What distinguishes these market transactions from Professor R’s reluctance to sell his wine, or the reluctance of Super Bowl ticket holders to sell even at a very high price? The distinctive feature is that both the shoes the merchant sells you and the money you spend from your budget for shoes are held “for exchange.” They are intended to be traded for other goods. Other goods, such as wine and Super Bowl tickets, are held “for use,” to be consumed or otherwise enjoyed. Your leisure time and the standard of living that your income supports are also not intended for sale or exchange.
Knetsch, Thaler, and I set out to design an experiment that would highlight the contrast between goods that are held for use and for exchange. We borrowed one aspect of the design of our experiment from Vernon Smith, the founder of experimental economics, with whom I would share a Nobel Prize many years later. In this method, a limited number of tokens are distributed to the participants in a “market.” Any participants who own a token at the end Bon s A end Bon of the experiment can redeem it for cash. The redemption values differ for different individuals, to represent the fact that the goods traded in markets are more valuable to some people than to others. The same token may be worth $10 to you and $20 to me, and an exchange at any price between these values will be advantageous to both of us.
Smith created vivid demonstrations of how well the basic mechanisms of supply and demand work. Individuals would make successive public offers to buy or sell a token, and others would respond publicly to the offer. Everyone watches these exchanges and sees the price at which the tokens change hands. The results are as regular as those of a demonstration in physics. As inevitably as water flows downhill, those who own a token that is of little value to them (because their redemption values are low) end up selling their token at a profit to someone who values it more. When trading ends, the tokens are in the hands of those who can get the most money for them from the experimenter. The magic of the markets has worked! Furthermore, economic theory correctly predicts both the final price at which the market will settle and the number of tokens that will change hands. If half the participants in the market were randomly assigned tokens, the theory predicts that half of the tokens will change hands.
We used a variation on Smith’s method for our experiment. Each session began with several rounds of trades for tokens, which perfectly replicated Smith’s finding. The estimated number of trades was typically very close or identical to the amount predicted by the standard theory. The tokens, of course, had value only because they could be exchanged for the experimenter’s cash; they had no value for use. Then we conducted a similar market for an object that we expected people to value for use: an attractive coffee mug, decorated with the university insignia of wherever we were conducting the experiments. The mug was then worth about $6 (and would be worth about double that amount today). Mugs were distributed randomly to half the participants. The Sellers had their mug in front of them, and the Buyers were invited to look at their neighbor’s mug; all indicated the price at which they would trade. The Buyers had to use their own money to acquire a mug. The results were dramatic: the average selling price was about double the average buying price, and the estimated number of trades was less than half of the number predicted by standard theory. The magic of the market did not work for a good that the owners expected to use.
We conducted a series of experiments using variants of the same procedure, always with the same results. My favorite is one in which we added to the Sellers and Buyers a third group—Choosers. Unlike the Buyers, who had to spend their own money to acquire the good, the Choosers could receive either a mug or a sum of money, and they indicated the amount of money that was as desirable as receiving the good. These were the results:
Sellers
$7.12
Choosers
$3.12
Buyers
$2.87
The gap between Sellers and Choosers is remarkable, because they actually face the same choice! If you are a Seller you can go home with either a m Bon s A a m Bonug or money, and if you are a Chooser you have exactly the same two options. The long-term effects of the decision are identical for the two groups. The only difference is in the emotion of the moment. The high price that Sellers set reflects the reluctance to give up an object that they already own, a reluctance that can be seen in babies who hold on fiercely to a toy and show great agitation when it is taken away. Loss aversion is built into the automatic evaluations of System 1.
Buyers and Choosers set similar cash values, although the Buyers have to pay for the mug, which is free for the Choosers. This is what we would expect if Buyers do not experience spending money on the mug as a loss. Evidence from brain imaging confirms the difference. Selling goods that one would normally use activates regions of the brain that are associated with disgust and pain. Buying also activates these areas, but only when the prices are perceived as too high—when you feel that a seller is taking money that exceeds the exchange value. Brain recordings also indicate that buying at especially low prices is a pleasurable event.
The cash value that the Sellers set on the mug is a bit more than twice as high as the value set by Choosers and Buyers. The ratio is very close to the loss aversion coefficient in risky choice, as we might expect if the same value function for gains and losses of money is applied to both riskless and risky decisions. A ratio of about 2:1 has appeared in studies of diverse economic domains, including the response of households to price changes. As economists would predict, customers tend to increase their purchases of eggs, orange juice, or fish when prices drop and to reduce their purchases when prices rise; however, in contrast to the predictions of economic theory, the effect of price increases (losses relative to the reference price) is about twice as large as the effect of gains.
