Loss Aversion
and the
Endowment
Effect
Reading
• Predictably Irrational by Dan Ariely
– Chapter 8: The High Price of Ownership
• Thinking, Fast and Slow by Daniel Kahneman
– Chapter 26: Prospect Theory, “Loss Aversion”
– Chapter 27: The Endowment Effect
Prospect Theory
• This is easily the most famous
theoretical contribution to
behavioral economics
– Prospect Theory: An Analysis of
Decision under Risk, by Daniel
Kahneman and Amos Tversky,
Econometrica, Vol. 47, No. 2
(March 1979), pp. 263-292
• One of the key components of
prospect theory is loss aversion
Two behavioral economics principles
1. The endowment effect
“Ownership creates satisfaction”
2. Loss aversion
“People are more motivated by avoiding a loss than
acquiring a similar gain”
Kahneman and Tversky’s “Prospect Theory” describes how people
evaluate gains and losses; it includes concepts such as status quo bias,
loss aversion, and the endowment effect
The endowment effect
• People value a
thing more
once it
becomes
theirs
• Ownership
increases
utility
• Term
originated by
Richard Thaler
(U. of Chicago)
Thaler, R. (University of Chicago), 1980, Toward a positive theory of consumer choice. Journal of
Economic Behavior and Organization, March, 39-60.
Students in every other
seat were given
university mugs. Then
reported how much
they would be willing to
sell the mug for.
Students who did not
get a mug reported the
price they would be
willing to pay to get
one.
What happened?
a) The students with mugs priced them higher.
b) The students with no mugs priced them higher.
c) Both sets of students priced them about the same
Students with the mugs Students with no mugs
were willing to sell them, were willing to buy
them, on average, for
on average, for
$4.50
$2.25
Kahneman, D. (UC Berkley), Knetsch, J. (Simon Fraser U), Thaler, R. (Cornell), 1990, Experimental tests of the
endowment effect and the Coase theorem. Journal of Political Economy, 98(6), 1325-1348.
Class A
At the beginning,
students given a
coffee mug. At
the end, given
option to trade
for a bar of Swiss
chocolate.
Class B
Students given a
chocolate bar.
At the end,
given option to
trade for a
coffee mug.
?
?
Class C
At the beginning,
offered a choice
between a
chocolate bar or
coffee mug.
?
Class A
At the beginning,
students given a
coffee mug. At
the end, given
option to trade
for a bar of Swiss
chocolate.
Class B
Students given a
chocolate bar.
At the end,
given option to
trade for a
coffee mug.
?
?
Class C
At the beginning,
offered a choice
between a
chocolate bar or
coffee mug.
?
Class A
Class B
Class C
89% 10% 59%
chose coffee mug
chose coffee mug
chose coffee mug
?
?
?
J. Knetsch (Simon Fraser U.), 1989,
The endowment effect and
evidence of nonreversible
indifference curves. American
Economic Review, 79, 1277-1284.
33 chimpanzees given frozen-juice popsicle or tube of
peanut butter (both familiar items) and then an
opportunity to trade.
?
?
When initially given
peanut butter
When initially given
popsicle
Chose peanut butter
Chose peanut butter
89%
42%
Brosnan, S. (Emory), et al (Texas, Vanderbilt), 2007, Endowment effects in chimpanzees. Current
Biology, 17, 1704-1707.
Endowment effect in basketball tickets?
Dr. Dan Ariely, Duke University
http://www.youtube.com/watch?v=drEVExtrUgQ
Carmon, Ziv and Dan Ariely (2000), “Focusing on the Forgone: How Value Can Appear So
Different to Buyers and Sellers,” Journal of Consumer Research, 27 (December), 360–70.
Duke basketball tickets experiment
• At Duke, home-game basketball tickets are
distributed by lottery
• Ariely gets a list of the winners and losers
• Calls the losers and asks how much they’d pay
for a ticket ($170 on average)
• Calls the winners and asks at what price they’d
sell ($1,400)
• This is evidence of the endowment effect
Duke basketball tickets experiment
• The lottery losers were willing to pay $170 on
average for a ticket
• This means the lottery losers valued a ticket at
approximately $170.01
• The lottery winners were willing to sell their
tickets for $1400 on average
• This means the lottery winners valued a ticket at
approximately $1399.99
• Why would two randomly chosen groups value
the same thing at such different levels?
The endowment
effect in art
Dr. Dan Gilbert,
Harvard University
http://www.youtube.com/watch?v=LTO_dZUvbJA 8:25-13:57
Students in a non-credit photography class at Harvard
picked two photos to develop then chose one to keep.
