Thinking, Fast and Slow

by Daniel Kahneman

In labor negotiations, it is well understood by both sides that the reference point is the existing contract and that the negotiations will focus on mutual demands for concessions relative to that reference point.

Even if a gain of 12 vacation days was as impressive as a gain of $10,000, the same improvement of leisure is not sufficient to compensate for a loss of $10,000.

Albert will stay at A because the disadvantage of moving outweighs the advantage.

The same reasoning applies to Ben, who will also want to keep his present job because the loss of now-precious leisure outwei...

Conventional indifference maps and Bernoulli’s representation of outcomes as states of wealth share a mistaken assumption: that your utility for a state of affairs depends only on that state and is not affected by your history. Correcting that mistake has been one of the achievements of behavioral economics.

Professor R (now revealed to be Richard Rosett, who went on to become the dean of the University of Chicago Graduate School of Business) was a firm believer in standard economic theory as well as a sophisticated wine lover.

Richard Thaler found many examples of what he called the endowment effect, especially for goods that are not regularly traded.

Suppose you hold a ticket to a sold-out concert by a popular band, which you bought at the regular price of $200.

been willing to pay up to $500 fo...

desperate fans are offeri...

Your lowest selling price is above $3,000 and your maximum bu...

This is an example of an endowment effect, and a believer in standard economic theory would be puzzled by it. Thaler was looking for an account ...

The solution was to abandon the standard idea that Professor R had a unique utility for the state of having a particular bottle.

whether or not the professor owns the bottle now. If he owns it, he considers the pain of giving up the bottle. If he does not own it, he considers the pleasure of getting the bottle.

The slope of the function is steeper in the negative domain; the response to a loss is stronger than the response to a corresponding gain.

This was the explanation of the endowment effect that Thaler had been searching for. And the first application of prospect theory to an economic puzzle now appears to have been a significant milestone in the development of behavioral economics.

The distinctive feature is that both the shoes the merchant sells you and the money you spend from your budget for shoes are held “for exchange.

Other goods, such as wine and Super Bowl tickets, are held “for use,” to be consumed or otherwise enjoyed.

Individuals would make successive public offers to buy or sell a token, and others would respond publicly to the offer.

As inevitably as water flows downhill, those who own a token that is of little value to them (because their redemption values are low) end up selling their token at a profit to someone who values it more.

When trading ends, the tokens are in the hands of those who can get the most money for them from the experimenter.

Furthermore, economic theory correctly predicts both the final price at which the market will settle and the number ...

Selling goods that one would normally use activates regions of the brain that are associated with disgust and pain.

The fundamental ideas of prospect theory are that reference points exist, and that losses loom larger than corresponding gains.

For a rational agent, the buying price is irrelevant history—the current market value is all that matters.

Not so for Humans in a down market for housing.

However, it is well understood that reference points are labile, especially in unusual laboratory situations, and that the endowment effect can be eliminated by changing the reference point.

The experimental economist John List, who has studied trading at baseball card conventions, found that novice traders were reluctant to part with the cards they owned, but that this reluctance eventually disappeared with trading experience.

At a convention, List displayed a notice that invited people to take part in a short survey, for which they would be compensated with a small gift:

coffee mug or a chocolate bar of equal value.

List found that only 18% of the inexperienced traders were willing to exchange their gift for the other. In sharp contrast, experienced traders showed no trace of an endowment effect: 48% of them traded!

Veteran traders have apparently learned to ask the correct question, which is “How much do I want to have that mug, compared with other things I could have instead?” This is the question that Econs ask, and with this question there is no endowment effect, because the asymmetry between the pleasure of getting and the pain of giving up is irrelevant.

decision making under poverty” suggest that the poor are another group in which we do not expect to find the endowment effect.

People who are poor think like traders, but the dynamics are quite different. Unlike traders, the poor are not indifferent to the differences between gaining and giving up. Their problem is that all their choices are between losses. Money that is spent on one good is the loss of another good that could have been purchased instead. For the poor, costs are losses.

two-systems

model of the mind, and specifically a biological and psychological view in which negativity and escape dominate positivity and approach.

but one part of their brain evidently knew: the amygdala, which has a primary role as the “threat center” of the brain,

The brains of humans and other animals contain a mechanism that is designed to give priority to bad news.

By shaving a few hundredths of a second from the time needed to detect a predator, this circuit improves the animal’s odds of living long enough to reproduce.

Of course, we and our animal cousins are quickly alerted to signs of opportunities to mate or to feed, and advertisers design billboards accordingly. Still, threats are privileged above opportunities, as they should be.

There is no real threat, but the mere reminder of a bad event is treated in System 1 as threatening.

The psychologist Paul Rozin, an expert on disgust, observed that a single cockroach will completely wreck the appeal of a bowl of cherries, but a cherry will do nothing at all for a bowl of cockroaches.

Golden saying!

As he points out, the negative trumps the positive in many ways, and loss aversion is one of many manifestations of a broad negativity dominance.

“Bad Is Stronger Than Good,” summarized the evidence as follows: “Bad emotions, bad parents, and bad feedback have more impact than good ones, and bad informa...

In many situations, however, the boundary between good and bad is a reference point that changes over time and depends on the immediate circumstances.

Loss aversion refers to the relative strength of two motives: we are driven more strongly to avoid losses than to achieve gains. A reference point is sometimes the status quo, but it can also be a goal in the future: not achieving a goal is a loss, exceeding the goal is a gain.

The aversion to the failure of not reaching the goal is much stronger than the desire to exceed it.

Economic logic implies that cabdrivers should work many hours on rainy days and treat themselves to some leisure on mild days, when they can “buy” leisure at a lower price. The

logic of loss aversion suggests the opposite: drivers who have a fixed daily target will work many more hours when the pickings are slim and go home early when rain-drenched customers are begging to be taken somewhere.

The existing terms define reference points, and a proposed change in any aspect of the agreement is inevitably viewed as a concession that one side makes to the other.