Reflection Effect (More Accurate Version) – the Fourfold Pattern
Small Probabilities Medium to Large Probabilities Gains Risk-Seeking Risk Averse Losses Risk-Averse Definition: The reflection effect is the finding that preferences switch from risk averse to risk seeking if we change the outcomes from gains or losses. The direction of the change, from risk averse to risk seeking or from risk seeking to risk averse, depends on the size of the probabilities. Psych 466, Miyamoto, Aut '17 Ask the Class for Examples in Each Cell of this Table
10
Reflection Effect (More Accurate Version) – the Fourfold Pattern
Small Probabilities Medium to Large Probabilities Gains Examples? Losses Definition: The reflection effect is the finding that preferences switch from risk averse to risk seeking if we change the outcomes from gains or losses. Psych 466, Miyamoto, Aut '17 Show Class Your Examples in Each Cell of This Table
11
Reflection Effect (More Accurate Version) – the Fourfold Pattern
Definition: The reflection effect is the finding that preferences switch from risk averse to risk seeking if we change the outcomes from gains or losses. Psych 466, Miyamoto, Aut '17 Same Slide w-o the Emphasis Rectangles
12
Reflection Effect (More Accurate Version) – the Fourfold Pattern
Definition: The reflection effect is the finding that preferences switch from risk averse to risk seeking if we change the outcomes from gains or losses. Psych 466, Miyamoto, Aut '17 Graphs: Prospect Theory Value Function & Prob Weighting Function
13
Reflection Effect – The Fourfold Pattern of Risk Attitude
Small Probabilities Medium to Large Probabilities Gains Risk-Seeking Risk Averse Losses Risk-Averse Psych 466, Miyamoto, Aut '17 Same Slide w-o Emphasis Rectangles
14
Reflection Effect – The Fourfold Pattern of Risk Attitude
Small Probabilities Medium to Large Probabilities Gains Risk-Seeking Risk Averse Losses Risk-Averse Psych 466, Miyamoto, Aut '17 Transition: Next We Will Focus on Column 3
15
Reflection Effect (More Accurate Version) – the Fourfold Pattern
Small Probabilities Medium to Large Probabilities Gains Risk-Seeking Risk Averse Losses Risk-Averse Next: Focus of examples will be here. Definition of the Reflection Effect: The reflection effect is the finding that preferences switch from risk averse to risk seeking if we change the outcomes from gains or losses. Psych 466, Miyamoto, Aut '17 Asian Disease Problem - Gain Frame
16
Asian Disease Problem (Gain Frame)
Problem 1: Imagine that the US is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume that the exact scientific estimates of the consequences of the programs are as follows: If Program A is adopted, 200 people will be saved. If Program B is adopted, there is 1/3 probability that 600 people will be saved, and 2/3 probability that no people will be saved. Which of the two programs would you favor? Psych 466, Miyamoto, Aut '17 Asian Disease Problem – Loss Frame
17
Asian Disease Problem (Loss Frame)
Problem 2: Imagine that the US is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume that the exact scientific estimates of the consequences of the programs are as follows: If Program C is adopted 400 people will die. If Program D is adopted there is 1/3 probability that nobody will die, and 2/3 probability that 600 people will die. Which of the two programs would you favor? Psych 466, Miyamoto, Aut '17 Results for Asian Disease Problem
18
Results of Outcome Framing & Reflection Effect
Asian Disease Problem: Imagine that the US is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Gain Frame (N = 152) Loss Frame (N = 155) If Program A is adopted, 200 people will be saved. If Program B is adopted, there is 1/3 probability that 600 people will be saved, and 2/3 probability that no people will be saved. Which of the two programs would you favor? If Program C is adopted 400 people will die. If Program D is adopted there is 1/3 probability that nobody will die, and 2/3 probability that 600 people will die. Which of the two programs would you favor? 72% 22% 28% 78% Psych 466, Miyamoto, Aut '17 Relation Btwn Asian Disease Problem & Shape of Value Function
