In economics

Economics

Economics is the social science that analyzes the production, distribution, and consumption of goods and services. The term economics comes from the Ancient Greek from + , hence "rules of the house"...

 and decision theory

Decision theory

Decision theory in economics, psychology, philosophy, mathematics, and statistics is concerned with identifying the values, uncertainties and other issues relevant in a given decision, its rationality, and the resulting optimal decision...

, loss aversion refers to people's tendency to strongly prefer avoiding losses to acquiring gains. Some studies suggest that losses are twice as powerful, psychologically, as gains.
Loss aversion was first convincingly demonstrated by Amos Tversky

Amos Tversky

Amos Nathan Tversky, was a cognitive and mathematical psychologist, a pioneer of cognitive science, a longtime collaborator of Daniel Kahneman, and a key figure in the discovery of systematic human cognitive bias and handling of risk. Much of his early work concerned the foundations of measurement...

 and Daniel Kahneman

Daniel Kahneman

Daniel Kahneman is an Israeli-American psychologist and Nobel laureate. He is notable for his work on the psychology of judgment and decision-making, behavioral economics and hedonic psychology....

.

This leads to risk aversion

Risk aversion

Risk aversion is a concept in psychology, economics, and finance, based on the behavior of humans while exposed to uncertainty....

 when people evaluate a possible gain; since people prefer avoiding losses to making gains. This explains the curvilinear shape of the prospect theory

Prospect theory

Prospect theory is a theory that describes decisions between alternatives that involve risk i.e. where the probabilities of outcomes are known. The model is descriptive: it tries to model real-life choices, rather than optimal decisions.-Model:...

 utility graph in the positive domain. Conversely people strongly prefer risks that might possibly mitigate a loss (called risk seeking behavior).

Loss aversion may also explain sunk cost

Sunk cost

In economics and business decision-making, sunk costs are retrospective costs that have already been incurred and cannot be recovered. Sunk costs are sometimes contrasted with prospective costs, which are future costs that may be incurred or changed if an action is taken...

 effects.

Loss aversion implies that one who loses $100 will lose more satisfaction than another person will gain satisfaction from a $100 windfall. In marketing

Marketing

Marketing is the process used to determine what products or services may be of interest to customers, and the strategy to use in sales, communications and business development. It generates the strategy that underlies sales techniques, business communication, and business developments...

, the use of trial periods and rebates try to take advantage of the buyer's tendency to value the good more after he incorporates it in the status quo.

Note that whether a transaction is framed as a loss or as a gain is very important to this calculation: would you rather get a $5 discount, or avoid a $5 surcharge? The same change in price framed differently has a significant effect on consumer behavior. Though traditional economists consider this "endowment effect

Endowment effect

In behavioral economics, the endowment effect is a hypothesis that people value a good or service more once their property right to it has been established. In other words, people place a higher value on objects they own than objects that they do not...

" and all other effects of loss aversion to be completely irrational

Irrationality

Irrationality is cognition, thinking, talking or acting without inclusion of rationality. It is more specifically described as an action or opinion given through inadequate reasoning, emotional distress, or cognitive deficiency...

, that is why it is so important to the fields of marketing

Marketing

Marketing is the process used to determine what products or services may be of interest to customers, and the strategy to use in sales, communications and business development. It generates the strategy that underlies sales techniques, business communication, and business developments...

 and behavioral finance

Behavioral finance

Behavioral economics and its related area of study, behavioral finance, use social, cognitive and emotional factors in understanding the economic decisions of individuals and institutions performing economic functions, including consumers, borrowers and investors, and their effects on market...

. The effect of loss aversion in a marketing setting was demonstrated in a study of consumer reaction to price changes to insurance policies. The study found price increases had twice the effect on customer switching, compared to price decreases.

Loss aversion and the endowment effect

Loss aversion was first proposed as an explanation for the endowment effect

Endowment effect

In behavioral economics, the endowment effect is a hypothesis that people value a good or service more once their property right to it has been established. In other words, people place a higher value on objects they own than objects that they do not...

—the fact that people place a higher value on a good that they own than on an identical good that they do not own—by Kahneman, Knetsch, and Thaler (1990). Loss aversion and the endowment effect lead to a violation of the Coase theorem—that "the allocation of resources will be independent of the assignment of property rights when costless trades are possible" (p. 1326).

In several studies, the authors demonstrated that the endowment effect could be explained by loss aversion but not five alternatives: (1) transaction costs, (2) misunderstandings, (3) habitual bargaining behaviors, (4) income effects, or (5) trophy effects. In each experiment half of the subjects were randomly assigned a good and asked for the minimum amount they would be willing to sell it for while the other half of the subjects were given nothing and asked for the maximum amount they would be willing to spend to buy the good. Since the value of the good is fixed and individual valuation of the good varies from this fixed value only due to sampling variation, the supply and demand curves should be perfect mirrors of each other and thus half the goods should be traded. KKT also ruled out the explanation that lack of experience with trading would lead to the endowment effect by conducting repeated markets.

The first two alternative explanations—that under-trading was due to transaction costs or misunderstanding—were tested by comparing goods markets to induced-value markets under the same rules. If it was possible to trade to the optimal level in induced value markets, under the same rules, there should be no difference in goods markets.

The results showed drastic differences between induced-value markets and goods markets. The median prices of buyers and sellers in induced-value markets matched almost every time leading to near perfect market efficiency, but goods markets sellers had much higher selling prices than buyers' buying prices. This effect was consistent over trials, indicating that this was not due to inexperience with the procedure or the market. Since the transaction cost that could have been due to the procedure was equal in the induced-value and goods markets, transaction costs were eliminated as an explanation for the endowment effect.

