One of the most interesting findings in behavioral economics, and definitely in
one of the earliest finding, has been this idea of loss of aversion.
And loss of aversion is the idea that we get happy when we make money.
But, we really suffer when we lose money. So, for example, ask yourself, if I flip
the coin and you got the $150. If it fell on tails and you lost a $100,
if it fell on heads would you take this bet?
The expected value is positive, but would you take it?
Most people would say no. And if you say yes to that one, what about
if the positive was 125 and the negative was minus 100, will you take that?
At some point, most people say I would not take it even though the expected value,
the average of those two outcomes is positive.
Also, if you've invested in the stock market, you probably realize that on days
when you make 2%, you're happy. But on days that you lose 2%, you're
really miserable. And this asymmetry around the neutral
point has become very important, and this be calling Loss Aversion.
Gains make us happy, but losses make us really miserable.
And there are all kind of consequences of this idea of, of loss aversion.
For example, it's important to realize that the losses are not just around the
zero, it's around where you are. So, for example, imagine that all of a
sudden I give you some salary. I give you maybe $50,000 a year as a
salary. Once I gave you that amount of money, what
do you think about the reduction of your salary?
Are you looking at compared to zero? No.
You look at it from this new point of making $50,000.
And if I try to take something away from you, it's becoming incredibly unpleasant.
So, how might we use this idea of loss aversion?
First of all, let's think about the following example.
Imagine that you're working for me, you're a sales person and you're selling TVs for
example. And you're selling TV A and TVs B's.
And both of those companies pay commission.
Company A pays you when you sell a TV A's, and company B sell you gives you
commission when you sell TV B. How could these companies get you to sell
more of their TVs? Of course, they could increase their
commission. If you got more commission from one TV,
you would sell that more. If you got more commission from the other
TV, you would sell that more. But can we use loss aversion?
So, imagine what would happen if one of the companies prepaid you.
They, they said look, we think that this year you're going to sell 300 TVs from our
TVs and we're going to give you all the commission up front.
And then, every TV you don't sell that is ours, you have to give us the money back.
So, we run many experiments like this. And we get people to be in the position of
the salesperson. And for one type of TV they sell, they get
commission after the fact. And for the other type of TV, they get the
comission in advance as if they always sold just this TV.
And then, they can, if they don't sell the TV, they have to give the money back.
So, imagine for example, that I am the salesperson.
And if I sell one of the TVs, TV B, I make $12.
But then, if I, and if I sell TV A, I make $10.
But if TV A prepays me, it means that if I sell, if I sell TV B I get $12 and I have
to pay back $10. Now, it's still a good deal for me because
I get more money and have to get rid of less, right?
If I sell TV A, I'm, I'm, I've gotten $10 and nothing happened.
If I sell TV B, I have to give back $10 but I actually made more money.
What happened in the experiment? People oversell the TV that's prepaid.
Even when it's irrational, even when they lose money.
Which suggests that once you give people money, they value that money to a higher
degree, they don't want to give it up. And because of that, they are redirecting
their efforts. Here's another way to think about how
these effects might work. So, imagine you work for a company.
And every month you can save money in your retirement plan.
And the way it usually works is that you put some money in, let's say 5% of your
salary, and the company matches 5% of your salary.
And those 5%, and 5% go into your long-term savings account.
Now, what if your company actually matches up to 10%?
If you're putting 5 and they're putting 5, you're leaving some money on the table but
you don't see it being left on the table. One of the things that we predict would
happen is the following. What if the company gave 10% up front and
then you matched it? But you only put 5%.
And then, they take those other 5% that you did not match, and they take it back.
Now, we have the principal of loss aversion working, right?
Now, you see money going into your long-term savings.
You see that you are not matching all of it, and you see some of it going away.
And the idea is that money that we don't get, it's a shame.
But money that goes away have a lot of psychological impact.
And because of the prediction is that under those conditions, people would save
more money. There's another implication for loss
aversion which is very interesting, which is something called the endowment effect.
And again, the idea is once we get something, we get used to owning it.
And from that starting point, we think about gaining from that perspective, or
losing from that perspective. But we've adjusted to this new level of
ownership, right? We get the salary, we get the house.
Whatever it is. The initial experiments on the endowment
effect were done with mugs. They took a big group of students.
They gave half of them mugs and they gave half of them candy.
And then they said, look, the people who have the mugs, how much would you sell
your mug for? And then they told them, and how much
would you pay for candy? And the people who had the candy, the
chocolate bar, they say, how much would you sell?
You can be, bar four, and how much would you buy a mug for?
Now, because you assigned the mugs and the candies randomly, 50% of the people got
those, 50% of the people got those. You would expect that for 50%, they would
prefer the other good. But what happens when you do it?