19
Asian Disease Problem - Conclusion
Changing the description of choices from an emphasis on gains to an emphasis on losses changes the preferences from risk averse to risk seeking. Asian disease problem is an example of a framing effect. This kind of framing is called “outcome framing” because outcomes are described either as potential gains or potential losses. Psych 466, Miyamoto, Aut '17 Definition of Framing Effects
20
Framing Effects By definition, a framing effect is a change in preference that occurs when: the description of the problem is changed, and ... the content of the problem is not changed (same outcomes and same probabilities in the two problems). By “content” I mean the logical structure of the problem If two problems are logically equivalent, they have the same content. EU theory assumes that framing effects will not occur. Problem descriptions should not matter if the content stays the same. EU theory defines the calculation of expected utility in terms of the actual gambles and outcomes, not in terms of a particular manner of presenting the gambles and outcomes. Psych 466, Miyamoto, Aut '17 Why Gain/Loss Framing Changes Preferences
21
Framing Effects Due To Reflection & Gain/Loss Framing
Prospect theory (PT) predicts that framing effects can occur when we change the problem description from gains to losses (without changing the objective problem) because ... … people are risk averse for gains and risk seeking for losses; and ... … people are sensitive to changes in value rather than the objective outcomes. EU theory denies (2). In the past, many EU theorists would also deny (1). Psych 466, Miyamoto, Aut '17 Adjustment of Status Quo in Prospect Theory
22
Adjustment of Reference Level – Redefinition of Gains & Losses
What happens when you get richer? E.g., you finish school and get a job? Do you start becoming risk averse for small losses? Example: Hopefully, 5 years from now you will be substantially richer. Will your risk attitude be determined by a shift to the right along the X-axis of the graph? New Wealth Adaptation Level Theory Example – Adaptation to ambient lighting in a room. Example – Adaptation to current level of wealth Redefinition of gains and losses. Psych 466, Miyamoto, Aut '17 Gain/Loss Framing & Pref Btwn Gambles
23
Framing Effect in Gambles for Apparent Gains or Losses
Assume yourself richer by $300 than you are today. Now choose between (a) and (b): (a) A sure gain of $100. (b) A 50% chance to gain $200 and a 50% chance to gain nothing. Assume yourself richer by $500 than you are today. Now choose between (a') and (b'): (a') A sure loss of $100. (b') A 50% chance to lose nothing and a 50% chance to lose $200. Psych 466, Miyamoto, Aut '17 Same Slide with All Text and Results Displayed
24
Framing Effect in Gambles for Apparent Gains or Losses
Assume yourself richer by $300 than you are today. Now choose between (a) and (b): (a) A sure gain of $100. (b) A 50% chance to gain $200 and a 50% chance to gain nothing. Assume yourself richer by $500 than you are today. Now choose between (a') and (b'): (a') A sure loss of $100. (b') A 50% chance to lose nothing and a 50% chance to lose $200. 72% prefer (a) in K&T experiment 36% prefer (b’) in K&T experiment Psych 466, Miyamoto, Aut '17 Same Slide with All Results Displayed
25
Framing Effect in Gambles for Apparent Gains or Losses
Assume yourself richer by $300 than you are today. Now choose between (a) and (b): (a) A sure gain of $100. (b) A 50% chance to gain $200 and a 50% chance to gain nothing. Assume yourself richer by $500 than you are today. Now choose between (a') and (b'): (a') A sure loss of $100. (b') A 50% chance to lose nothing and a 50% chance to lose $200. 72% prefer (a) in K&T experiment 36% prefer (b’) in K&T experiment Psych 466, Miyamoto, Aut '17 EU Analysis of This Problem
