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Posts Tagged ‘Prospect Theory’

More loss aversion in male tennis players when behind.

August 4, 2017 Leave a comment

A paper entitiled ‘Is Roger Federer more loss averse than Serena Williams?’published by By Nejat Anbarci, K. Peren Arin, Cagla Okten and Christina Zenker on tennis serving and loss aversion caught my attention. The paper found that:

Roger_Federer.jpg
1 a server will put more effort into his/her serve speed when behind in score than when ahead in score,
2 players’ effort levels and thus serve speeds get less sensitive to losses or gains
when score difference gets too large,
3 A female player, on the other hand, does not change her serve speed and thus her effort when behind compared to when the score is tied, while she serves slower when ahead than when the score is tied.
4. Overall servers will be more risk averse in the domain of gains than in the domain of losses.
Researchers used serve speed at different points of matches in the high-stakes, professional Dubai Tennis Tournament to test their theoretical predictions and whether overall players exhibited the fundamental bias of loss aversion.

 

Loss Aversion and the  Endowment Effect

Loss aversion can be explained by prospect theory, which states that an individual’s value function (whether for money or otherwise) is concave for gains but convex for losses. In other words, people are more sensitive to losses compared to gains of similar magnitude. This is illustrated below.

Prospect theory

The reference point in the diagram is the current position of the individual concerned. Gains and losses are evaluated with reference to this neutral reference point. The value function takes an asymmetric S-shape because marginal value (or sensitivity) declines as absolute gains and losses increase in size. A dollar lost more than outweighs a dollar gained. In conventional economics, gains and losses are treated equally – a dollar lost simply cancels out a dollar gained. Golf provides a perfect example of a reference point: par. Every hole on a golf course has a number of strokes associated with it; the par provides the baseline for good – but not outstanding – performance. For a professional golfer, a birdie (one stroke under par) is a gain, and a bogey (one stroke over par) is a loss. Economists have compared two situations a player might face when hear the hole:

  • putt to avoid a bogey
  • putt to achieve a birdie

One group of economists analysed more than 2.5 million putts in exquisite detail to test that prediction and found that whether the putt was easy or hard, at every distance from the hole, the players were more successful when putting for par than for a birdie. The difference in their rate of success when going for par (to avoid a bogey) or for a birdie was 3.6%.

 

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Behavioural Economics and reclining airline seats

June 2, 2017 Leave a comment

I picked up this topic from Michael Cameron’s blog Sex, Drugs, and Economics which looked in detail at the economics behind reclining airline seats. The issue that he refers to is – who owns the space between reclining airline seats?

Externalities

The person (Recliner) who reclines their seat reduces the amount of space that the person (Reclinee) behind has especially if they have their tray table down and becomes a negative externality to them. Some airlines are worse than others with regard to space – American carriers tend to have very little room as do the low cost airlines. However carriers that operate more long haul flights especially Emirates seem to be more generous with the space between seats. However if there is nobody in the seat behind then there is no externality. This refers to the Coase Theory (see previous blog post) in which Ronald Coase stated that problems are jointly produced by the person who creates the externality and the person who is affected by it. He argued that bargaining between parties could produce a mutually beneficial and efficient solution to problems like the scares resource i.e. the space between airline seats.

An article on the site Evonomics by Buccafusco (Cardozo School of Law) and Sprigman (NYU School of Law) looked at research into how much passengers would be willing to pay to recline their seat. They looked at the following scenarios.

Default – you have the right to recline your seat
Recliners wanted on average $41 to refrain from reclining, while reclinees were willing to pay only $18 on average. Only about 21 percent of the time would ownership of the 4 inches change hands

Default – you don’t have the right to recline your seat and have to negotiate
Recliners were only willing to pay about $12 to recline while reclinees were unwilling to sell their knee room for less than $39. Recliners would have ended up purchasing the right to recline only about 28 percent of the time—the same right that they valued so highly in the other condition.

The Coase theorem suggests that the initial allocation of rights should not matter, because if the person who values the right the most doesn’t start out with it, they will simply purchase it from the other. But what Buccafusco and Sprigman found suggests that this simple solution might not work. What they found was an endowment effect.

