Loss aversion

In prospect theory, loss aversion refers to the tendency for people strongly to prefer avoiding losses than acquiring gains. Some studies suggest that losses are twice as powerful, psychologically, as gains.Loss aversion was first convincingly demonstrated by Amos Tversky and Daniel Kahneman.

This leads to risk aversion when people evaluate a possible gain; since people prefer avoiding losses to making gains. This explains the curvilinear shape of the prospect theory utility graph in the positive domain. Conversely people strongly prefer risks that might possibly mitigate a loss (called risk seeking behavior).

Loss aversion may also explain sunk cost effects.

Loss aversion implies that one who loses $100 will lose more satisfaction than another person will gain satisfaction from a $100 windfall. In marketing, the use of trial periods and rebates try to take advantage of the buyer's tendency to value the good more after he incorporates it in the status quo.

Note that whether a transaction is framed as a loss or as a gain is very important to this calculation: would you rather get a 5% discount, or avoid a 5% surcharge? The same change in price framed differently has a significant effect on consumer behavior. Though traditional economists consider this "endowment effect" and all other effects of loss aversion to be completely irrational, that is why it is so important to the fields of marketing and behavioral finance.

Social Psychology

Loss aversion is a concept of Social Psychology as much as economics. It is not the reality of loss that matters but the perception. Nations have gone to war until their doom because of loss aversion. It simply means you refuse to admit you made a mistake. Social Psychology Fourth Edition, Aronson et al., p. 175: "Once we have committed a lot of time or energy to a cause, it is nearly impossible to convince us that it is unworthy" The real question is "How bad do your losses have to be before you change course?" In stocks this is called capitulation. Cognitive Dissonance further explains this effect.

An Alternative Example

Imagine that your country is preparing for an outbreak of a disease which is expected to kill 600 people. Given the choice between two vaccination schedules, Program A which will save 200 and Program B which will save all 600 with probability 1/3, most will choose Program A. [Tversky, A., & Kahneman, D. (1981). The framing of decisions and the psychology of choice. Science, 211, 453-458.]

However, if the question is framed as:

Imagine that your country is preparing for an outbreak of a disease which is expected to kill 600 people. Given the choice between two vaccination schedules, Program C which will allow 400 people to die and Program D which will let no one die with probability 1/3 and all 600 will die with probability 2/3, most people will choose option D.

This is an example of loss aversion: the two situations are identical in quantitative terms, but in the second one the decision maker is losing instead of saving lives, thus setting 0 lives lost as the status quo from which losses are measured, making the sure loss of 400 people more loathsome than the probable loss of 600.

Loss Aversion and the Endowment Effect

Loss aversion was first proposed as an explanation for the endowment effect - the fact that people place a higher value on a good that they own than on an identical good that they do not own - by Kahneman, Knetsch, and Thaler (1990) [Kahneman, D., Knetsch, J., & Thaler, R. (1990). Experimental Test of the endowment effect and the Coase Theorem. Journal of Political Economy 98(6), 1325-1348.] . Loss aversion and the endowment effect lead to a violation of the Coase theorem - that "the allocation of resources will be independent of the assignment of property rights when costless trades are possible" (p. 1326).

In several studies, the authors demonstrated that the endowment effect could be explained by loss aversion but not five alternatives: (1) transaction costs, (2) misunderstandings, (3) habitual bargaining behaviors, (4) income effects, or (5) trophy effects. In each experiment half of the subjects were randomly assigned a good and asked for the minimum amount they would be willing to sell it for while the other half of the subjects were given nothing and asked for the maximum amount they would be willing to spend to buy the good. Since the value of the good is fixed and individual valuation of the good varies from this fixed value only due to sampling variation, the supply and demand curves should be perfect mirrors of each other and thus half the goods should be traded. KKT also ruled out the explanation that lack of experience with trading would lead to the endowment effect by conducting repeated markets.

The first two alternative explanations - that under-trading was due to transaction costs or misunderstanding - were tested by comparing goods markets to induced-value markets under the same rules. If it was possible to trade to the optimal level in induced value markets, under the same rules, there should be no difference in goods markets.

The results showed drastic differences between induced-value markets and goods markets. The median prices of buyers and sellers in induced-value markets matched almost every time leading to near perfect market efficiency, but goods markets sellers had much higher selling prices than buyers' buying prices. This effect was consistent over trials, indicating that this was not due to inexperience with the procedure or the market. Since the transaction cost that could have been due to the procedure was equal in the induced-value and goods markets, transaction costs were eliminated as an explanation for the endowment effect.

The third alternative explanation was that people have habitual bargaining behaviors, such as overstating their minimum selling price or understating their maximum bargaining price, that may spill over from strategic interactions where these behaviors are useful to the laboratory setting where they are sub-optimal. An experiment was conducted to address this by having the clearing prices selected at random. Buyers who indicated a willingness-to-pay higher than the randomly drawn price got the good, and vice versa for those who indicated a lower WTP. Likewise, sellers who indicated a lower willingness-to-accept than the randomly drawn price sold the good and vice versa. This incentive compatible value elicitation method did not eliminate the endowment effect but did rule out habitual bargaining behavior as an alternative explanation.

Income effects were ruled out by giving one third of the participants mugs, one third chocolates, and one third neither mug nor chocolate. They were then given the option of trading the mug for the chocolate or vice versa and those with neither were asked to merely choose between mug and chocolate. Thus, wealth effects were controlled for those groups who received mugs and chocolate. The results showed that 86% of those starting with mugs chose mugs, 10% of those starting with chocolates chose mugs, and 56% of those with nothing chose mugs. This ruled out income effects as an explanation for the endowment effect. Also, since all participants in the group had the same good, it could not be considered a 'trophy', eliminating the final alternative explanation.

Thus, the five alternative explanations were eliminated in the following ways:1 & 2: Induced-value market vs. consumption goods market;3: Incentive compatible value elicitation procedure;4 & 5: Choice between endowed or alternative good.

See also

*Risk aversion
*Equity premium puzzle
*Status quo bias
*List of cognitive biases

Sources

*Kahneman, D., Knetsch, J., & Thaler, R. (1990). Experimental Test of the endowment effect and the Coase Theorem. "Journal of Political Economy" 98(6), 1325-1348.
*Kahneman, D. & Tversky, A. (1979). Prospect Theory: An Analysis of Decision under Risk. "Econometrica" 47, 263-291.
*Tversky, A. & Kahneman, D. (1991). Loss Aversion in Riskless Choice: A Reference Dependent Model. "Quarterly Journal of Economics" 106, 1039-1061.

* [http://ssrn.com/abstract=831104 "A Psychological Law of Inertia and the Illusion of Loss Aversion"] , David Gal, September 2005

References