Chapter 27 begins with a figure that displays an “indifference map” for two goods—in this case, the relationship between leisure days/year and income. The curve of the graph shows the points at which the two goods have the same worth to people. What is missing from the figure, however, is an indication of current income and leisure.
Kahneman investigates another piece of accepted economic theory, and again demonstrates the importance of noting the reference point so that the change in wealth and goods is considered, not only the amount by itself.
The reference point’s importance is demonstrated by an example featuring Albert and Ben, two fictional characters who have identical tastes and who have identical starting jobs. The firm then offers them two new positions: Albert will get a raise of $10,000, and Ben will get an extra day of paid vacation each month. Some time passes, and the firm offers them the chance to switch jobs (and also perks) if they wish. The standard theory assumes that they will need little to no incentive to switch. Prospect theory asserts that they will definitely prefer to stay as they are, because they have become accustomed to their added benefits. Prospect theory thus favors the status quo.
In this example, prospect theory accounts for Ben and Albert’s desire to remain with the status quo. Because they have become accustomed to these benefits, the pain of giving up the benefits they currently have hurts worse than the enjoyment they would gain from the newly added benefit—the concept of loss aversion.
Behavioral economics got its start with Richard Thaler in the early 1970s, who was a graduate student at the time. He liked to point out evidence of economic irrationality of his professors. One of them, Professor R, was a firm believer in economic theory. He also loved wine, and Thaler observed that he would buy wines at auctions, but only for less than $35. At the same time, he was very reluctant to sell a bottle of his collection for $100 or less.
In this example from Thaler’s experience, the concept of loss aversion is true not only of money or benefits, but also extends to various goods—in this case, a bottle of wine. Thus, loss aversion has a broad set of applications even beyond pure monetary value and shows that wealth is measured by several parameters.
This gap is inconsistent with economic theory: if the wine is worth $35, Professor R should be willing to sell that wine for any price over $35. But in this instance, owning the good appeared to increase its value. Thaler found many examples like this and discovered what he called the “endowment effect.” Thaler read an early draft of prospect theory and realized that loss aversion could explain the endowment effect. The pain of giving up the bottle is harsher than the joy of getting the bottle.
In Professor R’s case, the value of the wine is not determined by the mere monetary value of the wine (what he could buy or sell it for), but instead how he valued it—how he felt it added to his personal circumstances. This value, then, makes it hard for him to want to relinquish it.
Thaler spent a year at Stanford while Kahneman and Tversky completed their work. During this period, they become friends and explored the endowment effect. They realized that the concept was not universal: there is no loss aversion when you shop for shoes, for example. To the seller, the shoes are a proxy for the money they want to receive. To the buyer, the money is a proxy for the shoes. The difference between the shoes and the wine, is that the shoes are “for exchange” and the wine is held “for use,” to be consumed or otherwise enjoyed.
A possible explanation for the lack of loss aversion in the instance of the shoes is that the shoes are (to the buyer) the more valuable goods, while to the seller the money is actually more valuable. And thus, each one feels an improvement in their general circumstances based on the exchange.
Kahneman, Thaler, and a local economist named Jack Knetsch, designed an experiment that would highlight the contrast between these two types of goods. A limited number of coffee mugs (a good for use) are distributed to the participants in a “market”—some had to buy, and some had to sell. The results demonstrated that for a good that is for use, the average selling price was nearly double the average buying price, and the number of trades was much less than a similar experiment run with a good that was “for exchange.”
Even in a fake “market” experiment, in which people did not even have truly own the goods, the same principle was shown—that goods that they might have the opportunity to use were worth more to people than goods that would simply be exchanged for money.
Observations in real markets illustrate the power of the idea of the reference point. A study of the market for condo apartments in Boston during a downturn yielded these clear concepts. Econs would ignore buying prices—the current market value is all that should matter. But not so for Humans. Owners who have paid more money for their homes set a higher price and spend a longer time trying to sell them, eventually receiving more money.
This example recalls the example of the traders who hang on to their “losers” while selling their “winners.” People are loath to sell something for less than they bought it for, and thus they hang on to it. This is a better strategy when selling a home than trading stocks, however, because the value of homes are much larger and because people buy and sell them a lot less frequently.
Trading experience makes people oddly immune to the endowment effect, however. Economist John List found that inexperienced traders are reluctant to make trades, but experienced traders will make them much more readily. Veteran traders ask the correct question when considering a trade: “How much do I want to have that mug, compared with other things I could have?” This eliminates the endowment effect because it reduces the pain of giving something up.
The difference between the perspective of traders and the perspective of other people is that, in this scenario, the traders treat the thing that they have as a potential proxy for other things (as in the shoe example) and not as something they already own and with which they do not want to part.
Poor people also do not experience the endowment effect, but for different reasons. For them, all costs are losses, and so the pain of buying something is the same as the pain of giving something up.
For poor people, loss aversion is present in every economic decision, because like the traders, they view every purchase as the potential to buy something else instead.