Group 1
“pick your
favorite, … you
won’t be able
to change your
mind.”
Group 2
If you change
your mind
within four
days, you can
swap it. I’ll call
at the end to
double-check.
Gilbert, D. (Harvard) & Ebert, J. (MIT), 2002, Decisions and revisions: The affective forecasting of
changeable outcomes. Journal of Personality and Social Psychology, 82, 503-514
Both before and two days after their choice,
participants were asked how much they liked their
photograph from 1 (not at all) to 9 (very much)
Group 1
Change in
satisfaction
with picture
Group 2
Change in
satisfaction
with picture
+1.3
-1.8
Gilbert, D. (Harvard) & Ebert, J. (MIT), 2002, Decisions and revisions: The affective forecasting of
changeable outcomes. Journal of Personality and Social Psychology, 82, 503-514
Gilbert, D. (Harvard) & Ebert, J. (MIT), 2002, Decisions and revisions: The affective forecasting of
changeable outcomes. Journal of Personality and Social Psychology, 82, 503-514
Students ranked 6 art posters. Next, allowed to take
home either 3rd or 4th ranked poster. 15 minutes later,
they rated their chosen poster again.
Group A: “if … any time
in the next month, you
can just let me know
and we will exchange it
for you.”
Group B: Final choice, no
exchanges.
Gilbert, D. (Harvard) & Ebert, J. (MIT), 2002, Decisions and revisions: The affective forecasting of
changeable outcomes. Journal of Personality and Social Psychology, 82, 503-514
Change in ranking of the art poster before and after
they chose to take it home.
-.07
Group A: “if … any time
in the next month, you
can just let me know
and we will exchange it
for you.”
+.71
Group B: Final choice, no
exchanges.
Gilbert, D. (Harvard) & Ebert, J. (MIT), 2002, Decisions and revisions: The affective forecasting of
changeable outcomes. Journal of Personality and Social Psychology, 82, 503-514
When allowed to pick their type of choice
(changeable or unchangeable), people preferred:
66.3%
Group A: “if … any time
in the next month, you
can just let me know
and we will exchange it
for you.”
33.7%
Group B: Final choice, no
exchanges.
Gilbert, D. (Harvard) & Ebert, J. (MIT), 2002, Decisions and revisions: The affective forecasting of
changeable outcomes. Journal of Personality and Social Psychology, 82, 503-514
When asked which type of choice the typical student
would prefer, they believed:
84.3%
Group A: “if … any time
in the next month, you
can just let me know
and we will exchange it
for you.”
15.7%
Group B: Final choice, no
exchanges.
Gilbert, D. (Harvard) & Ebert, J. (MIT), 2002, Decisions and revisions: The affective forecasting of
changeable outcomes. Journal of Personality and Social Psychology, 82, 503-514
Endowment effect and marketing
• Money-back guarantees are offered by
businesses because it reduces people’s
resistance to trying a product
• Once someone tries the product, the
endowment effect may seal the deal
The IKEA effect
• One’s sense of ownership of something
increases when one invests more of one’s
resources in it
Virtual Ownership
• We may feel as though we already own
something if we can vividly imagine taking
possession of it and living with it
• This virtual ownership leads to a purchase and
to actual ownership
• Successful advertisements are good at
enabling us to vividly imagine life with a
product
Endowment Effect in Ideas
• Once we accept an idea it is very difficult for
us to let it go
• This is how ideological rigidity sets in
• We find it hard to take evidence seriously
when it threatens an idea we feel is ours
• We only consider evidence when it supports
an idea we already believe
Gilbert, D. (Harvard) & Ebert, J. (MIT), 2002, Decisions and revisions: The affective forecasting of
changeable outcomes. Journal of Personality and Social Psychology, 82, 503-514
Dr. Dan Gilbert, Harvard University
http://www.youtube.com/watch?v=LTO_dZUvbJA 14:19-19:05
Loss
Aversion
People are more motivated to avoid a loss
than to acquire a similar gain.
Loss Aversion, Measured
• Daniel Kahneman on loss aversion:
http://www.youtube.com/watch?v=VorB7X5L
8ZY&feature=related
• Experiment after experiment has shown that
people will accept a gamble with equal odds
of a loss and a gain, as long as the gain is
roughly 2.5 times the loss
Loss aversion and
endowment effect
Once I own something,
not having it becomes
more painful, because
it is a loss.
If I don’t yet own it,
then acquiring it is less
important, because it is
a gain.
Loss aversion and framing
If the same choice is
framed as a loss,
rather than as a
gain, different
decisions will
be made.
