Loss Aversion,
Endowment Effect & Sunk Costs
Psychology 466: Judgment & Decision Making
Instructor: John Miyamoto
11/19/2015: Lecture 08-2
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Outline
• Experimental demonstration of loss aversion
• Is loss aversion due to pain of loss or change in attractiveness
when you own something.
• Affective forecasting
Psych 466, Miyamoto, Aut '15
Table Comparing EU Theory to Prospect Theory
2
Probability Weighting Function
in 1979 Prospect Theory
0.6
0.4
Probability Weight
How Prospect Theory (PT) Differs
From Expected Utility (EU) Theory
0.2
Gains
0.0
Losses
0.8
Value
1.0
Value Function in Prospect Theory
0.0
0.2
0.4
0.6
0.8
1.0
Stated Probability
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 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 People evaluate gains and losses with
one big account.
respect to mental accounts.
Psych 466, Miyamoto, Aut '15
Next: Focus on Loss Aversion
3
1.0
0.8
0.6
0.4
Gains
0.0
0.2
Losses
How Prospect Theory (PT) Differs
From Expected Utility (EU) Theory
Probability Weighting Function
in 1979 Prospect Theory
Probability Weight
Value
Value Function in Prospect Theory
0.0
0.2
0.4
0.6
0.8
1.0
Stated Probability
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 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 People evaluate gains and losses with
one big account.
respect to mental accounts.
Psych 466, Miyamoto, Aut '15
Graph Showing Loss Aversion
4
Loss Aversion
♦
Example: Compare the
pleasure of unexpectedly
finding $100 to the pain of
unexpectedly losing $100.
Psych 466, Miyamoto, Aut '15
Loss Aversion: A loss has greater impact
than an objectively equal gain.
Value
• Loss aversion –
the pain of losing X is
greater than the pleasure
of gaining X.
-x
Losses
+x
Gains
Credit Cards: Cash Discount versus Credit Card Surcharge
5
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?
Psych 466, Miyamoto, Aut '15
Endowment Effect & Loss Aversion
6
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 except that:
♦
Suppose 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.
Psych 466, Miyamoto, Aut '15
Experimental Demonstration of Endowment Effect
7
Experimental Demonstration of Endowment Effects
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)
♦
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.
Sellers
Buyers
Choosers
Psych 466, Miyamoto, Aut '15
Gain
Lose
$
Mug
selling price
Mug
$  Mug
$
buying price
---
Contrasting: Pain of Loss Versus Change in Attractiveness
8
Predictions
Sellers
Gain
Lose
$
Mug
selling price
Buyers
Mug
$  Mug
Choosers
$
buying price
---
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.
Psych 466, Miyamoto, Aut '15
Contrasting: Pain of Loss Versus Change in Attractiveness
9
Results
Sellers
Lose
$
Mug
selling price
Buyers
Choosers
Sellers: $7.12;
Gain
$
Mug
buying price
$  Mug
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 '15
What Causes Loss Aversion: Pain of Loss Versus Change in Attractiveness
10
What Causes the Endowment Effect?
Value
• Pain of Loss Hypothesis:
The endowment effect results
from loss aversion.
Loss Aversion: A loss has greater impact
than an objectively equal gain.
-x
• Change in Perception Hypothesis:
Once you own something, you
perceive it as more desirable
than before owning it.
Losses
x
Gains
• Possibly possessing an object changes
how people evaluate an object.
Psych 466, Miyamoto, Aut '15
Experimental Test of Pain of Loss Versus Change in Perception
11
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
Rating of Pen
% Choosing Pen
Psych 466, Miyamoto, Aut '15
Results for Owners and Non-Owners
12
Predictions
Rate Attractiveness
of Pen
Choose
Pen or Candy Bars
Owners
Rating of Pen
% Choosing Pen
Non-Owners
Rating of Pen
% Choosing Pen
Owners' Ratings of Pen = Non-Owners Ratings of Pen
% Owners Keep Pen > %Non-Owners Keep Pen
Change in Value (of Pen) Hypothesis Predicts:
Owners' Ratings of Pen > Non-Owners Ratings of Pen
% Owners Keep Pen > %Non-Owners Keep Pen
Psych 466, Miyamoto, Aut '15
Same
Different
Pain of Loss Hypothesis Predicts:
Same Slide w-o Colored Brackets
13
Predictions
Rate Attractiveness
of Pen
Choose
Pen or Candy Bars
Owners
Rating of Pen
% Choosing Pen
Non-Owners
Rating of Pen
% Choosing Pen
Loss Aversion Hypothesis Predicts:
Owners' Ratings of Pen = Non-Owners Ratings of Pen
% Owners Keep Pen > %Non-Owners Keep Pen
Change in Value (of Pen) Hypothesis Predicts:
Owners' Ratings of Pen = Non-Owners Ratings of Pen
% Owners Keep Pen > %Non-Owners Keep Pen
Psych 466, Miyamoto, Aut '15
Results for Owners and Non-Owners
14
Results for Owners and Non-Owners of the Pen
Key Finding: Attractiveness ratings for the pen were
the same in the two groups.