The third alternative explanation was that people have habitual bargaining behaviors, such as overstating their minimum selling price or understating their maximum bargaining price, that may spill over from strategic interactions where these behaviors are useful to the laboratory setting where they are sub-optimal. An experiment was conducted to address this by having the clearing prices selected at random. Buyers who indicated a willingness-to-pay higher than the randomly drawn price got the good, and vice versa for those who indicated a lower WTP. Likewise, sellers who indicated a lower willingness-to-accept than the randomly drawn price sold the good and vice versa. This incentive compatible value elicitation method did not eliminate the endowment effect but did rule out habitual bargaining behavior as an alternative explanation.

Income effects were ruled out by giving one third of the participants mugs, one third chocolates, and one third neither mug nor chocolate. They were then given the option of trading the mug for the chocolate or vice versa and those with neither were asked to merely choose between mug and chocolate. Thus, wealth effects were controlled for those groups who received mugs and chocolate. The results showed that 86% of those starting with mugs chose mugs, 10% of those starting with chocolates chose mugs, and 56% of those with nothing chose mugs. This ruled out income effects as an explanation for the endowment effect. Also, since all participants in the group had the same good, it could not be considered a "trophy", eliminating the final alternative explanation.

Thus, the five alternative explanations were eliminated in the following ways:

• 1 & 2: Induced-value market vs. consumption goods market;
• 3: Incentive compatible value elicitation procedure;
• 4 & 5: Choice between endowed or alternative good.

Questions about the existence of loss aversion

Recently, studies have questioned the existence of loss aversion. In several studies examining the effect of losses in decision making under risk and uncertainty no loss aversion was found (Erev, Ert & Yechiam, 2008; Ert & Erev, 2008; Harinck, Van Dijk, Van Beest, & Mersmann, 2007; Kermer, Driver-Linn, Wilson, & Gilbert, 2006; Yechiam & Ert, 2007). There are several explanations for these findings: one, is that loss aversion does not exist in small payoff magnitudes; the other, is that the generality of the loss aversion pattern is lower than that thought previously. Alternatively, Gal (2006) argues that the phenomena previously attributed to loss aversion are more parsimoniously explained by inertia than by a loss/gain asymmetry. However, loss aversion may be more salient when people compete. Gill and Prowse (forthcoming) provide experimental evidence that people are loss averse around reference points given by their expectations in a competitive environment with real effort.

Loss aversion in nonhuman subjects

In 2005, experiments were conducted on the ability of capuchin monkey

Capuchin monkey

The capuchins are New World monkeys of the genus Cebus. The range of capuchin monkeys includes Central America and South America as far south as northern Argentina...

s to use money. After several months of training, the monkeys began showing behavior considered to reflect understanding of the concept of a medium of exchange. They exhibited the same propensity to avoid perceived losses demonstrated by human subjects and investors.
However, a subsequent study by Silberberg and colleagues suggested that in fact the 2005 results were not indicative of loss aversion because there was an unequal time delay in the presentation of gains and losses. Losses were presented with a delay. Hence, the results can also be interpreted as indicating "delay aversion".

See also

• Risk aversion
  Risk aversion
  Risk aversion is a concept in psychology, economics, and finance, based on the behavior of humans while exposed to uncertainty....
  
  
• Equity premium puzzle
  Equity premium puzzle
  The equity premium puzzle is a term coined in 1985 by economists Rajnish Mehra and Edward C. Prescott. It is based on the observation that in order to reconcile the much higher returns of stocks compared to government bonds in the United States, individuals must have implausibly high risk aversion...
  
  
• Status quo bias
  Status quo bias
  The status quo bias is a cognitive bias for the status quo; in other words, people tend not to change an established behavior unless the incentive to change is compelling...
  
  
• List of cognitive biases

Sources

• Ert, E., & Erev, I. (2008). The rejection of attractive gambles, loss aversion, and the lemon avoidance heuristic. Journal of Economic Psychology, 29, 715-723.
• Erev, I., Ert, E., & Yechiam, E. (2008). Loss aversion, diminishing sensitivity, and the effect of experience on repeated decisions. Journal of Behavioral Decision Making, 21, 575-597.
• Gal, D. (2006). A psychological law of inertia and the illusion of loss aversion. Judgment and Decision Making, 1, 23-32.
• Harinck, F., Van Dijk, E., Van Beest, I., & Mersmann, P. (2007). When gains loom larger than losses: Reversed loss aversion for small amounts of money. Psychological Science, 18, 1099-1105.
• Kahneman, D., Knetsch, J., & Thaler, R. (1990). Experimental Test of the endowment effect and the Coase Theorem. Journal of Political Economy 98(6), 1325-1348.
• Kahneman, D. & Tversky, A. (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica 47, 263-291.
• Kermer, D.A., Driver-Linn, E., Wilson, T.D., & Gilbert, D.T. (2006). Loss aversion is an affective forecasting error. Psychological Science, 17, 649-653.
• McGraw, A.P., Larsen, J.T., Kahneman, D., & Schkade, D. (2010). Comparing gains and losses. Psychological Science.
• Silberberg, A., et al. (2008). On loss aversion in capuchin monkeys. Journal of the experimental analysis of behavior, 89, 145-155
• Tversky, A. & Kahneman, D. (1991). Loss Aversion in Riskless Choice: A Reference Dependent Model. Quarterly Journal of Economics 106, 1039-1061.
• Yechiam, E., & Ert, E. (2007). Evaluating the reliance on past choices in adaptive learning models. Journal of Mathematical Psychology, 52, 75-84.