1. Behavioral Finance
Economics 437

2. Endowment Effect Richard Thaler story Professor collects wine
Bought specific bottle at $10, now sells for $200
Is neither willing to pay $200 to buy more bottles or sell current inventory for $200

3. Endowment Effect Kahneman, Knetsch, and Thaler experiment
Half participants endowed with coffee mugs
Other half with nothing
Each asked reservation price to trade
Sellers’ reservation price was 2.5x buyers’

4. Endowment Effect Knetsch experiment
Participants randomly given either $4.50 or five ballpoint pens
Asked to respond to series of offers
Response pattern implied indifference curves
Those with pens required much more money to give up their pens than those with money were willing to pay for pens.

5. Endowment Effect Hypothetical Example
Two employees have identical preferences and start at the same salary.
Both offered either extra $10k in salary or extra 12 vacation days and are indifferent.
Each chooses one via coin flip.
After some time, they are offered to reverse their decision.
Will they switch?

6. Endowment Effect What do all of these examples have in common?
The outcomes all contradict what traditional economic theory would say will happen.
Thaler story: violates utility ordinality assumption
KKT: Buyers’ and sellers’ reservation prices should be approximately the same.

7. Endowment Effect
Knetsch experiment: Crossing indifference curves

8. Endowment Effect
Hypothetical: Referential indifference curves

9. Classic Utility Theory
Assumes people make decisions based on current and prospective future levels of wealth.
Practical experiments have demonstrated many scenarios that contradict this claim.
Most people cannot name their wealth.
Jack and Jill example.

10. Prospect Theory Example:
If I gave you $1,000, and you could pick either:
Another $500 for sure, or
50% chance of another $1,000 & 50% no chg
What do you do?
If I gave you $2,000, and you could pick either:
Lose $500 for sure, or
50% chance of losing $1,000 & 50% no chg

11. Prospect Theory
Most pick the first option in the first example and the second in the second.
They are, of course, equivalent scenarios.
Both amount to a choice between getting $1,500 for sure or a 50% chance of getting $1,000 and a 50% chance of getting $2,000.

12. Prospect Theory
Classic utility theory would conclude a given person would make the same choice in both framings.
The fact that most people do not means classic utility theory must be missing something.

13. Prospect Theory
For one, people make decisions relative to a reference point.
Generally this reference point is what they think their current situation/status is.
Endowment effect. Status quo bias.
But how do they make choices from there?

14. Prospect Theory Another thought experiment.
If you could choose between:
Get $900 for sure, or
90% chance of getting $1,000
What do you do?
Losing $900 for sure, or
90% chance of losing $1,000

15. Prospect Theory
Most people choose the first option in the first set – this agrees with classic utility theory / risk aversion.
But most people choose the second option in the second set.
What does this mean?

16. Prospect Theory The origin is the reference point.
Risk-aversion to the upper-right.
Risk-loving to the lower left.

17. Loss Aversion
Further, the lower-left portion is “steeper” than the upper-right.
Loss aversion: losses hurt more than commensurate gains help.

18. Loss Aversion
Thought experiment: If you could have a 50% chance of winning $150 or a 50% chance of losing $100, would you take this gamble?
Some would, some wouldn’t.
Loss aversion could partially explain this.

19. Loss Aversion Can’t this be explained with traditional utility theory?
Matthew Rabin demonstrated this yields ludicrous implications.
E.g., rejecting 50/50 gamble of +$110 vs -$100 at any wealth < $300k implies would reject 50/50 gamble of +$718,190 vs -$1000.

20. Loss Aversion & Prospect Theory
One important implication: Happiness is path-dependent.
Implied by utility as a function of reference point.
Has important implications for investing.

21. Fungibility Fungibility – the ability to turn one asset into another.
If one asset can be converted into another, they should trade at the same price.
One practical example of assets becoming fungible.

22. Fungibility Chinese exchanges: Shanghai exchange (“A”)
Hong Kong exchange (“H”)
Many companies “dual-listed.”
However, cannot sell from one exchange to the other.

23. Fungibility
Shares for same company on different exchanges would often trade at very different prices.
They could maintain these price differences indefinitely.
China announces “through-train.”

24. Fungibility

25. Fungibility

26. Fungibility

27. Fungibility

28. Fungibility

29. Fungibility

30. Fungibility

31. The End