Conclusion: Endowment effect occurs because
of pain of loss, not change in attractiveness.
Choice response replicates 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 '15
Real World Example – Auto Insurance Example
15
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.
• Approximately 80% of the New Jersey citizens kept the cheaper policy (did
not change to the expensive one) but only 25% of the Pennsylvania citizens
chose the cheaper policy (changed away from the expensive one).
Psych 466, Miyamoto, Aut '15
Wine Example - Table Showing the Transaction
16
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
$200
1 Bottle
Don't Sell &
Don’t Buy
nothing
nothing
Buy One More
Bottle
1 Bottle
$200
Sell One Bottle
Psych 466, Miyamoto, Aut '15
Endowment Effect - Conclusions
17
Endowment Effect - Conclusions
• Endowment effects appear to be due to a difference between
willingness to give something up and incentive to receive
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.
Sunk Costs
Psych 466, Miyamoto, Aut '15
18
Sunk Costs – Football Ticket Example
(same as ski ticket example from earlier in quarter)
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:
a)
if you didn't already have tickets and someone offered to take
you to the game for free, you wouldn't go; and ....
b)
since you have already paid for the tickets, you feel that
you should go to the game; so you go.
I.e., are you prone in this situation to honor sunk costs?
Analysis of the Football Ticket Example Using Mental Accounting and Loss Aversion
Psych 466, Miyamoto, Aut '15
19
Analysis of Football Ticket Example
Option 1
Option 2
• Go to football game.
• Stay at home.
• Have an unpleasant day because you feel sick.
• Have a reasonably enjoyable day.
• You do not “lose” the price of the ticket
because it has been compensated for by
attendance at the game. (mental accounting)
• 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 '15
Another Sunk Cost Example – Government Spending on Projects
20
When Do We Feel We Should Honor Sunk Costs?
• Example: Government expends $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 and loss aversion:
♦
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).
Of course, we retain the power to use the $1 B that we didn't spend.
Psych 466, Miyamoto, Aut '15
Return to Table that Contrasts EU Theory with Prospect Theory
21
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.
Psych 466, Miyamoto, Aut '15
Return to the Table that Compares EU Theory to Prospect Theory
22
1.0
0.8
0.6
0.4
Gains
0.0
0.2
Losses
How Prospect Theory (PT) Differs
From Expected Utility (EU) Theory
Probability Weighting Function
in 1979 Prospect Theory
Probability Weight
Value
Value Function in Prospect Theory
0.0
0.2
0.4
0.6
0.8
1.0
Stated Probability
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 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 People evaluate gains and losses with
one big account.
respect to mental accounts.
Psych 466, Miyamoto, Aut '15
New Topic: Affective Forecasting
23
Outline
• Affective forecasting - what is it?
• Examples of affective forecasting
♦
Focusing illusion
♦
Impact bias
♦
Duration bias
Psych 466, Miyamoto, Aut '15
Lecture ends here
Affective Forecasting
24
Why Do People Have Difficulty With Affective Forecasting?
• People have incomplete or inaccurate self-theories?
• Response to novel experiences is hard to anticipate?
• Affect set point – overall happiness/unhappiness is determined
by internal personal factors? People sometimes fail to take this
into account.
• People are unaware of the influence of cognitive processes:
Focusing illusion & impact bias
Duration neglect
Psych 466, Miyamoto, Aut '15
Focusing Illusion
25
Focusing Illusion
Focusing illusion – if attention is focused on some but not all of
the attributes (aspects/issues) of an option, these attributes are
likely to be overweighted in predictions of affect.
♦
Changes in attribute levels tend to be focused on, and hence,
overweighted.
Example: Schwarz et al. asked 2 questions to college students:
(i) How happy are you?
(ii) How many dates did you have last month?
• Correlation between answers was .12 when asked in the
order (i), then (ii).
• Correlation between answers was .66 when asked in the
order (ii), then (i) .
Psych 466, Miyamoto, Aut '15
Anticipated quality of life in midwest or California
26
Focusing Illusion
• Focusing illusion – if attention is focused on some but not all of
the attributes (aspects/issues) of an option, these attributes are
likely to be overweighted in predictions of affect.
♦
Changes in attribute levels tend to be focused on, and hence,
overweighted.
• Focalism: The tendency to exaggerate the effect of
circumstances when we predict the effect of these
circumstances.
.
P 466, Miyamoto, Aut '15
Anticipated quality of life in midwest or California
27
Is Life Better in California (or Does It Just Look That Way)?
