Thinking, Fast and Slow: Part 4, Chapter 27 Summary & Analysis

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.

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.

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.

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.

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.

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.”

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.

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.

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.