The mugs experiment has remained the standard demonstration of the endowment effect, along with an even simpler experiment that Jack Knetsch reported at about the same time. Knetsch asked two classes to fill out a questionnaire and rewarded them with a gift that remained in front of them for the duration of the experiment. In one session, the prize was an expensive pen; in another, a bar of Swiss chocolate. At the end of the class, the experimenter showed the alternative gift and allowed everyone to trade his or her gift for another. Only about 10% of the participants opted to exchange their gift. Most of those who had received the pen stayed with the pen, and those who had received the chocolate did not budge either.
Thinking Like a Trader
The fundamental ideas of prospect theory are that reference points exist, and that losses loom larger than corresponding gains. Observations in real markets collected over the years illustrate the power of these concepts. A study of the market for condo apartments in Boston during a downturn yielded particularly clear results. The authors of that study compared the behavior of owners of similar units who had bought their dwellings at different prices. For a rational agent, the buying price is irrelevant history—the current market value is all that matters. Not so for Humans in a down market for housing. Owners who have a high reference point and thus face higher losses set a higher price on their dwelling, spend a longer time trying to sell their home, and eventually receive more money.
The original demonstration of an asymmetry between selling prices and buying prices (or, more convincingly, between selling and choosing) was very important in the initial acceptance of the ideas of reference point and loss aversi Bon s Aersi Bonon. However, it is well understood that reference points are labile, especially in unusual laboratory situations, and that the endowment effect can be eliminated by changing the reference point.
No endowment effect is expected when owners view their goods as carriers of value for future exchanges, a widespread attitude in routine commerce and in financial markets. The experimental economist John List, who has studied trading at baseball card conventions, found that novice traders were reluctant to part with the cards they owned, but that this reluctance eventually disappeared with trading experience. M
ore surprisingly, List found a large effect of trading experience on the endowment effect for new goods.
At a convention, List displayed a notice that invited people to take part in a short survey, for which they would be compensated with a small gift: a coffee mug or a chocolate bar of equal value. The gift s were assigned at random. As the volunteers were about to leave, List said to each of them, “We gave you a mug [or chocolate bar], but you can trade for a chocolate bar [or mug] instead, if you wish.” In an exact replication of Jack Knetsch’s earlier experiment, List found that only 18% of the inexperienced traders were willing to exchange their gift for the other. In sharp contrast, experienced traders showed no trace of an endowment effect: 48% of them traded! At least in a market environment in which trading was the norm, they showed no reluctance to trade.
Jack Knetsch also conducted experiments in which subtle manipulations made the endowment effect disappear. Participants displayed an endowment effect only if they had physical possession of the good for a while before the possibility of trading it was mentioned. Economists of the standard persuasion might be tempted to say that Knetsch had spent too much time with psychologists, because his experimental manipulation showed concern for the variables that social psychologists expect to be important. Indeed, the different methodological concerns of experimental economists and psychologists have been much in evidence in the ongoing debate about the endowment effect.
Veteran traders have apparently learned to ask the correct question, which is “How much do I want to have that mug, compared with other things I could have instead?” This is the question that Econs ask, and with this question there is no endowment effect, because the asymmetry between the pleasure of getting and the pain of giving up is irrelevant.
Recent studies of the psychology of “decision making under poverty” suggest that the poor are another group in which we do not expect to find the endowment effect. Being poor, in prospect theory, is living below one’s reference point. There are goods that the poor need and cannot afford, so they are always “in the losses.” Small amounts of money that they receive are therefore perceived as a reduced loss, not as a gain. The money helps one climb a little toward the reference point, but the poor always remain on the steep limb of the value function.
People who are poor think like traders, but the dynamics are quite different. Unlike traders, the poor are not indifferent to the differences between gaining and giving up. Their problem is that all their choices are between losses. Money that is spent on one good is the loss of another good that could have been purchased instead. For the poor, costs are losses.
We all know people for whom spending is painful, although they are objectively quite well-off. There may also be cultural differences in the attitude toward money, and especially toward the spending of money on whims Bon s Ahims Bon and minor luxuries, such as the purchase of a decorated mug. Such a difference may explain the large discrepancy between the results of the “mugs study” in the United States and in the UK. Buying and selling prices diverge substantially in experiments conducted in samples of students of the United States, but the differences are much smaller among English students. Much remains to be learned about the endowment effect.
Speaking Of The Endowment Effect
“She didn’t care which of the two offices she would get, but a day after the announcement was made, she was no longer willing to trade. Endowment effect!”
“These negotiations are going nowhere because both sides find it difficult to make concessions, even when they can get something in return. Losses loom larger than gains.”
“When they raised their prices, demand dried up.”
“He just hates the idea of selling his house for less money than he paid for it. Loss aversion is at work.”
“He is a miser, and treats any dollar he spends as a loss.”