• Schkade & Kahneman (1998):
S&K
Subjects were 992 students at midwestern universities
and 1,002 students at southern California universities.
Dependent Variables:
• Rate importance of a series of dimension for yourself and for
“someone like you” who attends University X.
♦
X = a California university for a midwestern student
and a midwestern university for a California student.
♦
Dimensions: Job prospects, academic opportunities, financial situation,
personal safety, outdoor activities, weather, ....
♦
These ratings are used to determine the students’ theory of what
determines life satisfaction.
• Rate overall quality of life for self and for “someone like you”
University X.
Graph of Importance of Dimensions 28
P 466, who
Miyamoto, attends
Aut '15
Results for
Importance
of
Dimensions
Schkade &
Kahneman,
Figure 2
♦
Midwestern and California students had similar importance ratings.
♦
Notice: “Job Prospects” & “Academic Opportunity” rated much more
important for well-being than weather.
P 466, Miyamoto, Aut '15
Results for Michigan/California Quality of Life on Various Dimensions
29
Results for Quality of Life on Various Dimensions
Schkade & Kahneman (1998):
S&K
• Rated Quality of Non-Weather Dimensions:
Cal – Midwest differences were small or zero
♦
Non-Weather Dimensions: Job prospects, academic opportunity, financial situation,
personal safety, social life, outdoor activities, natural beauty, cultural opportunities
• Rated Quality of Weather Dimension:
Cal – Midwest difference was very large, i.e., both Cal and
midwest students agreed that Cal had much better weather.
♦
Weather Dimensions: Overall climate, summer weather, winter weather
P 466, Miyamoto, Aut '15
Women’s Predictions About the Impact of Wealth on Mood
30
Results for Actual & Predicted Satisfaction
Schkade & Kahneman (1998):
S&K
• Actual Satisfaction:
Cal and midwest students were equally satisfied with life;
• Predicted Satisfaction for “Someone like Them” in
the Other Region: Both groups predict that "someone like
them" would be more satisfied if living in California.
♦
Mediation analysis shows that weather accounts for rated difference in
life quality in midwest and California.
• S&K’s Interpretation: People suffer from a focusing illusion;
♦
Cal versus midwest difference in weather is salient;
its true impact is much less than its predicted impact.
P 466, Miyamoto, Aut '15
Women’s Predictions About the Impact of Wealth on Mood
31
Women’s Predictions About the Impact of Wealth on Mood
Kahneman, D., Krueger, A. B., Schkade, D., Schwarz, N., & Stone, A. A. (2006). Would you be happier if you were richer?
A focusing illusion. Science, 312, 1908-1910.
Participants were working women. Between subjects design.
Participants ....
(a)
stated the percentage of time they were in a bad mood on the preceding
day, and ....
(b)
predicted the percentage of time in a bad mood experienced by a woman
similar to themselves who had high or low incomes. (Similar question for
married/single, health insurance/no health insurance, ...)
• Since some of the women did have income < $20,000 or
> $100,000, or were alone or married, etc., we also have the
actual self-rating of time in a bad mood.
UW Psych 466, Miyamoto, Aut '10
How Would You Feel If You Were ____? - Results
32
Women’s Predictions About the Impact of Wealth on Mood
N > 59 in all cases
Results for Household Income
Actual Difference = 32.0 - 19.8 = 12.2
Predicted Difference = 57.7 - 25.7 = 32.0
UW Psych 466, Miyamoto, Aut '10
Same Slide with Sample Sizes Added to It
33
Women’s Predictions About the Impact of Wealth on Mood
N > 59 in all cases
• In general, ACTUAL difference < PREDICTED difference
♦
The contrast between good and bad circumstances was exaggerated.
(Good and bad circumstances do have an effect, but not as much as predicted.)
♦
Result explained by focalism – we exaggerate the predicted effects of variables that we
focus on.
UW Psych 466, Miyamoto, Aut '10
Same Slide with Sample Sizes Added to It
34
A Note re Sample Sizes for this Study
Sample Sizes
Actual
Predicted
64
59
75
237
96
211
82
221
83
83
84
84
83
85
85
87
N > 59 in all cases
• Sample sizes were large enough to produce reliable results.
UW Psych 466, Miyamoto, Aut '10
Focusing Illusion – Summary - END
35
Focusing Illusion - Summary
• Focusing on any one aspect of a larger situation exaggerates its
impact on the hedonic response to the situation.
"Nothing in life is quite as important
as you think it is while you are thinking about it."
Schkade and Kahneman (1998)
• We often focus on changes.
Hence, we often exaggerate the impact of changes.
♦
♦
Distinguish between the short-term and long-term impact of changes.
Long-term impact of changes is the experience of a stable, non-changing
state (more or less).
• Focusing illusion is relevant when we attempt to anticipate
the value of a change in circumstance.
Psych 466, Miyamoto, Aut '15
END
36