1. Loss Aversion, Endowment Effect & Sunk Costs
Psychology 466: Judgment & Decision Making Instructor: John Miyamoto 11/19/2015: Lecture 08-2
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2. Outline Experimental demonstration of loss aversion
Is loss aversion due to pain of loss or change in attractiveness when you own something.
Affective forecasting
Table Comparing EU Theory to Prospect Theory
Psych 466, Miyamoto, Aut '15

3. 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 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.
Next: Focus on Loss Aversion
Psych 466, Miyamoto, Aut '15

4. 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 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.
Graph Showing Loss Aversion
Psych 466, Miyamoto, Aut '15

5. Loss Aversion
Loss aversion – the pain of losing X is greater than the pleasure of gaining X.
Example: Compare the pleasure of unexpectedly finding $100 to the pain of unexpectedly losing $100. +
Credit Cards: Cash Discount versus Credit Card Surcharge
Psych 466, Miyamoto, Aut '15

6. 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?
Endowment Effect & Loss Aversion
Psych 466, Miyamoto, Aut '15

7. 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.
Experimental Demonstration of Endowment Effect
Psych 466, Miyamoto, Aut '15

8. 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,
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.
Gain
Lose
Sellers
$ selling price
Mug
Buyers
$ buying price
Choosers
$  Mug
---
Contrasting: Pain of Loss Versus Change in Attractiveness
Psych 466, Miyamoto, Aut '15

9. Predictions
Gain
Lose
Sellers
$ selling price
Mug
Buyers
$ 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 '15

10. Results Sellers: $7.12; Buyers: $2.87; Choosers: $3.12
Gain
Lose
Sellers
$ selling price
Mug
Buyers
$ 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.
What Causes Loss Aversion: Pain of Loss Versus Change in Attractiveness
Psych 466, Miyamoto, Aut '15

11. 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.
Experimental Test of Pain of Loss Versus Change in Perception
Psych 466, Miyamoto, Aut '15

12. 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
Results for Owners and Non-Owners
Psych 466, Miyamoto, Aut '15

13. 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
Pain of Loss 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
Different
Same
Same Slide w-o Colored Brackets
Psych 466, Miyamoto, Aut '15

14. 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 Keep Pen
Change in Value (of Pen) Hypothesis Predicts:
Results for Owners and Non-Owners
Psych 466, Miyamoto, Aut '15

15. 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.
Real World Example – Auto Insurance Example
Psych 466, Miyamoto, Aut '15

16. 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).
Wine Example - Table Showing the Transaction
Psych 466, Miyamoto, Aut '15

17. 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
Sell One Bottle
$200
1 Bottle
Don't Sell & Don’t Buy
nothing
Buy One More Bottle
Endowment Effect - Conclusions
Psych 466, Miyamoto, Aut '15

18. 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

19. 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:
if you didn't already have tickets and someone offered to take you to the game for free, you wouldn't go; and ....
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

20. 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 '15

21. 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.
Return to Table that Contrasts EU Theory with Prospect Theory
Psych 466, Miyamoto, Aut '15

22. 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 '15

23. 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 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.
New Topic: Affective Forecasting
Psych 466, Miyamoto, Aut '15

24. Outline Affective forecasting - what is it?
Examples of affective forecasting
Focusing illusion
Impact bias
Duration bias
Lecture ends here
Affective Forecasting
Psych 466, Miyamoto, Aut '15

25. 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
Focusing Illusion
Psych 466, Miyamoto, Aut '15

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.
Example: Schwarz et al. asked 2 questions to college students:
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) .
Anticipated quality of life in midwest or California
Psych 466, Miyamoto, Aut '15

27. 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. .
Anticipated quality of life in midwest or California
P 466, Miyamoto, Aut '15

28. 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” who attends University X.
Graph of Importance of Dimensions
P 466, Miyamoto, Aut '15

29. 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.
Results for Michigan/California Quality of Life on Various Dimensions
P 466, Miyamoto, Aut '15

30. 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
Cal & midwest ratings were very similar for the quality of job prospects, academic opportunities, social life, etc.
Cal & midwest ratings large in the direction of favoring Cal for weather.
Women’s Predictions About the Impact of Wealth on Mood
P 466, Miyamoto, Aut '15

31. 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.
Cal & midwest ratings were very similar for the quality of job prospects, academic opportunities, social life, etc.
Cal & midwest ratings large in the direction of favoring Cal for weather.
Women’s Predictions About the Impact of Wealth on Mood
P 466, Miyamoto, Aut '15

32. 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,
Participants were working women. Between subjects design.
Participants ....
stated the percentage of time they were in a bad mood on the preceding day, and ....
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.
How Would You Feel If You Were ____? - Results
UW Psych 466, Miyamoto, Aut '10

33. Women’s Predictions About the Impact of Wealth on Mood
N > 59 in all cases
Results for Household Income
Actual Difference = = 12.2
Predicted Difference = =
Same Slide with Sample Sizes Added to It
UW Psych 466, Miyamoto, Aut '10

34. 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.
Same Slide with Sample Sizes Added to It
UW Psych 466, Miyamoto, Aut '10

35. A Note re Sample Sizes for this Study
Sample Sizes Actual Predicted
N > 59 in all cases
Sample sizes were large enough to produce reliable results.
Focusing Illusion – Summary - END
UW Psych 466, Miyamoto, Aut '10

36. 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.
END
Psych 466, Miyamoto, Aut '15