Thinking, Fast and Slow

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Thinking, Fast and Slow Page 54

by Daniel Kahneman


  A closely related phenomenon can be demonstrated at the low end of the probability range. Suppose you are undecided whether or not to purchase earthquake insurance because the premium is quite high. As you hesitate, your friendly insurance agent comes forth with an alternative offer: “For half the regular premium you can be fully covered if the quake occurs on an odd day of the month. This is a good deal because for half the price you are covered for more than half the days.” Why do most people find such probabilistic insurance distinctly unattractive? Figure 2 suggests an answer. Starting anywhere in the region of low probabilities, the impact on the decision weight of a reduction of probability from p to p/2 is considerably smaller than the effect of a reduction from p/2 to 0. Reducing the risk by half, then, is not worth half the premium.

  The aversion to probabilistic insurance is significant for three reasons. First, it undermines the classical explanation of insurance in terms of a concave utility function. According to expected utility theory, probabilistic insurance should be definitely preferred to normal insurance when the latter is just acceptable (see Kahneman and Tversky 1979). Second, probabilistic insurance represents many forms of protective action, such as having a medical checkup, buying new tires, or installing a burglar alarm system. Such actions typically reduce the probability of some hazard without eliminating it altogether. Third, the acceptability of insurance can be manipulated by the framing of the contingencies. An insurance policy that covers fire but not flood, for example, could be evaluated either as full protection against a specific risk (e.g., fire), or as a reduction in the overall probability of property loss. Figure 2 suggests that people greatly undervalue a reduction in the probability of a hazard in comparison to the complete elimination of that hazard. Hence, insurance should appear more attractive when it is framed as the elimination of risk than when it is described as a reduction of risk. Indeed, Slovic, Fischhoff, and Lichtenstein (1982) showed that a hypotheti ct arnative cal vaccine that reduces the probability of contracting a disease from 20% to 10% is less attractive if it is described as effective in half of the cases than if it is presented as fully effective against one of two exclusive and equally probable virus strains that produce identical symptoms.

  Formulation Effects

  So far we have discussed framing as a tool to demonstrate failures of invariance. We now turn attention to the processes that control the framing of outcomes and events. The public health problem illustrates a formulation effect in which a change of wording from “lives saved” to “lives lost” induced a marked shift of preference from risk aversion to risk seeking. Evidently, the subjects adopted the descriptions of the outcomes as given in the question and evaluated the outcomes accordingly as gains or losses. Another formulation effect was reported by McNeil, Pauker, Sox, and Tversky (1982). They found that preferences of physicians and patients between hypothetical therapies for lung cancer varied markedly when their probable outcomes were described in terms of mortality or survival. Surgery, unlike radiation therapy, entails a risk of death during treatment. As a consequence, the surgery option was relatively less attractive when the statistics of treatment outcomes were described in terms of mortality rather than in terms of survival.

  A physician, and perhaps a presidential advisor as well, could influence the decision made by the patient or by the President, without distorting or suppressing information, merely by the framing of outcomes and contingencies. Formulation effects can occur fortuitously, without anyone being aware of the impact of the frame on the ultimate decision. They can also be exploited deliberately to manipulate the relative attractiveness of options. For example, Thaler (1980) noted that lobbyists for the credit card industry insisted that any price difference between cash and credit purchases be labeled a cash discount rather than a credit card surcharge. The two labels frame the price difference as a gain or as a loss by implicitly designating either the lower or the higher price as normal. Because losses loom larger than gains, consumers are less likely to accept a surcharge than to forgo a discount. As is to be expected, attempts to influence framing are common in the marketplace and in the political arena.

  The evaluation of outcomes is susceptible to formulation effects because of the nonlinearity of the value function and the tendency of people to evaluate options in relation to the reference point that is suggested or implied by the statement of the problem. It is worthy of note that in other contexts people automatically transform equivalent messages into the same representation. Studies of language comprehension indicate that people quickly recode much of what they hear into an abstract representation that no longer distinguishes whether the idea was expressed in an active or in a passive form and no longer discriminates what was actually said from what was implied, presupposed, or implicated (Clark and Clark 1977). Unfortunately, the mental machinery that performs these operations silently and effortlessly is not adequate to perform the task of recoding the two versions of the public health problem or the mortality survival statistics into a common abstract form.

  Transactions and Trades

  Our analysis of framing and of value can be extended to choices between multiattribute options, such as the acceptability of a transaction or a trade. We propose that, in order to evaluate a multiattribute option, a person sets up a men cset optiotal account that specifies the advantages and the disadvantages associated with the option, relative to a multiattribute reference state. The overall value of an option is given by the balance of its advantages and its disadvantages in relation to the reference state. Thus, an option is acceptable if the value of its advantages exceeds the value of its disadvantages. This analysis assumes psychological—but not physical—separability of advantages and disadvantages. The model does not constrain the manner in which separate attributes are combined to form overall measures of advantage and of disadvantage, but it imposes on these measures assumptions of concavity and of loss aversion.

