In economics and decision theory, loss aversion refers to people's tendency to strongly prefer avoiding losses to acquiring gains. Some studies suggest that losses are twice as powerful, psychologically, as gains. Loss aversion was first demonstrated by Amos Tversky and Daniel Kahneman.
This 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.
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 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. 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. 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 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). 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. 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 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 behaviour 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.
Questions about the existence of loss aversion
Recently, studies have questioned the existence of loss aversion. 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 arousal than gains even in the absence of loss aversion.
Loss aversion may be more salient when people compete. Gill and Prowse (2012) provide experimental evidence that people are loss averse around reference points given by their expectations in a competitive environment with real effort.
Loss aversion and the endowment effect are often confused. Gal (2006) argued that the endowment effect, previously attributed to loss aversion, is more parsimoniously explained by inertia than by a loss/gain asymmetry.
Loss aversion in nonhuman subjects
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 by Silberberg and colleagues suggested that in fact the 2005 results were not indicative of loss aversion because 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 within Education
Loss aversion experimentation has most recently been applied within an educational setting in an effort to improve achievement within the U.S. Recent results from Programme for International Student Assessment (PISA) 2009 ranked the US ranks #31 in Math and #17 in Reading. In this latest experiment, Fryer et al. posits framing merit pay in terms of a loss in order to be most effective. This study 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 on the ThinkLink Predictive Assessment and K-2 students took the Iowa Test of Basic Skills (ITBS) in March). 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.
Methodology - Gain” and “Loss” teachers received identical net payments for a given level of performance. The only difference is the timing and framing of the rewards. An advance on the payment and the reframing of the incentive as avoidance of a loss, the researchers observed treatment effects in excess of 0.20 and some as high as 0.398 standard deviations. According to the authors, 'this suggests that there may be significant potential for exploiting loss aversion in the pursuit of both optimal public policy and the pursuit of profits'.
Utilizing loss aversion, specifically within the realm of education, has gotten much notoriety in blogs and mainstream media.
The Washington Post discussed merit pay in a recent article and specifically the study conducted by Fryer et al. The article discusses the positive results of the experiment and estimates the testing gains of those of the “loss” group are associated with an increase in lifetime earnings of between $37,180 and $77,740. They also comment on the fact that it didn’t matter much whether the pay was tied to the performance of a given teacher or to the team to which that teacher was assigned. They state that “a merit pay regime need not pit teachers in a given school against each other to get results”.
Science Daily specifically covers the Fryer study stating that the study showed that “students gained as much as a 10 percentile increase in their scores compared to students with similar backgrounds -- if their teacher received a bonus at the beginning of the year, with conditions attached.” It also explains how there was no gain for students when teachers were offered the bonus at the end of the school year. Thomas Amadio, superintendent of Chicago Heights Elementary School District 170, where the experiment was conducted, is quoted in this article stating “the study shows the value of merit pay as an encouragement for better teacher performance”.
Education weekly also weighs in and discusses utilizing loss aversion within education, specifically merit pay. The article states there are “few noteworthy limitations to the study, particularly relative to scope and sample size; further, the outcome measure was a “low-stakes” diagnostic assessment, not the state test—it’s unclear if findings would look the same if the test was used for accountability purposes. Still Fryer et al. have added an interesting tumbling element to the merit-pay routine”.
The Sun Times interviewed John List, Chairman of the University of Chicago’s department of economics. He stated ‘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’. The article also speaks to only one other study to enhance performance in a work environment. The only prior field study of a “loss aversion” payment plan, they said, “occurred in Nanjing, China, where it improved productivity among factory workers who made and inspected DVD players and other consumer electronics”. The article also covers a reaction by Barnett Berry, president of the Center for Teaching Quality, who stated “the study seems to suggest that districts pay “teachers working with children and adolescents” in the same way “Chinese factory workers” were paid for “producing widgets”. I think this suggests a dire lack of understanding of the complexities of teaching.”
There has also been other criticism of the notion of loss aversion as an explanation of greater effects.
Larry Ferlazzo in his blog questioned what kind of positive classroom culture a “loss aversion” strategy would create with students, and what kind of effect a similar plan with teachers would have on school culture. He states that “the usual kind of teacher merit pay is bad enough, but a threatened “take-away” strategy might even be more offensive”.
Researchers Nathan Novemsky and Daniel Kahneman also state there are limits to loss aversion. Their article focuses on individual intentions and how such intentions can produce or inhibit loss aversion. 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.
Bill Ferriter also posted an article in the Teacher’s Leaders Network exclaiming that no matter when external incentives are awarded, they are not effective in education because teachers are already working as hard as they can.
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