Behavioral Economics Lesson Three – Loss Aversion, Endowment Effects, and Default Bias
Why don’t we always choose the best option when making a decision?
The lesson presents three short illustrations of how people may not always make decisions by weighing the costs and benefits of the alternatives. The lesson emphasizes how reference points can influence people’s decisions. Related to this idea, behavioral economists have observed that people tend to weigh losses (relative to a reference point) more than gains (relative to a reference point) when trying to decide what to do.
Traditional economic theory assumes rational consumers make decisions by weighing the marginal costs versus the marginal benefits of an action. By doing so, decision makers choose the options that maximize their happiness. Behavioral economists have observed that sometimes people’s decisions are influenced by factors other than costs and benefits. Behavioral economists study these factors.
One pattern behavioral economists have observed is that people don’t evaluate only the absolute costs and benefits of a decision. Many times people also evaluate how much they stand to gain or lose relative to a specific reference point (for example, where they started), and when they make these evaluations they tend to weigh losses relative to the reference point more heavily than gains.
Behavioral Economics concepts in this lesson: Endowment Effect, Loss Aversion, Default Bias
- Explain how people’s decisions may be influenced by more than just the absolute costs and benefits.
- Discuss how the endowment effect and loss aversion affect decision making.
Give an example of how default bias influences how people make choices.
- Slides 1 – 10 (PPT) or (PDF)
- Activity 1, one copy per student.
- An equal quantity of two small items (called item A and item B in the lesson) such as snack size candy bars—enough for everyone in the class to have one of each—placed in a box labeled “Prize Box.” The items should be chosen so that some in the class would prefer item A and some would prefer item B (for example, with candy bars, say Snickers and Twix); do not choose items of which everyone would prefer one over the other (e.g., everyone would prefer a quarter to a nickel). Alternatively, to reduce the amount of prizes given out, small cardboard pieces with the name of an item could be handed out, with some students randomly chosen to receive the actual prize at the end of the lesson.
- A box labeled “Trade-In Box,” initially hidden from sight.
- Activity 2, one copy per student.
- Foreward and Acknowledgements
Before beginning the lesson, hand out Activity 1 to the students. Tell students to decide which stock they will sell after they have examined the information. Tell them that you will discuss the results later in the lesson and that they do not need to worry about whether their answer is right or wrong since it depends on their opinion. After 5 minutes, tell the students to flip the sheets over and leave them on their desks for later.
Begin the lesson by telling students that traditional economics teaches that people make decisions based on the costs and benefits of the alternatives. Behavioral economics suggests that other factors may also influence decisions.
Display Slide 1. Tell students that “Econs” refer to the people who make decisions according to traditional economic theories and that “Humans” refer to the people whose decisions may be influenced by other factors beyond costs and benefits. Tell students that today they will be studying about some behavioral economics ideas.
Tell students that to begin the lesson, you will be giving them a prize that is theirs to keep. Take the prize box out and hand out one item to each student, either item A or Item B, alternating between item A and item B so at the end of the process, half the class has item A and half the class has item B. Do not allow the students to request item A or item B. Do not allow the students to trade items. Keep track of how many prizes you handed out – in other words, the number of students in the class, since each student gets one prize.
Tell students that the item is now theirs and that they will be able to take it home. Ask them if they are happier than before they had the item. (The answer is yes, unless they are very unhappy because they prefer the other prize to their own. Note: This question is designed to allow the students to get attached to their item by giving them time to think about their prize, so do not rush the discussion.)
Look into the prize box that contains the remaining items. Tell the class that it looks like you have enough so that if they want to, they can exchange the item they received for the item they did not receive. Take out the box labeled “Trade-In Box.”
Tell students that if they want to make a trade, they can come up and place their item in the trade-in box. In return, you’ll give them their desired item from the prize box.
Note to students that the prizes were evenly distributed initially. Ask students how many exchanges they would expect to occur in this case. (Accept any answer for now.)
Tell students that traditional economic theory would predict that 50% of the students will make an exchange. Explain the 50% using either one of the next two steps.
- If all the students preferred item A, how many should exchange? (Since ½ would receive item B, ½ should want to exchange.)
- If all the students preferred item B, how many should exchange? (Since ½ would receive item A, ½ should want to exchange.)
- If ½ preferred A and ½ preferred B, how many would exchange? (Since, of the ½ that preferred A, ½ would get B, ½ of the ½ or ¼ of the total group would exchange B for A; since, of the ½ that preferred B, ½ would get A, ½ of the ½ or ¼ of the total group would exchange A for B. So 25% would change A for B and another 25% would exchange B for A. In total, we would expect 50% to exchange.)
Tell students that there are four possibilities and that the probability of each possibility can be calculated in this way: since we do not know the proportion of people for whom item A is preferred to item B, we will just denote that proportion as q. Since we will assume that the people preferring A to B are randomly distributed around the classroom, q is the probability an item is given to someone who prefers good A.