Imagine that the US is
preparing for the outbreak
of an unusual disease,
which is expected to kill
600 people.
Choose a program to
address the problem.
A: 200 people will be saved
B: 1/3 chance that 600
people will be saved. 2/3
chance that no people
will be saved.
Imagine that the US is
preparing for the outbreak
of an unusual disease,
which is expected to kill
600 people.
Choose a program to
address the problem.
72% A: 200 people will be saved
28% B: 1/3 chance that 600
people will be saved. 2/3
chance that no people
will be saved.
Tversky, A. & Kahneman, D., 1981, The framing of decisions and the psychology of choice. Science, 211, 453-458.
Imagine that the US is
preparing for the outbreak
of an unusual disease
which is expected to kill
600 people.
Choose a program to
address the problem.
A: 400 people will die.
B: 1/3 chance that nobody will die.
2/3 chance that 600 people will
die.
Imagine that the US is
preparing for the outbreak
of an unusual disease
which is expected to kill
600 people.
Choose a program to
address the problem.
22%
A: 400 people will die.
78%
B: 1/3 chance that nobody will die.
2/3 chance that 600 people will
die.
Tversky, A. & Kahneman, D., 1981, The framing of decisions and the psychology of choice. Science, 211, 453-458.
Only the framing changed
600 people expected
to die…
600 people expected
to die…
1/3 chance that
nobody will die.
2/3 chance that 600
people will die.
=
1/3 chance that 600
people will be saved.
2/3 chance that no
people will be saved.
78%
≠
28%
We will take great risks to avoid a loss. Reframing the
same option as a loss changes the choices.
Tversky, A. & Kahneman, D., 1981, The framing of decisions and the psychology of choice. Science, 211, 453-458.
Choose
A) A sure gain of
$240
B) 25% chance to
gain $1000, and
75% chance to
gain nothing
Choose
A) A sure loss of
$750
B) 75% chance to
lose $1000, and
25% chance to
lose nothing
We are less
likely to
risk to get
an extra
gain
We are
more likely
to risk to
avoid a
sure loss
Tversky, A. & Kahneman, D., 1981, The framing of decisions and the psychology of choice. Science, 211, 453-458.
Framing a gamble as a loss or a gain
http://www.youtube.com/watch?v=Ng9V2JneJ68 start – 5:54
• When an investor
sells a losing stock,
she is committing to
the loss.
• Does loss aversion
cause investors to
hold losing stocks
longer than winning
stocks?
Study: Tracking 10,000 brokerage accounts from
1987-1993 including 162,948 trades.
In any one year…
What share of losing stocks were sold?
What share of gaining stocks were sold?
Study: Tracking 10,000 brokerage accounts from
1987-1993 including 162,948 trades.
In any one year…
What share of losing stocks were sold?
What share of gaining stocks were sold?
Odean, T. (UC-Davis), 1998, Are investors reluctant to realize their losses? Journal of Finance, 53, 1775-1798.
Would investors have been
better off to hold the
winners and sell the losers?
Average 252-day gain after
winners sold
Average 252-day gain after
other stocks sold, but losing
stocks held
Would investors have been
better off to hold the
winners and sell the losers?
Average 252-day gain after
winners sold
+2.35% (better than market)
Average 252-day gain after
other stocks sold, but losing
stocks held
-1.06% (worse than market)
Odean, T. (UC-Davis), 1998, Are investors reluctant to realize their losses? Journal of Finance, 53, 1775-1798.
Why losses hurt more
Is there a conflict
between the core
“elephant” side of the
brain and the rational
pre-frontal cortex
“rider”. Why?
http://www.youtube.com/watch?v=G
GQLO_iXKlU 3:06-end
Using prospect theory to pursue your goals
1. Make it a habit (status quo bias)
2. Own it (endowment effect)
3. Fear its loss (loss aversion)
1. Make it a habit
(Goal pursuit becomes the status quo)
“Creating a good habit requires
much conscious effort, but once
the groove has been produced the
acts which make up a habitual
pattern are not consciously
willed.”
H. Keane (Australian National University),
2000, Setting yourself free: Techniques of
recovery. Health, 4, 324-346.
2. Own it
Ownership
creates
satisfaction
(endowment
effect). By
completely
identifying
yourself with a
future goal, you
become more
attached to it
3. Fear its loss
By “owning” a
future goal,
immediate
temptations
which put that
future at risk can
be framed as a
potential loss.
Application
question
Suppose you are
advising a friend
who wants to
become a surgeon.
What practical
suggestions can you
give to help her
“own” her identity
as a future
surgeon?