  Our analysis of mental accounting owes a large debt to the stimulating work of Richard Thaler (1980, 1985), who showed the relevance of this process to consumer behavior. The following problem, based on examples of Savage (1954) and Thaler (1980), introduces some of the rules that govern the construction of mental accounts and illustrates the extension of the concavity of value to the acceptability of transactions.

  Problem 7: Imagine that you are about to purchase a jacket for $125 and a calculator for $15. The calculator salesman informs you that the calculator you wish to buy is on sale for $10 at the other branch of the store, located 20 minutes’ drive away. Would you make a trip to the other store?

  This problem is concerned with the acceptability of an option that combines a disadvantage of inconvenience with a financial advantage that can be framed as a minimal, topical, or comprehensive account. The minimal account includes only the differences between the two options and disregards the features that they share. In the minimal account, the advantage associated with driving to the other store is framed as a gain of $5. A topical account relates the consequences of possible choices to a reference level that is determined by the context within which the decision arises. In the preceding problem, the relevant topic is the purchase of the calculator, and the benefit of the trip is therefore framed as a reduction of the price, from $15 to $10. Because the potential saving is associated only with the calculator, the price of the jacket is not included in the topical account. The price of the jacket, as well as other expenses, could well be included in a more comprehensive account in which the saving would be evaluated in relation to, say, monthly expenses.

  The formulation of the preceding problem appears neutral with respect to the adoption of a minimal, topical, or comprehensive account. We suggest, however, that people will spontaneously frame decisions in terms of topical accounts that, in the context of decision making, play a role analogous to that of “good forms” in perception and of basic-level categories in cognition. Topical organization, in conjunction with the concavity of value, entails that the willingness to travel
to the other store for a saving of $5 on a calculator should be inversely related to the price of the calculator and should be independent of the price of the jacket. To test this prediction, we constructed another version of the problem in which the prices of the two items were interchanged. The price of the calculator was given as $125 in the first store and $120 in the other branch, and the price of the jacket was set at $15. As predicted, the proportions of respondents who said they would make the trip differed sharply in the two problems. The results showed that 68% of the respondents (N = 88) were willing to drive to the other branch to save $5 on a $15 calculator, but only 29% of 93 respondents were willing to make the same trip to save $5 on a $125 calculator. This finding cThinchsupports the notion of topical organization of accounts, since the two versions are identical both in terms of a minimal and a comprehensive account.

  The significance of topical accounts for consumer behavior is confirmed by the observation that the standard deviation of the prices that different stores in a city quote for the same product is roughly proportional to the average price of that product (Pratt, Wise, and Zeckhauser 1979). Since the dispersion of prices is surely controlled by shoppers’ efforts to find the best buy, these results suggest that consumers hardly exert more effort to save $15 on a $150 purchase than to save $5 on a $50 purchase.

  The topical organization of mental accounts leads people to evaluate gains and losses in relative rather than in absolute terms, resulting in large variations in the rate at which money is exchanged for other things, such as the number of phone calls made to find a good buy or the willingness to drive a long distance to get one. Most consumers will find it easier to buy a car stereo system or a Persian rug, respectively, in the context of buying a car or a house than separately. These observations, of course, run counter to the standard rational theory of consumer behavior, which assumes invariance and does not recognize the effects of mental accounting.

  The following problems illustrate another example of mental accounting in which the posting of a cost to an account is controlled by topical organization:

  Problem 8 (N= 200): Imagine that you have decided to see a play and paid the admission price of $10 per ticket. As you enter the theater, you discover that you have lost the ticket. The seat was not marked, and the ticket cannot be recovered.

  Would you pay $10 for another ticket?

  Yes (46%) No (54%)

  Problem 9 (N= 183): Imagine that you have decided to see a play where admission is $10 per ticket. As you enter the theater, you discover that you have lost a $10 bill.

  Would you still pay $10 for a ticket for the play?

  Yes (88%) No (12%)

  The difference between the responses to the two problems is intriguing. Why are so many people unwilling to spend $10 after having lost a ticket, if they would readily spend that sum after losing an equivalent amount of cash? We attribute the difference to the topical organization of mental accounts. Going to the theater is normally viewed as a transaction in which the cost of the ticket is exchanged for the experience of seeing the play. Buying a second ticket increases the cost of seeing the play to a level that many respondents apparently find unacceptable. In contrast, the loss of the cash is not posted to the account of the play, and it affects the purchase of a ticket only by making the individual feel slightly less affluent.

  An interesting effect was observed when the two versions of the problem were presented to the same subjects. The willingness to replace a lost ticket increased significantly when that problem followed the lost-cash version. In contrast, the willingness to buy a ticket after losing cash was not affected by prior presentation of the other problem. The juxtaposition of the two problems apparent clemosition ly enabled the subjects to realize that it makes sense to think of the lost ticket as lost cash, but not vice versa.

