The core premise of economic theory is that people choose by optimizing. Of all the goods and services a family could buy, the family chooses the best one that it can afford.
Giving up the opportunity to sell something does not hurt as much as taking the money out of your wallet to pay for it. Opportunity costs are vague and abstract when compared to handing over actual cash.
I called this phenomenon the “endowment effect” because, in economists’ lingo, the stuff you own is part of your endowment, and I had stumbled upon a finding that suggested people valued things that were already part of their endowment more highly than things that could be part of their endowment, that were available but not yet owned.
Roughly speaking, losses hurt about twice as much as gains make you feel good.
The fact that a loss hurts more than an equivalent gain gives pleasure is called loss aversion. It has become the single most powerful tool in the behavioral economist’s arsenal.
“By default, the method of hypothetical choices emerges as the simplest procedure by which a large number of theoretical questions can be investigated. The use of the method relies on the assumption that people often know how they would behave in actual situations of choice, and on the further assumption that the subjects have no special reason to disguise their true preferences.”
Psychologists tell us that in order to learn from experience, two ingredients are necessary: frequent practice and immediate feedback.
Because learning takes practice, we are more likely to get things right at small stakes than at large stakes. This means critics have to decide which argument they want to apply. If learning is crucial, then as the stakes go up, decision-making quality is likely to go down.
Eventually I settled on a formulation that involves two kinds of utility: acquisition utility and transaction utility. Acquisition utility is based on standard economic theory and is equivalent to what economists call “consumer surplus.”
Humans, on the other hand, also weigh another aspect of the purchase: the perceived quality of the deal. That is what transaction utility captures. It is defined as the difference between the price actually paid for the object and the price one would normally expect to pay, the reference price
With those provisos out of the way, we can proceed to the punch line. People are willing to pay more for the beer if it was purchased from the resort than from the convenience store. The median† answers, adjusted for inflation, were $7.25 and $4.10.
Because consumers think this way, sellers have an incentive to manipulate the perceived reference price and create the illusion of a “deal.” One example that has been used for decades is announcing a largely fictional “suggested retail price,” which actually just serves as a misleading suggested reference price. In America, some products always seem to be on sale, such as rugs and mattresses, and at some retailers, men’s suits.
Once you recognize the break-even effect and the house money effect, it is easy to spot them in everyday life. It occurs whenever there are two salient reference points, for instance where you started and where you are right now. The house money effect—along with a tendency to extrapolate recent returns into the future—facilitates financial bubbles.
When most people think about Adam Smith, they think of his most famous work, The Wealth of Nations. This remarkable book—the first edition was published in 1776—created the foundation for modern economic thinking. Oddly, the most well-known phrase in the book, the vaunted “invisible hand,” mentioned earlier, appears only once, treated with a mere flick by Smith. He notes that by pursuing personal profits, the typical businessman is “led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it.”
The bulk of Smith’s writings on what we would now consider behavioral economics appeared in his earlier book The Theory of Moral Sentiments, published in 1759.
These worries led Strotz to engage in what has become an obligatory discussion of Homer’s tale of Odysseus and the Sirens. Almost all researchers on self-control—from philosophers to psychologists to economists—eventually get around to talking about this ancient story, and for once, I will follow the traditional path. Odysseus wanted to both hear the music and live to tell about it. He devised a two-part plan to succeed. The first part was to make sure that his crew did not hear the Sirens’ call, so he instructed them to fill their ears with wax. The second part of the plan was to have his crew bind him to the mast, allowing Odysseus to enjoy the show without risking the inevitable temptation to steer the ship toward the rocks.
At some point in pondering these questions, I came across a quote from social scientist Donald McIntosh that profoundly influenced my thinking: “The idea of self-control is paradoxical unless it is assumed that the psyche contains more than one energy system, and that these energy systems have some degree of independence from each other.”
One innovation was the rebate, introduced by Chrysler in 1975, and quickly followed by Ford and GM. The car companies would announce a temporary sale whereby each buyer of a car would receive some cash back, usually a few hundred dollars. A rebate seems to be just another name for a temporary sale, but they seemed to be more popular than an equivalent reduction in price, as one might expect based on mental accounting. Suppose the list price of the car was $14,800. Reducing the price to $14,500 did not seem like a big deal, not a just-noticeable difference. But by calling the price reduction a rebate, the consumer was encouraged to think about the $300 separately, which would intensify its importance.
In many situations, the perceived fairness of an action depends not only on who it helps or harms, but also on how it is framed. But firms don’t always get these things right. The fact that my MBA students think it is perfectly fine to raise the price of snow shovels after a blizzard should be a warning to all business executives that their intuitions about what seems fair to their customers and employees might need some fine-tuning.
Of course, if we look around, we see counterexamples to this result all the time. Some people donate to charities and clean up campgrounds, and quite miraculously, at least in America, most urban dog owners now carry a plastic bag when they take their dog for a “walk” in order to dispose of the waste. (Although there are laws in place supposedly enforcing this norm, they are rarely enforced.) In other words, some people cooperate, even when it is not in their self-interest to do so.
The discussion with Charlie and Vernon also led us to recognize that the endowment effect, if true, will reduce the volume of trade in a market. Those who start out with some object will tend to keep it, while those who don’t have such an object won’t be that keen to buy one.
We ran numerous versions of these experiments to answer the complaints of various critics and journal referees, but the results always came out the same. Buyers were willing to pay about half of what sellers would demand, even with markets and learning. Again we see that losses are roughly twice as painful as gains are pleasurable, a finding that has been replicated numerous times over the years.
And while loss aversion is certainly part of the explanation for our findings, there is a related phenomenon: inertia. In physics, an object in a state of rest stays that way, unless something happens. People act the same way: they stick with what they have unless there is some good reason to switch, or perhaps despite there being a good reason to switch. Economists William Samuelson and Richard Zeckhauser have dubbed this behavior “status quo bias.”
A paradigm shift is one of the rare cataclysmic events in science when people make a substantial break with the way the field has been progressing and pursue a new direction. The Copernican revolution, which placed the sun at the center of the solar system, is perhaps the most famous example. It replaced Ptolemaic thinking, in which all the objects in our solar system revolved around the Earth.
Economics is distinguished from other social sciences by the belief that most (all?) behavior can be explained by assuming that agents have stable, well-defined preferences and make rational choices consistent with those preferences in markets that (eventually) clear.