The four possibilities and their probabilities are:
- Person prefers item A and gets item A: q x ½ = ½ q
- Person prefers item A and gets item B: q x ½ = ½ q
- Person prefers item B and gets item A: (1-q) x ½ = ½ – ½ q
Person prefers item B and gets item B: (1-q) x ½ = ½ – ½ q
The person will trade if b or c happen, so the probability of trade is: (½ q) + ( ½ – ½ q) , which equals ½ or 50%. So we expect 50% of the students to trade. Note to the students that we do not need to know the actual proportion q.
- Ask students:
Ask students: “In class today, what percentage of you made an exchange?” (Count the number of items in the trade-in box and announce the number of trades to the class. Then divide by the number of students, multiplying by 100 to turn the number into a percentage, and announce the percentage. In general, the percentage will be considerably lower – about 25% – when this experiment is run.)
Note to the students that the percentage of people that traded was lower than economic theory would predict (this step assumes that the class has behaved as many experiments have shown in the past). Ask the students to speculate on why people are reluctant to trade items in their possession. (Accept a wide variety of answers, but encourage students who suggest that they became attached to their items to elaborate on their thoughts.)
Tell the students that this result of having less than the predicted 50% of trades is typical when this experiment is run. Behavioral economists attribute this to the endowment effect. Display Slide 2. The endowment effect occurs because people become attached to the item they have and so are less likely to trade it away. One reason people may experience the endowment effect is that they fear future regret if they give something away.
Tell the students you will give them another example of how people do not always merely weigh costs and benefits. Ask the students to flip over Activity 1. Ask the students which stock they sold. (Answers will vary, but hopefully some students will choose A and some will choose B.)
Ask the students if an “Econ” (someone who thinks like a rational economist) would predict a difference in the fraction of students who sell stock A vs. stock B. (Traditional economic theory would predict that individuals weigh the expected future benefits vs. the expected future costs of selling the stock. Since the information is, while limited, the same for each stock going forward, there is no reason to think that people will choose one stock over another. The stocks have the same expected future return.) After discussing the results, note to the students that an “Econ” would say that selling either stock yields the same result, so a student deciding to sell one of the stocks should just flip a coin.
Ask the students what reasons they gave on their sheets for their decision about which stock to sell. (Answers will vary. Common answers are: The stocks are the same, so no difference. I was concerned about taxes – even though no taxes are levied in the example. I do not trust the forecasts. I was avoiding taking a loss on the stock.)
Ask the students if some chose to sell stock A over stock B. (It is likely some will have chosen A.) Ask the students who chose A why they did not sell B. (Answers will vary, but hopefully a student will say they did not want to sell stock B at a loss. When a student mentions this, tell the students that many people resist incurring losses even when it might be the perfectly sensible thing to do.)
Tell the students the only difference between the two stocks is that in one case the stock would sell at a loss (stock B); the other a gain (stock A). Behavioral economists have noted that people tend to avoid losses when they can. This is referred to as loss aversion. Display Slide 3. Even though the stocks are predicted to perform exactly the same for investors in the future, people will avoid selling the stock that will generate a loss relative to the price at which it was purchased.
Ask the students, again, what an Econ would do. (An Econ would note that both are the same going forward, so the benefit is the same—$15,000—and they give up the same appreciation of the stock. So an Econ would be indifferent between selling one vs. the other and might flip a coin.)
Ask why this example is important for them to understand when they manage their own finances in the future. (The students should note that some people may avoid selling stocks (or a home) at a loss even when this is the best thing to do.)
Tell the students you will give them one more classic example of loss aversion. Display Slide 4. (These examples are from Kahneman’s book, Thinking, Fast and Slow.) Ask the students if they would take the gamble, then display the result the studies have found: people take the sure thing.
Display Slide 5. Ask the students if they would take the gamble, then display the result the studies have found: people take the gamble.
Ask the students what the difference between scenarios A and B is. (In each case, the person has a 50% chance of $1,000 and a 50% chance of $2,000. The gamble can be traded for $1,500 in each case. In short, they are the same.) Ask the students why people gamble in the second scenario. (The students should realize that a person is willing to gamble to avoid a perceived loss as opposed to gamble for a perceived gain.) Traditional economic theory would predict that the percentage of people taking the gamble should be the same in each example.
Note to the students that these behaviors can influence how people decide on important issues such as trading stocks or whether to return an item to the store. Tell the students that while professionals whose job it is to trade stocks are less prone to avoiding losses than individual investors, even they exhibit loss aversion to some extent and it is common to observe this behavior in other settings. Individual investors may not want to take losses on stocks and instead decide to hold onto them even though selling them might be the wisest choice.
Tell students that in addition to the endowment effect and loss aversion, another common bias is demonstrated in the next example. Display Slide 6.
Form groups of three-to-five students, and hand out a copy of Activity 2 to each group. Tell the students to read the activity, which describes a decision faced by a human resource manager in a corporation. Give the groups ten minutes to prepare a short talk about how a corporation should present a retirement plan to their new employees.
After ten minutes, display Slides 7 and 8, which give the two ways of wording the offers. Ask one group to present their results. Suggested points in the discussion should come from the questions the groups discussed.
