A discrepancy between willingness to accept and willingness to pay leads to inefficient market behavior.
Willingness to accept and willingness to pay
Let’s consider a good that is in limited supply like it takes to a basketball game. The market price for those tickets should depend on matching buyers with sellers. Over time the ticket should end up in the hands of the people who find them most valuable.
Suppose that there were 500 tickets available for a game at thousand people one of those tickets. If one first gave out the tickets to 500 randomly chosen people then market theory predicts that some of the people who didn’t get the tickets we try to buy them from those who did and if the tickets would eventually end up in the hands of the 500 people who placed the greatest value on those tickets.
But this doesn’t happen. Duke University actually allocates basketball tickets to its students in this fashion. Students sign up for the option to buy tickets that are then allocated by lottery. Students who entered one lottery for championship game tickets were interviewed beforehand.
The median amount that students would be willing to pay to buy a ticket was $150, but the median price that people would be willing to accept to sell a ticket was a full $1500, and the random endowment change the very way that these students thought about the basketball tickets the students who won the ticket lottery describe going to basketball games as an almost priceless experience saying “things like this is an once-in-a-lifetime opportunity”.
But the students who lost the lottery, thought of the tickets as a consumer good saying things like “I could spend my money in many other ways”.
Experience versus consumer goods
Thinking about the tickets in terms of and experience versus as a consumer good turns out to have such strong effects on value. The above is a prototypical example of the endowment, effect randomly giving some people good here basketball tickets increase its objective value by factor of 10.
Needless to say these basketball tickets are not commonly traded on an open market sellers want far more money the buyers are willing to pay. To an economist allocation of Duke basketball tickets is inefficient.
The random distribution process leads to an enormous endowment effect. Preventing the flow of tickets to those who value the most beforehand but the process does have its advantages: the lucky winners see their tickets as expected ordinarily valuable which increases attendance, increases the enthusiasm of the crowd and builds the teams home-court advantage. reference dependence also contributes to a general bias toward loss aversion.
People are more sensitive to economic losses than to
People are more sensitive to economic losses than to economic gains, but how much more sensitive? Well, when we bring people into the laboratory for experiments we don’t have them make decisions about thousands of dollars we can’t spend that much, but we do ask them to make simple decisions about real gains and losses.
We might ask them whether they would be willing to play a coin flip game where if they flipped heads we pay them $20 but if they flip tales they pay is $15. Some people are willing to play that game, but most people aren’t. When we improve the stakes to a gain of $20 versus a loss of only five dollars, then almost everyone is willing to play the game.
Across many experiments over many years researchers have calculated the ratio of gains to losses in which people become willing to play the sort of coin flip game. Economic losses influence this simple decision approximately twice as much as economic gains.
This is not a small bias and almost everyone has it to some degree. So why are we paralyzed by loss aversion every time that we make a financial decision? People do not typically feel loss aversion when they give up something that is supposed to be given up.
Minimizing the potential loss aversion
One useful approach is to focus on what behavioral economists call substitutability. Show them a car that shares many of the positive qualities of their existing car, something similarly stylish maintenance free and fun to drive, but also emphasize a small set of specific advantages something like extra horsepower improved gas mileage.
Discuss the trading process in detail you want them to think about their existing car as an object for potential exchange. If they think about the process as a single transaction of upgrading her car, not a separate selling and buying transaction then you have them right we want them.
Salespeople, marketers and even political campaigns recognize the power of loss aversion shaping your behavior. It results from a fundamental feature of how your brain works: reference depends By evaluating outcomes in terms of changes for reference point your brain can use the same simple sort of computations in its decision-making as it does in vision hearing and many other processes.
Shifting your point of reference
Reference dependence provides a simple and flexible tool functioning a complex world, you can’t just make reference dependence go away even if you wanted to. So, how can we minimize the unwanted effects of reference dependence on our behavior, using it when it’s helpful but not letting it guide us astray?
Several strategies can help. One of the most powerful is the simplest: shifting your point of reference. Suppose you are considering whether to raise a deductible on your auto insurance.
When thinking about insurance the usual way in terms of protecting an asset like your car you might be relatively conservative and want lower deductibles, but you can shift your point of reference and think of insurance differently: it is forfeiting a sure amount of money against the unlikely event.
When people think of an insurance as a necessary cost, they tend to be relatively risk tolerant and they want higher deductibles. Shifting your reference point can even help you stay organized. When deciding whether to keep something say an old sweater or to donated to charity ask yourself what what I pay for this if I didn’t have it already.
If you wouldn’t be willing to pay much that might be a good indication that he should give it away, shifting the reference point used for decision is one way to reframe the decision problem.
Consider separately the larger and smaller consequences
A second useful approach is to consider separately the larger and smaller consequences of a decision. when making a very big decision is easy to lose perspective against the total cost of a new car spending extra on say custom floor mats may not seem like a big deal.
Ask yourself if I already own this car where I pay $500 for better floor mats
when you change your perspective saving them $500 may seem like a much better idea.
Create hypothetical alternatives
Third and finally create hypothetical alternatives for decision. Should you splurge on an extended family vacation this year. Of course, the vacation will be fine and of course the vacation will be expensive. By itself it may be hard to know whether the benefits are worth the cost, so force an alternative point of reference:
On what else would you spend the money? A different sort of vacation? A new car additional retirement savings? Very few economic decisions are made in complete isolation and you can improve your chances of making good decisions by forcing yourself to create alternatives.
Now you should have a deeper understanding of reference dependence, how it works in the brain how it changes our processing of information.