26
Framing Effect in Gambles for Apparent Gains or Losses
Assume yourself richer by $300 than you are today. Now choose between (a) and (b): (a) A sure gain of $100. (b) A 50% chance to gain $200 and a 50% chance to gain nothing. Assume yourself richer by $500 than you are today. Now choose between (a') and (b'): (a') A sure loss of $100. (b') A 50% chance to lose nothing and a 50% chance to lose $200. U(a) = U(current wealth ) = U(current wealth + 400) U(b) = (1/2)U(current wealth ) (1/2)U(current wealth ) = (1/2)U(current wealth + 500) (1/2)U(current wealth + 300) U(a') = U(current wealth ) = U(current wealth + 400) U(b') = (1/2)U(current wealth ) (1/2)U(current wealth ) = (1/2)U(current wealth + 500) (1/2)U(current wealth + 300) Psych 466, Miyamoto, Aut '17 Same Slide with All Text Displayed
27
Framing Effect in Gambles for Apparent Gains or Losses
Assume yourself richer by $300 than you are today. Now choose between (a) and (b): (a) A sure gain of $100. (b) A 50% chance to gain $200 and a 50% chance to gain nothing. Assume yourself richer by $500 than you are today. Now choose between (a') and (b'): (a') A sure loss of $100. (b') A 50% chance to lose nothing and a 50% chance to lose $200. U(a) = U(current wealth ) = U(current wealth + 400) U(b) = (1/2)U(current wealth ) (1/2)U(current wealth ) = (1/2)U(current wealth + 500) (1/2)U(current wealth + 300) U(a') = U(current wealth ) = U(current wealth + 400) U(b') = (1/2)U(current wealth ) (1/2)U(current wealth ) = (1/2)U(current wealth + 500) (1/2)U(current wealth + 300) Psych 466, Miyamoto, Aut '17 Interpretation of This Result
28
What Does the Preceding Example Show?
Changing the initial wealth level from +$300 to +$500 changes the gamble outcomes from apparent gains to apparent losses. We can rapidly adjust our reference level, so that what used to be gains are now losses. We tend to be risk averse for gambles whose outcomes look like gains, and risk seeking for gambles whose outcomes look like losses. Graphical Comparison of EU Theory vs Prospect Theory Psych 466, Miyamoto, Aut '17
29
EU Utility Function versus Prospect Th Value Function
Example 1 EU theory is like a spatial map of a location; prospect theory is like the perspective of an individual person who is standing in a specific place within the location of the map (position can change; map remains the same). R-code #Section: Hidden: bk c Examples of utility functions under EU theory xx = seq(-100, 100, by = .5) kk = .5 rr = -.01 yy = 1 - kk*exp(xx*rr) plot(xx, yy, axes = F, type = "n", xlab = "", ylab = "") axis(1, lab = F) axis(2, lab = F) abline(v = min(xx)) abline(h = min(yy)) mtext("Money ($)", 1, cex = 2, line = .5) mtext("Utility", 2, cex = 2, line = .5) mtext("Utility Function\nfor EU Theory", 3, cex = 2.5, line = -.5) lines(xx, yy, lwd = 2) aa = -10 bb = func(cbind(xx,yy), aa) arr.start = c(aa + (max(xx) - aa)*.2, bb*.25) arr.end = c(aa + (max(xx) - aa)*.02, bb*.98) arrows(arr.start[1], arr.start[2], arr.end[1], arr.end[2], lwd = 2) text(arr.start[1], arr.start[2]*.2, "Typical Risk Averse\nUtility Function", cex = 1.25) points(arr.end, pch = 16, cex = 1.5) #EndSection: Hidden: bk c1 ---- #Section: Hidden: bk c rr = -.001 damper = .005 yy = (1 - kk*exp(xx*rr)) + damper*sin(xx/10) arr.start = c(aa + (max(xx) - aa)*.2, bb*.97) arr.end = c(aa + (max(xx) - aa)*.02, bb*.99) text(arr.start[1]+15, arr.start[2]*.98, "Another Somewhat Strange\nUtility Function", cex = 1.25) #EndSection: Hidden: bk c2 ---- Example 2 EU theory – utility function does not identify the current (status quo) position. Prospect theory – status quo determines shift in shape of value function. Mental Accounting Psych 466, Miyamoto, Aut'12
30