- Are the two offers monetarily the same for the employees? (The offers are monetarily the same – the only difference is how they are offered to the employee.)
- Do the two offers communicate the same information for the employees? (The information is the same – the only difference is how the offers are presented.)
- Will it matter in terms of employee participation which way the offer is presented? (Groups will vary in their opinions.) Why or why not? (Some groups may argue that since the plans are monetarily the same, participation rates should not differ based on how people sign up. People should be making choices by weighing the costs and benefits of joining the plan, not how the plan is presented. Other groups, realizing that this lesson is about how choices are influenced by other things than costs and benefits, may correctly guess that the plan that automatically signs employees up will have higher participation rates.)
- The finance department has asked you to predict the percentage of employees that will be participating in the retirement program. Please provide an estimate, and if your group believes the way the offer matters, estimate a percentage for each of the choices. (Answers will vary. Of course, the interesting point is how big a difference some groups might think the participation rates will vary between offer types.)
The overall recommendation. (This will vary by group, but assuming that the group decides increased participation is desirable and if the group understands the power of defaults, then option #2 would be chosen.)
After having some of the groups present their opinions, tell the students that according to research by behavioral economists, it does matter how the decision is presented:
- Employees tend to do whatever is the default.
- If the plan is presented as in option #1, where the employee must opt in to the program, participation rates are lower than in option #2.
When employees are presented with option #2, more are likely to contribute to their retirement account.
Explain that this phenomenon is known as default bias – people tend to stick with the default option that is presented when making decisions. Display Slide 9, which now contains the three main terms from the lesson.
Explain that while people try to make good choices by acting like Econs, their choices can be influenced by how the alternatives are presented. Display Slide 10. For example, one study documented a 37.4% participation rate with no automatic enrollment versus 85.9% with automatic enrollment. Tell the students that most financial experts highly recommend participating in matching programs because of the high rate of return of a matching program, so the surprise in these results is why it is not almost 100%.
Ask students if they can come up with examples of when sellers of goods try to make use of default bias. (Students may point out that many online subscription services may offer a free or reduced rate for the first month or two of service. Then, unless you say otherwise, the regular rate applies. In other words, the default is the higher price unless you call to cancel or renegotiate the price.)
Summarize the results for students: All of the short demonstrations illustrate that people tend to avoid losses. Tell the students that the endowment effect, loss aversion, and default bias are commonly observed in experiments and are related. People tend to weigh losses more than gains when deciding what to do and so avoid losses.
- Students avoided giving away their item in the first demonstration where everyone received a prize. This endowment effect occurred because students became attached to the prize and avoided giving it away.
- In the stock example, people tended to avoid taking a financial loss even when the loss was in the past and there was no way to avoid the loss.
- In the example of choosing between two gambles, people will take risk to avoid a guaranteed loss but they won’t take risk if doing so means that they lose a guaranteed gain.
- Finally, people tend to stick with the default because changing away from the default means taking a chance that they will make a mistake and take a loss.
Behavioral economists have noted that when losses are perceived, people go to greater lengths to avoid them.
Display Slide 11, which shows comparisons of Econs versus Humans in behavioral economics. Summarize the following points with the students:
- Economics assumes that people weigh the costs and benefits of various alternatives in order to make a decision.
- Behavioral economics notes that people tend to weigh losses more than gains, so people make choices that are not explained by traditional economics.
- Another example is default bias, in which people tend to go with whatever is presented to them without fully comparing the costs and benefits of the decision.
- Understanding how people are prone to certain biases can help decision makers make better choices because, as some of the activities have demonstrated, people can improve their situation by acting like an Econ.
Extension Activity not available.
John is presented with two scenarios. In each scenario, he must choose either (A) or (B). Scenario 1: Begin with $100. Choose either to (A) receive another $50 or (B) flip a coin and if the coin is heads, receive an additional $100. Scenario 2: Begin with $200. Choose either to (A) lose $50 from the $200 or (B) flip a coin and if the coin is heads, lose $100 from the $200. Traditional economics would predict that John will ____________________.
- *make the same choice in both scenarios
- choose A in Scenario 1 and B in Scenario 2
- choose A in Scenario 2 and B in Scenario 1
- not make a choice
John is presented with two scenarios. In each scenario, he must choose either (A) or (B). Scenario 1: Begin with $100. Choose either to (A) receive another $50 or (B) flip a coin and if the coin is heads, receive an additional $100. Scenario 2: Begin with $200. Choose either to (A) lose $50 from the $200 or (B) flip a coin and if the coin is heads, lose $100 from the $200. Behavioral economics would predict that John will tend to ____________________.
- make the same choice in both scenarios
- *choose A in Scenario 1 and B in Scenario 2
- choose A in Scenario 2 and B in Scenario 1
- not make a choice
Constructed Response / Activity
Explain why stores have liberal return policies that allow people to bring a product home to try out. (Once something is brought home, people experience an endowment effect and are less likely to bring the item back. Liberal return policies allow undecided buyers to purchase the product with the assurance that if they don’t like it they can return it, but after bringing the product home, most buyers will decide to keep the product.)