Loss aversion
In cognitive science and behavioral economics, loss aversion refers to a cognitive bias in which the same situation is perceived as worse if it is framed as a loss, rather than a gain. It should not be confused with risk aversion, which describes the rational behavior of valuing an uncertain outcome at less than its expected value.
When defined in terms of the pseudo-utility function as in cumulative prospect theory, the left-hand of the function increases much more steeply than gains, thus being more "painful" than the satisfaction from a comparable gain. Empirically, losses tend to be treated as if they were twice as large as an equivalent gain. Loss aversion was first proposed by Amos Tversky and Daniel Kahneman as an important component of prospect theory.
History
In 1979, Daniel Kahneman and his associate Amos Tversky originally coined the term "loss aversion" in their initial proposal of prospect theory as an alternative descriptive model of decision making under risk. "The response to losses is stronger than the response to corresponding gains" is Kahneman's definition of loss aversion.After the first 1979 proposal in the prospect theory framework paper, Tversky and Kahneman used loss aversion for a paper in 1991 about a consumer choice theory that incorporates reference dependence, loss aversion, and diminishing sensitivity. Compared to the original paper above that discusses loss aversion in risky choices, Tversky and Kahneman discuss loss aversion in riskless choices, for instance, not wanting to trade or even sell something that is already in our possession. Here, "losses loom larger than gains" correspondingly reflects how outcomes below the reference level loom larger than those above the reference level, showing people's tendency to value losses more than gains relative to a reference point. Additionally, the paper supported loss aversion with the endowment effect theory and status quo bias theory. Loss aversion was popular in explaining many phenomena in traditional choice theory. In 1980, loss aversion was used in Thaler regarding endowment effect. Loss aversion was also used to support the status quo bias in 1988, and the equity premium puzzle in 1995. In the 2000s, behavioural finance was an area with frequent application of this theory, including on asset prices and individual stock returns.
Application
In marketing, the use of trial periods and rebates tries to take advantage of the buyer's tendency to value the good more after the buyer incorporates it in the status quo. In past behavioral economics studies, users participate up until the threat of loss equals any incurred gains. Methods established by Botond Kőszegi and Matthew Rabin in experimental economics illustrates the role of expectation, wherein an individual's belief about an outcome can create an instance of loss aversion, whether or not a tangible change of state has occurred.Whether a transaction is framed as a loss or as a gain is important to this calculation. The same change in price framed differently, for example as a $5 discount or as a $5 surcharge avoided, has a significant effect on consumer behavior. Although traditional economists consider this "endowment effect", and all other effects of loss aversion, to be completely irrational, it is important to the fields of marketing and behavioral finance. Users in behavioral and experimental economics studies decided to cease participation in iterative money-making games when the threat of loss was close to the expenditure of effort, even when the user stood to further their gains. Loss aversion coupled with myopia has been shown to explain macroeconomic phenomena, such as the equity premium puzzle. Loss aversion to kinship is an explanation for aversion to inheritance tax.
Prospect theory
Loss aversion is part of prospect theory, a cornerstone in behavioral economics. The theory explored numerous behavioral biases leading to sub-optimal decisions making. Kahneman and Tversky found that people are biased in their real estimation of probability of events happening. They tend to over-weight both low and high probabilities and under-weight medium probabilities.One example is which option is more attractive between option A and option B. Prospect theory and loss aversion suggests that most people would choose option B as they prefer the guaranteed $920 since there is a probability of winning $0, even though it is only 1%. This demonstrates that people think in terms of expected utility relative to a reference point as opposed to absolute payoffs. When choices are framed as risky, individuals tend to be loss-averse as they weigh losses more heavily than comparable gains.
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. 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".In several studies, the authors demonstrated that the endowment effect could be explained by loss aversion but not five alternatives, namely transaction costs, misunderstandings, habitual bargaining behaviors, income effects, and 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. The authors 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 explanation are 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, the first two through induced-value market vs. consumption goods market, the third with incentive compatible value elicitation procedure, and the fourth and fifth through a choice between endowed or alternative good.
Criticisms
Multiple studies have questioned the existence of loss aversion. In several studies examining the effect of losses in decision-making, no loss aversion was found under risk and uncertainty. There are several explanations for these findings: one is that loss aversion does not exist in small payoff magnitudes ; which seems to hold true for time as well. The other is that the generality of the loss aversion pattern is lower than previously thought. David Gal argued that many of the phenomena commonly attributed to loss aversion, including the status quo bias, the endowment effect, and the preference for safe over risky options, are more parsimoniously explained by psychological inertia than by a loss/gain asymmetry. Gal and Rucker made similar arguments. Mkrva, Johnson, Gächter, and Herrmann cast doubt on these critiques, replicating loss aversion in five unique samples while also showing how the magnitude of loss aversion varies in theoretically predictable ways.Loss aversion may be more salient when people compete. Gill and Prowse provide experimental evidence that people are loss averse around reference points given by their expectations in a competitive environment with real effort. Losses may also have an effect on attention but not on the weighting of outcomes; losses lead to more autonomic arousal than gains even in the absence of loss aversion. This latter effect is sometimes known as Loss Attention.