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Week 7: Loss Aversion and Reference Points (to be updated)
Kahneman, Daniel, Jack L. Knetsch, Richard Thaler (1990). “Experimental tests of the endowment effect and the Coase Theorem.” Journal of Political Economy 98: 1325-1348. [The endowment effect is one of the major pieces of evidence used in support of loss aversion.]
Johnson, Eric J., Gerald Haubl, et al. (2007). "Aspects of Endowment: A Query Theory of Value Construction." Journal Of Experimental Psychology: Learning Memory And Cognition 33(3): 461-474. [A new paper that suggests a retrieval-based account of loss aversion.]
Kahneman, Daniel (1992). “Reference Points, Anchors, Norms, and Mixed Feelings.” Organizational Behavior and Human Decision Processes 51(2): 296-312. [Although Kahneman's essay nominally deals with the implications of reference points for negotiation, his discussion of reference points is far more general, and of course quite insightful.]
Arkes, Hal R., David Hirshleifer, et al. (2008). "Reference point adaptation: Tests in the domain of security trading." Organizational Behavior and Human Decision Processes 105(1): 67-81. [This paper is probably the first that studies how reference points adapt in some dynamic fashion.]
Heath, Chip, Richard P. Larrick, and George Wu. (1999). “Goals as Reference Points.” Cognitive Psychology 38(1): 79-109. [This paper interprets goal setting literature in terms of the value function. The goal acts as a reference point, and "goals 'inherit' the properties of the value function." More generally, this paper suggests the role non-status quo reference points may have on behavior.]
Comprehension Questions
1. How can loss aversion explain: (i) the Willingness-to-pay/Willingness-to-accept disparity; (ii) Status Quo Bias; (iii) Endowment Effect; (iv) the rejection of symmetry bets (.5,x; .5,-x)?
2. How is loss aversion estimated in Tversky & Kahneman (1992)?
3. What is query theory? What implications does query theory have for the degree of loss aversion?
4. Kahneman also distinguishes between reference effects and anchoring. What's the difference?
5. How do Arkes et al show reference point adaptation? What assumptions do they evoke to measure the asymmetry of adaptation to gains and losses?
6. The major stylized facts of goal setting can be summed up as goals increase performance by increasing effort, attention, and persistence. How does the "goals as reference points" approach organize these findings? What part of the work does loss aversion do? What part of the work does diminishing sensitivity do?
Thought Questions (No stars provided, since most of these are hard!)
1. One criticism of loss aversion is that it is essentially a redescription of the phenomena. "The demonstration that people don't like gambles with losses in it shows that people are averse to losses." Put this way, it doesn't sound like the label "loss aversion" adds much. Let's try to unpack loss aversion a bit. What more basic processes could underlie loss aversion? Should we expect loss aversion to be the same across different kinds of domains? How could we induce increased loss aversion or decreased loss aversion?
2. Tversky & Kahneman (1992) and Kahneman, Knetsch, & Thaler (1990) both show loss aversion to be about 2 to 2.5. But the endowment effect and rejection of fair gambles seem to be pretty different phenomena. Here are two different views of this convergence:
a) First, the similarity of these estimates across these two different domains shows that the same thing (whatever that thing is) is operating in both the endowment effect and the rejection of fair gambles.
b) Second, this is just a coincidence. The superficial similarity of the two demonstrations and the convergence of the estimates has misled us. There is no reason to expect these to be the same. Why, for instance, should loss aversion for risk be the same as loss aversion for sure things?
c) Which of these views do you think is most reasonable?
3. It seems like there are many ways to measure loss aversion. Besides gambles and the endowment effect, how else would you measure loss aversion?
4. The Kahneman article provides some ideas that point us in the direction of a more complete picture of what is going on with reference points.
a. A recent paper [Ordóñez, Lisa D., Terry Connolly, and Richard Coughlan (2000). “Multiple reference points in satisfaction and fairness assessment.” Journal of Behavioral Decision Making 13(3): 329-344.] supports separation of reference points over integration of reference points. How general do you think this finding is? Can you think of some situations in which integration is more natural?
b. It might be useful to think about a particular application. For example, suppose that you are an investor who buys a stock at price
. The stock price path is
. Presumably all those are possible reference points. Presumably they are not all used or set as reference points. Which ones do you think will be chosen, and why? Are some chosen, and then abandoned?
c. Suppose that separation of reference points holds for this example. Ordonez et al suggest that the valuation of a future price P might follow:
, where all the functions have the prospect theory value function properties. What psychological principles determine the weights that reference points,
get? It is probably useful to separate principles into cognitive principles (e.g., attention, recency, etc.), and motivational principles (e.g., optimism, etc.). Is the weighting question (this question) the same as the selection question (b above)?
d. Are there any other reference point candidates that are not past prices? For one idea, see the next question.
e. The stock example is one in which time serves to offer many possible reference points. Can you think of some other examples which are rich with possible reference point candidates? Any new principles that come out by thinking through these examples?
5. Arkes et al suggest the reference point adaptation is governed by hedonic principles? How compelling do you have this account? What additional data would you want to see before you were convinced that hedonic considerations were in operation? What other principles do you think might govern reference point adaptation? How would you test these accounts?
6. Do you think that loss aversion will act the same for all reference points? For example, is the loss aversion coefficient for a non-status quo reference point the same as for the same as for a status quo reference point?
7. Kahneman discusses reference points and anchoring. One simple way of distinguishing between the two is that reference points influence valuation and anchoring influences judgments. However, in the real world, it might not be so easy to distinguish between the two processes. For example, Heath, Huddart, and Lang (1999, Quarterly Journal of Economics) found that the chance of exercising a stock option doubled after the stock price passed a 12-month high. They posit a reference point story. But, you could also posit an expectation story, e.g., stocks are mean-reverting. It is not important whether you believe this particular story; the general point is that it is hard in real world data to distinguish expectational (judgment) explanations from reference point (valuation) explanations. It is even more difficult if expectations serve as the reference points. When do you think that expectations might actually serve as reference points? If you do think that expectations serve as reference points in some situations, why do they do so?
8. Consider the "satisfaction paradox" of goal theory: although those who set high goals outperform those who set low goals, they are often less satisfied with their performance. Heath, Larrick, and Wu explain the satisfaction part in terms of the value function. But what remains still is the question of why people in the real world set goals that they won't reach (or probably won't reach). Is there a way of rescuing this paradox with the "goal as reference points" approach? More generally, this paradox highlights the indeterminacy with endogenous goal formation (goals set up by an individual instead of a boss or an experimenter). Why might somebody set a goal that they might fall short of? Can you think of other "endogenous" reference points of this sort?