Loss Aversion


Endowment effect

In economics and decision theory, loss aversion refers to people’s tendency to strongly prefer avoiding losses to acquiring gains. Most studies suggest that losses are twice as powerful, psychologically, as gains. The concept was first demonstrated by psychologists Amos Tversky and Daniel Kahneman. John List, Chairman of the University of Chicagos’ department of economics has said: ‘It’s a deeply ingrained behavioral trait. .. that all human beings have — this underlying phenomenon that ‘I really, really dislike losses, and I will do all I can to avoid losing something.’

Loss aversion leads to risk aversion when people evaluate an outcome comprising similar gains and losses; since people prefer avoiding losses to making gains. Loss aversion may also explain sunk cost effects, where people justify increased investment in a decision, based on the cumulative prior investment, despite new evidence suggesting that the cost, starting today, of continuing the decision outweighs the expected benefit.

Loss aversion implies that a person who loses $100 loses more satisfaction than they would have gained from a $100 windfall. In marketing, the use of trial periods and rebates tries 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. Traditional economists consider this ‘endowment effect’ (the tendency to overvalue things one already possesses) and all other effects of loss aversion to be completely irrational, which is why it is important to the fields of marketing and behavioral finance. The effect of loss aversion in a marketing setting was demonstrated in a study of consumer reaction to price changes to insurance policies. The study found price increases had twice the effect on customer switching, compared to price decreases.

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. Both effects 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.’ The two are often confused, but the endowment effect is more parsimoniously explained by inertia than by a loss/gain asymmetry. Recently, studies have questioned the existence of loss aversion in general. In several studies examining the effect of losses in decision making under risk and uncertainty no loss aversion was found. There are several explanations for these findings: one, is that loss aversion does not exist in small payoff magnitudes; the other, is that the generality of the loss aversion pattern is lower than that thought previously. Finally, losses may have an effect on attention but not on the weighting of outcomes; as suggested, for instance, by the fact that losses lead to more autonomic (involuntary) arousal than gains even in the absence of loss aversion. This latter effect is sometimes known as ‘Loss Attention.’ Loss aversion may also be more salient when people compete. A 2012 study provided experimental evidence that people are loss averse around reference points given by their expectations in a competitive environment with real effort.

Researchers Nathan Novemsky and Daniel Kahneman also state there are also limits to loss aversion with regard to individual intentions. They further state that ‘the coding of outcomes as gains and losses depends on the agent’s intentions and not only on the objective state of affairs at the moment of decision’. They provide an example of two individuals with different intentions performing a transaction. One, a consumer who has a pair of shoes and would consider giving them up a loss, because their intention would be to keep them. The other individual however, if he were a shoe salesman with different intentions, would not be affected by loss aversion, if he were to give up the shoes from his store.

Loss aversion has been studied in non-humans as well. In 2005, experiments were conducted on the ability of capuchin monkeys to use money. After several months of training, the monkeys began showing behavior considered to reflect understanding of the concept of a medium of exchange. They exhibited the same propensity to avoid perceived losses demonstrated by human subjects and investors. However, a subsequent study suggested there was an unequal time delay in the presentation of gains and losses. Losses were presented with a delay. Hence, the results can also be interpreted as indicating ‘delay aversion.’

Loss aversion experimentation has most recently been applied within an educational setting in an effort to improve achievement within the U.S. The study posited that framing merit pay in terms of a loss would motivate students. It was performed in the city of Chicago Heights within nine K-8 urban schools, which included 3,200 students. 150 out of 160 eligible teachers participated and were assigned to one of four treatment groups or a control group. Teachers in the incentive groups received rewards based on their students’ end of the year performance. The control group followed the traditional merit pay process of receiving ‘bonus pay’ at the end of the year based on student performance on standardized exams. However, the experimental groups received a lump sum given at beginning of the year, that would have to be paid back. The bonus was equivalent to approximately 8% of the average teacher salary in Chicago Heights, approximately $8,000. Teachers effectively received identical net payments for a given level of performance. The only difference was the timing and framing of the rewards. An advance on the payment and the reframing of the incentive as avoidance of a loss resulted in a significant improvement.

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