Mental Accounting Mental accounting occurs when we allocate expenses to particular "mental accounts" without looking at the overall balance sheet of expenses. Mental accounting can produce framing effects, i.e., different descriptions of expenses produce different choices even though the real options remain the same. See next slide for an example. Jacket & Calculator Purchase Psych 466, Miyamoto, Aut '17
31
Mental Accounting Example
Tversky & Kahneman 1981: Imagine that you are about to purchase a jacket for $125, and a calculator for $15. Situation 1: The salesman informs you that the calculator is on sale for $10 at the other branch of the store, located 20 minutes drive away. Would you make the trip to the other store? Situation 2: The salesman informs you that the jacket is on sale for $120 at the other branch of the store, located 20 minutes drive away. Would you make the trip to the other store? The real choice in either situation is: Option A: Spend $140, save 20 minutes of time. Option B: Spend $135, use 20 minutes to drive to other store. Results for this experiment Psych 466, Miyamoto, Aut '17
32
Results for the Mental Accounting Example
The real choice is Option A: Spend $140, save 20 minutes of time. Option B: Spend $135, use 20 minutes to drive to other store. With either option, you end up owning a jacket and a calculator. Situation 1: 68% of subjects choose Option A. Attracted to the reduction of the $15 expense to $10 for calculator. Situation 2: 29% of subjects choose Option A. Not attracted to the reduction of the $125 expense to $120 for jacket. People are more interested in saving $5 out of $15 dollar expense than saving $5 out of $125 dollar expense. People don't look at the bottom line. Framing effect! Theater Ticket Example Psych 466, Miyamoto, Aut '17
33
Theater Example (Mental Accounting) – Lose $10
Problem 8 [N = 183]: Imagine that you have decided to see a play where admission is $10 per ticket. As you enter the theater you discover that you have lost a $10 bill. Would you still pay $10 for a ticket for the play? Yes [88 per cent] No [12 per cent] How do you analyze this problem? Psych 466, Miyamoto, Aut '17 Alternative Frame: Lose the Ticket
34
Theater Example (Mental Accounting) – Lose $10
Problem 9 [N = 200]: Imagine that you have decided to see a play and have bought a $10 ticket. As you enter the theater you discover that you have lost the ticket. The ticket was for open seating and it cannot be recovered. Would you still pay $10 for a ticket for the play? Yes [46 per cent] No [54 per cent] How do you analyze this problem? Psych 466, Miyamoto, Aut '17 Summary of Theater Ticket Example
35
Theater Example - Summary
Regardless of whether you lose $10 cash or you lose the ticket, your real choices are: Bottom Line for Option 1: Go home without seeing the play. You are $10 poorer. Bottom Line for Option 2: Buy a theater ticket. You see the play. Your are $20 poorer. Typical Result: People choose Option 1 if they lose the ticket but they choose Option 2 if they lose the money for the ticket. This is an example of mental accounting. This behavior violates EU theory. Why do people behave this way? Conclusions re Mental Accounting Psych 466, Miyamoto, Aut '17
36
Conclusions re Mental Accounting
EU theory says that we should make choices based on how they affect our total personal assets - not how these assets are described or labeled as gains and losses. Psychologists find that people keep track of utility relative to separate "mental accounts." Purchasing example Lost theater ticket versus lost money for a theater ticket Framing effects due to mental accounting: People sometimes switch preferences when: (a) we keep the bottom line constant, but (b) we change the way that gains and losses are assigned to particular mental accounts. Psych 466, Miyamoto, Aut '17 Conclusion: Framing Effects Are Important
37
Conclusion: Framing effects are important!