Bad Events
The concept of loss aversion is certainly the most significant contribution of psychology to behavioral economics. This is odd, because the idea that people evaluate many outcomes as gains and losses, and that losses loom larger than gains, surprises no one. Amos and I often joked that we were engaged in studying a subject about which our grandmothers knew a great deal. In fact, however, we know more than our grandmothers did and can now embed loss aversion in the context of a broader two-systems model of the mind, and specifically a biological and psychological view in which negativity and escape dominate positivity and approach. We can also trace the consequences of loss aversion in surprisingly diverse observations: only out-of-pocket losses are compensated when goods are lost in transport; attempts at large-scale reforms very often fail; and professional golfers putt more accurately for par than for a birdie. Clever as she was, my grandmother would have been surprised by the specific predictions from a general idea she considered obvious.
Negativity Dominance
Figure 12
Your heartbeat accelerated when you looked at the left-hand figure. It accelerated even before you could label what is so eerie about that picture. After some time you may have recognized the eyes of a terrified person. The eyes on the right, narrowed by the Crro raised cheeks of a smile, express happiness—and they are not nearly as exciting. The two pictures were presented to people lying in a brain scanner. Each picture was shown for less than 2/100 of a second and immediately masked by “visual noise,” a random display of dark and bright squares. None of the observers ever consciously knew that he had seen pictures of eyes, but one part of their brain evidently knew: the amygdala, which has a primary role as the “threat center” of the brain, although it is also activated in other emotional states. Images of the brain showed an intense response of the amygdala to a threatening picture that the viewer did not recognize. The information about the threat probably traveled via a superfast neural channel that feeds directly into a part of the brain that processes emotions, bypassing the visual cortex that supports the conscious experience of “seeing.” The same circuit also causes schematic angry faces (a potential threat) to be processed faster and more efficiently than schematic happy faces. Some experimenters have reported that an angry face “pops out” of a crowd of happy faces, but a single happy face does not stand out in an angry crowd. The brains of humans and other animals contain a mechanism that is designed to give priority to bad news. By shaving a few hundredths of a second from the time needed to detect a predator, this circuit improves the animal’s odds of living long enough to reproduce. The automatic operations of System 1 reflect this evolutionary history. No comparably rapid mechanism for recognizing good news has been detected. Of course, we and our animal cousins are quickly alerted to signs of opportunities to mate or to feed, and advertisers design billboards accordingly. Still, threats are privileged above opportunities, as they should be.
The brain responds quickly even to purely symbolic threats. Emotionally loaded words quickly attract attention, and bad words (war, crime) attract attention faster than do happy words (peace, love). There is no real threat, but the mere reminder of a bad event is treated in System 1 as threatening. As we saw earlier with the word vomit, the symbolic representation associatively evokes in attenuated form many of the reactions to the real thing, including physiological indices of emotion and even fractional tendencies to avoid or approach, recoil or lean forward. The sensitivity to threats extends to the processing of statements of opinions with which we strongly disagree. For example, depending on your attitude to euthanasia, it would take your brain less than one-quarter of a second to register the “threat” in a sentence that starts with “I think euthanasia is an acceptable/unacceptable…”
The psychologist Paul Rozin, an expert on disgust, observed that a single cockroach will completely wreck the appeal of a bowl of cherries, but a cherry will do nothing at all for a bowl of cockroaches. As he points out, the negative trumps the positive in many ways, and loss aversion is one of many manifestations of a broad negativity dominance. Other scholars, in a paper titled “Bad Is Stronger Than Good,
” summarized the evidence as follows: “Bad emotions, bad parents, and bad feedback have more impact than good ones, and bad information is processed more thoroughly than good. The self is more motivated to avoid bad self-definitions than to pursue good ones. Bad impressions and bad stereotypes are quicker to form and more resistant to disconfirmation than good ones.” They cite John Gottman, the well-known expert in marital relations, who observed that the long-term success of a relationship depends far more on avoiding the negative than on seeking the positive. Gottman estimated that a stable relationship requires Brro Qres Brrthat good interactions outnumber bad interactions by at least 5 to 1. Other asymmetries in the social domain are even more striking. We all know that a friendship that may take years to develop can be ruined by a single action.
Some distinctions between good and bad are hardwired into our biology. Infants enter the world ready to respond to pain as bad and to sweet (up to a point) as good. In many situations, however, the boundary between good and bad is a reference point that changes over time and depends on the immediate circumstances. Imagine that you are out in the country on a cold night, inadequately dressed for the torrential rain, your clothes soaked. A stinging cold wind completes your misery. As you wander around, you find a large rock that provides some shelter from the fury of the elements. The biologist Michel Cabanac would call the experience of that moment intensely pleasurable because it functions, as pleasure normally does, to indicate the direction of a biologically significant improvement of circumstances. The pleasant relief will not last very long, of course, and you will soon be shivering behind the rock again, driven by your renewed suffering to seek better shelter.
Thinking, Fast and Slow Page 35