  The normative status of the effects of mental accounting is questionable. Unlike earlier examples, such as the public health problem, in which the two versions differed only in form, it can be argued that the alternative versions of the calculator and ticket problems differ also in substance. In particular, it may be more pleasurable to save $5 on a $15 purchase than on a larger purchase, and it may be more annoying to pay twice for the same ticket than to lose $10 in cash. Regret, frustration, and self-satisfaction can also be affected by framing (Kahneman and Tversky 1982). If such secondary consequences are considered legitimate, then the observed preferences do not violate the criterion of invariance and cannot readily be ruled out as inconsistent or erroneous. On the other hand, secondary consequences may change upon reflection. The satisfaction of saving $5 on a $15 item can be marred if the consumer discovers that she would not have exerted the same effort to save $10 on a $200 purchase. We do not wish to recommend that any two decision problems that have the same primary consequences should be resolved in the same way. We propose, however, that systematic examination of alternative framings offers a useful reflective device that can help decision makers assess the values that should be attached to the primary and secondary consequences of their choices.

  Losses and Costs

  Many decision problems take the form of a choice between retaining the status quo and accepting an alternative to it, which is advantageous in some respects and disadvantageous in others. The analysis of value that was applied earlier to unidimensional risky prospects can be extended to this case by assuming that the status quo defines the reference level for all attributes. The advantages of alternative options will then be evaluated as gains and their disadvantages as losses. Because losses loom larger than gains, the decision maker will be biased in favor of retaining the status quo.

  Thaler (1980) coined the term “endowment effect” to describe the reluctance of people to part from assets that belong to their endowment. When it is more painful to give up an asset than it is pleasurable to obtain it, buying prices will be significantly lower than selling prices. That is, the highest price that an individual will pay to acquire an asset will be smaller than the minimal compensation that would induce the same individual to give up that asset, once acquired. Thaler discussed some examples of the endowment effect in the behavior of consumers and entrepreneurs. Several studies have reported substantial discrepancies between buying and selling prices in both hypothetical and real transactions (Gregory 1983; Hammack and Brown 1974; Knetsch and Sinden 1984). These results have been presented as challenges to standard economic theory, in which buying and selling prices coincide except for transaction costs and effects of wealth. We also observed reluctance to trade in a study of choices between hypothetical jobs that differed in weekly salary (S) and in the temperature (T) of the workplace. Our respondents were asked to imagine that they held a particular position (S1, T1) and were offered the option of moving to a different position (S2, T2), which was better in one respect and worse in another. We found that most subjects who were assigned to (S1, T1) did not wish to move to (S2, T2), and c2< that most subjects who were assigned to the latter position did not wish to move to the former. Evidently, the same difference in pay or in working conditions looms larger as a disadvantage than as an advantage.

  In general, loss aversion favors stability over change. Imagine two hedonically identical twins who find two alternative environments equally attractive. Imagine further that by force of circumstance the twins are separated and placed in the two environments. As soon as they adopt their new states as reference points and evaluate the advantages and disadvantages of each other’s environments accordingly, the twins will no longer be indifferent between the two states, and both will prefer to stay where they happen to be. Thus, the instability of preferences produces a preference for stability. In addition to favoring stability over change, the combination of adaptation and loss aversion provides limited protection against regret and envy by reducing the attractiveness of foregone alternatives and of others’ endowments.

  Loss aversion and the consequent endowment effect are unlikely to play a significant role in routine economic exchange
s. The owner of a store, for example, does not experience money paid to suppliers as losses and money received from customers as gains. Instead, the merchant adds costs and revenues over some period of time and only evaluates the balance. Matching debits and credits are effectively canceled prior to evaluation. Payments made by consumers are also not evaluated as losses but as alternative purchases. In accord with standard economic analysis, money is naturally viewed as a proxy for the goods and services that it could buy. This mode of evaluation is made explicit when an individual has in mind a particular alternative, such as, “I can either buy a new camera or a new tent.” In this analysis, a person will buy a camera if its subjective value exceeds the value of retaining the money it would cost.

  There are cases in which a disadvantage can be framed either as a cost or as a loss. In particular, the purchase of insurance can also be framed as a choice between a sure loss and the risk of a greater loss. In such cases the cost-loss discrepancy can lead to failures of invariance. Consider, for example, the choice between a sure loss of $50 and a 25% chance to lose $200. Slovic, Fischhoff, and Lichtenstein (1982) reported that 80% of their subjects expressed a risk-seeking preference for the gamble over the sure loss. However, only 35% of subjects refused to pay $50 for insurance against a 25% risk of losing $200. Similar results were also reported by Schoemaker and Kunreuther (1979) and by Hershey and Schoemaker (1980). We suggest that the same amount of money that was framed as an uncompensated loss in the first problem was framed as the cost of protection in the second. The modal preference was reversed in the two problems because losses are more aversive than costs.

 

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