Loss Aversion and the  Endowment Effect

Loss aversion can be explained by prospect theory, which states that an individual’s value function (whether for money or otherwise) is concave for gains but convex for losses. In other words, people are more sensitive to losses compared to gains of similar magnitude. This is illustrated below.

Prospect theory

The reference point in the diagram is the current position of the individual concerned. Gains and losses are evaluated with reference to this neutral reference point. The value function takes an asymmetric S-shape because marginal value (or sensitivity) declines as absolute gains and losses increase in size. A dollar lost more than outweighs a dollar gained. In conventional economics, gains and losses are treated equally – a dollar lost simply cancels out a dollar gained. Golf provides a perfect example of a reference point: par. Every hole on a golf course has a number of strokes associated with it; the par provides the baseline for good – but not outstanding – performance. For a professional golfer, a birdie (one stroke under par) is a gain, and a bogey (one stroke over par) is a loss. Economists have compared two situations a player might face when hear the hole:

  • putt to avoid a bogey
  • putt to achieve a birdie

One group of economists analysed more than 2.5 million putts in exquisite detail to test that prediction and found that whether the putt was easy or hard, at every distance from the hole, the players were more successful when putting for par than for a birdie. The difference in their rate of success when going for par (to avoid a bogey) or for a birdie was 3.6%.

Note that endowment effects are working for the ‘reclinees’ as well – they are willing to give up their extra knee room for $39 if they had the right to keep it, but would only be willing to pay $18 to get that right if they didn’t start out with it.

The endowment effect means that this problem isn’t really amenable to a simple solution, because recliners already have the default rights, and are understandably unwilling to give those rights up. And any change in policy is going to incur passenger protest – because even though we may gain knee room, passengers would be giving up their right to recline, and loss aversion almost ensures that would be a painful and unwelcome trade-off for most passengers.

Behavioural Economics: Prospect Theory

March 27, 2013 Leave a comment

One of the first topics in the Behavioural Economics course that I am teaching is Prospect Theory. Of critical importance to behavioural economists is the fact that people are frequently subject to cognitive illusions (errors in understanding reality based on how information is presented or framed and how our brain processes information) causing errors and biases in decision making. Moreover these events are typically not one-time occurrences: People fail to learn appropriately from their mistakes, which is a product of not abiding by conventional economics behaviour norms. Nobel Laureate Daniel Kahneman and Amos Tversky referred to this as errors and biases approach. Prospect theory was developed as descriptive theory of certain aspects of average decision-making behaviour. Conventional economics can’t describe, explain, or predict choice behaviour. Emotions are a key driver of a person’s behaviour. People have been shown to be loss averse, generally appearing to dislike losing something roughly twice as much as they like gaining it. Such a phenomenon has been shown in a number of experimental studies in a broad range of contexts. Loss aversion can be explained by prospect theory , which states that an individual’s value function (whether for money or otherwise) is concave for gains but convex for losses. In other words, people are more sensitive to losses compared to gains of similar magnitude.

Prospect theoryThis is illustrated in the graph. The reference point in the diagram is the current position of the individual concerned. Gains and losses are evaluated with reference to this neutral reference point. The value function takes an asymmetric S-shape because marginal value (or sensitivity) declines as absolute gains and losses increase in size. A dollar lost more than outweighs a dollar gained. In conventional economics, gains and losses are treated equally – a dollar lost simply cancels out a dollar gained.

Relative Income

Many people pay special attention to reference points when income or wealth increases or decreases. What counts isn’t total income or wealth but the relative changes in income and wealth – this is why the negative and positive dimensions of the value function are drawn from a reference point. In conventional economics, what people are most concerned about is the endpoint or total amount of income or wealth. But from the perspective of prospect theory, many people are happier if their income increase by 10% from a lower level of income than 2% from a much higher level of income. If my income goes up by 10% from $1,000 to $1,100, I’ll be happier than if my income goes up 2% from $10,000 to $10,200. Of course in conventional economics, your emotions don’t introduce concerns about reference points that may override your desire to increase your absolute level of income.

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