ENDOWMENT EFFECT

Endowment effect- The most important characteristic the endowment effect is loss aversion which describes the reference point (here-current state of affair) and decreases in object value which influences decision more than increases of object value does. Endowment effect explains how evaluation of an objects can have significant economic consequences.

For my last lecture we read the paper by E. Johnson, A. Keinan and G. Haubl called "Aspects of endowment; A Query Theory of Value Construction". The authors argue that the value which we assign to a given object depends on the ownership; if we are in the posses ion of an object, or in the possession of money, or not endowed with anything. If we are endowed with an object, with assign a higher value to that object than the person who would like to buy it from us. They also suggest that the order in which we retrieve from memory series of queries differs for buyers and sellers and if we changed the order in which the natural queries are produced, we can eliminate the endowment effect completely. They have conducted three experiments which support their arguments.

The concept of experiments was rather simple and similar in each of them. Firstly student were asked to perform a simple task. Participant who did not understand it were eliminated. Those who stayed were randomly divided into two groups; sellers (endowed with a mug) and buyers (not endowed with a mug). Next they were asked to write down all the reasons, one by one, why they would like to either have the mug or the money. After that they were asked to assign a monetary value to the mug. The results showed that the sellers were giving much higher price to the mug then the buyers were willing to pay. Therefore choosers produced more value-decreasing aspects (positive thought about the money and negative thought about the mug) and sellers produced more value-increasing aspects (positive thoughts about the mug and negative thoughts about the money)

In the second experiment the natural order in which participants were producing queries was reversed. People who were endowed with a mug were asked to first produce value-increasing aspects and than value-decreasing aspects, and sellers the other way round. As the authors predicted as soon as the natural order was reversed, the endowment effect disappeared. The third experiment in which no one was endowed with an object also support the authors hypothesis.

Findings have challenged most of the economic theories. Authors have proven that the query theory exists and that sellers use very different aspects of knowledge in their evaluation of a given object that the buyers. Memory retrieval is therefore important in our evaluation of an object.

Framing Effect

The focus of my last lecture was on framing effect. As this blog is about judgement and decision making it is crucial to mention how framing questions and sentences in a choice between 2 problems can influence our decision. Our task was to read the article by Daniel Kahneman and Amos Tversky called " Choices, Values, and Frames". This study considers normative (logic and rational) and descriptive (preference and beliefs) analysis under risk and risk less choices.. Next they move on the principles of analysis of rational choice which incorporate 2 principles; dominance ( if prospect A is as good as B in all respects and better than B in at least one respect then A should be preferred) and invariance which requires that preference should not depend on the way choice problem is described, more importantly 2 problems shown together or separately should yield the same outcomes. By bringing up the framing of outcomes theory they prove that invariance in most situation can not be satisfied.

Consider problem that authors described in their study (1984, 343)

U.S. prepares for outbreak of dangerous Asian disease which is expected to kill 600 people. 2 different programs were proposed to combat the disease. Estimated consequences of these programs are as follows;

1.

If program A is adopted 200 people will be saved (72%)

If program B is adopted there is 1/3 probability that 600 people will be saved and 2/3 probability that no one will be saved.

150 respondents were considering this problem. As predicted majority are risk averse and chose program A,a as in problem B we do not save anyone for sure, there is only a probability of saving people.

Now consider another problem in which same story is followed with different description of a problem associated with 2 programs.

2.

If program C is adopted, 400 people will die (22%)

If program D is adopted there is 1/3 probability that nobody will die and 2/3 probability that 600 people will die (78%)

Problem A and B is the same as C and D. However problem D has an option that no one will die therfore people are more risk seeking and go for the gamble. There is more risk seeking in the second problen than there is risk averse in the first.

It is a prove for failure of invariance.

Now lets consider the Formulation effect. The authors suggest that formulation effect can occur without people being aware of the impact of the frame on their decisions. In lung cancer example we can clearly see the impact of a frame effect; in the choice between therapies for lung cancer the outcomes were described in terms of morality and survival. As surgery entails risk of deth, this option was less attractive when statistics of treatment were described in terms of morality than when they were described in terms of survival. The framing effect is very popular in political world, therefore we should be aware of it.

Decision making under risk

The focus of our last lecture was on the decisions under risk and uncertainty. We needed to read an article -"The Priority Heuristic; Making Choices Without Trade-Offs" by Ralf Hertwig, E. Brandstatter and G. Gigerenzer.

I found this article rather difficult to read, however I have eventually managed to understand it correctly and even enjoy reading it.

In this article, authors were revising and studying Bernoulli's framework of expected utility theory. While looking for evidence authors studied framework of fast and frugal priority heuristics.

Utility theory does not have one clear definition. It refers to subjective notion of values. In expected utility theory trade-offs ( losing something and gaining something else) we weight utility of expected monetary of 2 different, e.g lottery tickets, outcomes by their probabilities and then by summing both expected outcomes. The one that has higher utility becomes our choice. The level of utility depends on the person e.g. If poor person gets 100£ he or she will be very happy, however when person as wealthy as Donald Trump will receive the same amount of money, he will not even react to that as 100£ is a very small sum comparing to his wealth. One problem with utility theory is the evidence that people not always maximise expected utility Hardman (2007, 68). This is called the Allais paradox. It is visible when we remove a common element from the choice of 2 problems, the preferences changes. This violate a 'sure'thing'principle of expected utility theory.

Priority heuristics are introduced to react to the difference between the data and expected utility theory. Decisions are taken from decision rather than experience. The word 'priority' relates to the order by which people go through reasons to make their decision. Experiments suggest that outcome counts more than probability. According to the authors stopping rule (making decision and not looking any further for evidence) makes priority heuristic different than utility theory as the latest does not have a stopping rule. We reason by looking at minimum gain than probability of minimum gain and in the end at maximum gain. The focus is on minimum outcome so that we could avoid the worst possible outcome. Stopping rule can even occur after the first one if expected outcome is good enough.

The article study the accuracy of heuristic in predicting people's choices in contrast with heuristics that has been proposed before. They found that priority heuristic outperformed all the other ones. The key difference is the stopping rule. While classic heuristic looked at the same pieces of information, priority ones, focuses on specific aspects of the problem. They also found that priority heuristic is the best in predicting choices, even better than utility theory or prospect theory.

Prospect theory relates to how we code decision outcomes (gains and loses) in relation to the reference point. Sometimes gains can be psychological loses e.g. if we knew that we will get bonus worth 1000£ and we only get bonus worth 400£ we gain money but we feel like we've lost 600£ as that was our expected value. Value function is very similar to utility.

Measuring Utility

A
B

During the last lecture we were given a simple test to understand how utility can be measured. There are two methods of measurement Certainty Equivalent method and Probability Equivalent method. The outcome of that exercise is presented in the above graphs. Horizontal axes represents monetary values and the vertical ones utility values. The task was to state the amount of money that would make us indifferent between that amount and a gamble. Graph A shows you that the higher the certain amount the higher must be the the chance of winning a gamble. Graphs suggests that I am more likely to gamble when the certain amount of money is small. Although the 2 graphs are fairly ssimmilar, there are some differences. As you can see the higher the probability of a satisfactory outcome the more likely I will go for the certain option.

I have found relevant article that can give you a better understanding of the utility measurment. If you are interested you can download it for free via London Metropolitan on line library. (as long as you are studying there off course!)

"Perceptual accuracy and conflicting effects of

certainty on risk-taking behaviour"