Prospect theory The value function is concave for gains and convex for losses. This tends to make people risk averse for gains and risk seeking for losses. People are sensitive to changes in wealth (gains and losses). The Asian disease problem and gamble framing effects show that people’s preferences change depending on the way a problem is described. Mental accounting shows that we calculate gains and losses with respect to "mental accounts" (not a total accounting of our state of wealth). Labeling as gains or losses influences decisions even when the bottom line stays the same. Psych 466, Miyamoto, Aut '17 Comment: Manipulating Political Frames to Motivate People to Take Action
38
Example: Motivating People Towards Political Action
Getting people to take action – emphasize potential losses due to inaction. Example: Lobbying for the Equal Rights Amendment (ERA). Example: American Christian conservatives emphasize the Christian faith of founding Americans (circa the American Revolution). Christians have "lost" their rights to practice their faith in modern secular America. "Take back America!" Example: Politics of victimization - if you are a victim, you must take action to regain what has been taken from you. Psych 466, Miyamoto, Aut '17 Summary – How EU & Prospect Theory Differ
39
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. Same Slide without Emphasis Rectangles Psych 466, Miyamoto, Aut '17
40
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. Next: Focus on Loss Aversion Psych 466, Miyamoto, Aut '17
41
Tuesday, November 14, 2017: The Lecture Ended Here
Psych 466, Miyamoto, Aut '17
42
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 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
43
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. Credit Cards: Cash Discount versus Credit Card Surcharge Psych 466, Miyamoto, Aut '17
44
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
45
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, 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? Endowment Effect & Loss Aversion Psych 466, Miyamoto, Aut '17
46
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. Experimental Demonstration of Endowment Effect Psych 466, Miyamoto, Aut '17
47
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, 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
48
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
49
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
50
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
51
Is Endowment Effect Due to Pain of Loss or 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 Results for Owners and Non-Owners
52
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: Owners' Ratings of Pen = Non-Owners Ratings of Pen % Owners Keep Pen > % Non-Owners Choose Pen Change in Value (of Pen) Hypothesis Predicts: Owners' Ratings of Pen > Non-Owners Ratings of Pen Different Same Psych 466, Miyamoto, Aut '17 Same Slide w-o Colored Brackets
53
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: Owners' Ratings of Pen = Non-Owners Ratings of Pen % Owners Keep Pen > % Non-Owners Choose Pen Change in Value (of Pen) Hypothesis Predicts: Owners' Ratings of Pen > Non-Owners Ratings of Pen Psych 466, Miyamoto, Aut '17 Results for Owners and Non-Owners
54
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. Result contradicts change in value hypothesis. Conclusion: Endowment effect occurs because of pain of loss, not change in attractiveness. Secondary Result: Choice responses replicate previous findings for endowment effect. 56% of owners chose to keep the pen; 44% chose the candy bars. 24% of non-owners chose the pen; 76% chose the candy bars. Psych 466, Miyamoto, Aut '17 Real World Example – Auto Insurance Example
55
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
56
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, 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
57
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
58
Sunk Costs – Football Ticket 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
59
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. Another Sunk Cost Example – Government Spending on Projects Psych 466, Miyamoto, Aut '17
60
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 Return to Table that Contrasts EU Theory with Prospect Theory
61
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
62
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 without Emphasis Rectangle
63
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 END
64
Set Up for Instructor Turn off your cell phone. Close web browsers if they are not needed. Classroom Support Services (CSS), 35 Kane Hall, If the display is odd, try setting your resolution to 1024 by 768 Run Powerpoint. For most reliable start up: Start laptop & projector before connecting them together If necessary, reboot the laptop Psych 466, Miyamoto, Aut '17
65
Note to Self (5/29/2016) Consider incorporating Theirry Post's discussion of the Deal or No Deal TV show. Post, T., van den Assem, M., Baltussen, G., & Thaler, R.H. (2008). Deal or no deal? Decision making under risk in a large-payoff game show. American Economic Review, 98(1), <D:\pprs\utility\PostT Deal Or No Deal - Decis Mak Under Risk i Game Show.pdf> Illustrates many concepts: Certainty equivalents Risk aversion/risk seeking Dynamic consistency Psych 466, Miyamoto, Aut '17
Similar presentations
© 2025 SlidePlayer.com. Inc.
All rights reserved.