Almost nobody switches. The people who owned mugs say, oh my
goodness, mugs are wonderful. I don't want to give them up.
Let me keep them. I'm not willing to give them up.
People who owned the candy bars say, oh, candy bars are just fantastic.
I'm not willing to give up the candy. So, what happen is the moment you give
people mugs, they get used to mugs. They think mugs are great.
And they want a high price for giving up these mugs.
The people who get candy, all of a sudden, want a high price for candy.
And because of that, there's no switching in this marketplace.
We did these experiments with Duke basketball tickets.
I teach at Duke. At Duke, there's a huge basketball team.
It's really important for the students. It's something very central.
And toward the end of the season, if the team is doing very well, there's some
really important games. And the students are camping in order to
get tickets for these games. But in that particular year, there were
not going to be enough tickets for all the students.
So, the students camped out in order to be in line for the tickets.
They camped for many days. And at the end of those many days, they
had a lottery. And they said, well, all of you camped,
all of you deserve tickets. But, we don't have tickets for all of you.
So, we're going to have a lottery and some of you are going to get the tickets and
some of you are not. So, we had the group that all had high
interest in those tickets and they were randomly assigned by the lottery to people
who are ticket owners and people who are not ticket owners.
So, together we achieve common, we called up these people.
We found out what the lottery outcome was. And we knew who was the ticket owner and
who was not, and we called them up and we said, hey, if you're a ticket owner, can
we tempt you to sell us the tickets? And if you were not a ticket owner, we
said, hey, we might get a ticket for you. How much would you pay for it?
What happened? The people who were ticket owners wanted
about $2,000 to give up their tickets. Lots of money.
The people who did not have tickets were willing to buy one for a hundred and some
dollars but not more than that. What happened is the moment people became
ticket owners, they value it to a higher degree, and giving it up became much more
important. The people who did not own the ticket did
not value it as much. Now, not only that.
But when we asked them to explain their reasons, the reasons were very different.
Now, these two people are on two sides of the transaction.
They have reasons for switching to the other side and they have reasons for
keeping where they are. If you have a ticket, you have a reason to
try and sell the ticket to get money, and you have your reasons to go to the game.
If you don't have a ticket, you have reasons to go to the game, and to keep the
money or not to spend the money. But what we heard from people when we
asked them why, were reasons only about their side of the transaction.
People who had this ticket said, going to his game is going to be my defining moment
to do. It's going to be incredibly important,
it's something that would be the capstone of my experience.
I will tell my children about it and my grandchildren about it.
I'll keep on remember it. I'll think about it.
It'll be a huge part of my experience. The people who did not have the ticket,
could also give us this reason. They could say, I want to go to the game
because it will be apart of my life, telling my children, but no, those people
thought about the money. They said, well, I don't want to spend so
much money on a ticket. I can go to a bar, I could see the game
for free, and maybe buy some drinks, and that would actually be more interesting
for me. So, what happens is the moment you move on
the ownership curve, you start to evaluate things from that perspective.
And you think very differently about what you're going to lose and what you're going
to gain. And in that particular case, when you're
thinking about selling a ticket, you're thinking about what you're going to give
up, the ticket. And that's what you focus on.
And that's what you think about the experiences.
If you have money but no ticket, what are you thinking?
You're thinking about giving up the money. You're thinking about that side of the
transaction. So, it seems that loss of aversion is a
very general way for us to think about what we have and what we own.
And the moment you own something, you think about your changes in terms of gains
and losses, and then losses are more salient and prominent, and actually more
important in our decision. As a final thing, you can think about what
does 30 day money back guarantee basically provide.
It basically says, yeah, look. Why don't you buy a sofa, take it home,
see how it is, and you could always bring it back, right?
And from you as a consumer, it says, okay, I have no risk.
I can take this sofa home, I can try it, I can get, I can get see how it works for
me. What you don't probably appreciate is loss
aversion, the endowment affect. Probably what you don't appreciate is by
the time you bring the sofa home, and you use it for a few days, you become to like
it to a slightly higher degree. All of a sudden, it's yours, and giving it
up is more difficult. So, while you initially value the
transaction and saying, oh, that's not a big deal, let me just take it home and I
will evaluate how it works. Once you take it home, you get used to it.
You change your position to think of yourself as an owner of that sofa.
Now, all of a sudden, giving it up is tougher.
So, in summary, loss of aversion is really interesting.
It's one of the first important findings in behavioral economics.
And if you think about it, it's everywhere.
And you can also think about how to introduce it in places where people could
actually be prompted by it, like in financial savings, to behave better.