The Endowment Effect

In preparation for this weeks lecture our group was given the reading by John. A List, 'Neoclassical Theory Vs. Prospect Theory.'

The reading and lecture was based on 'The endowment effect' which can be described as people value a good a lot more once their property right to it has been established. I'm sure a lot of people would agree with this as it seems a reasonable statement, we tend to feel more attached to said good if it is ours rather than a good on a shelf. The paper that we read was focusing on the endowment effect and the way in which both the neoclassical and prospect theory can or can't explain it.

The prospect theory is seen as being a good explanation for the endowment effect as by loosing the item it is weighting more heavily that gaining a new one. However, the endowment effect is inconsistent with economic theories such as the neoclassical theory as according to them, you would weight the price of the item the same for what you would sell it for as for what you would buy it for. So the neoclassical theory cannot explain this effect, whereas in the prospect theory there is weighting around a reference point.

The neoclassical theory's argument for the endowment effect, is that simply inexperienced buyers would experience it, and that it is something that needs to be learned and a mistake made by an inexperienced consumer. The more experience in the market place you have the more likely your behaviour will resemble that of the neoclassical model.

An experiment took place in which there were 4 conditions, you were endowed with either a mug or candy bar, both or neither. There were two groups, non-dealers and dealers. The results showed that the non-dealers, with very little experience in the marketplace once endowed with a candy bar 81% kept it when asked if they would like to trade for a mug. Only 7% wanted to trade. This provides evidence of the endowment effect supported by prospect theory, but also for the idea that with experience it does not effect you. As in the experiment the Dealers were not influenced by the conditions.

I have found the idea of the endowment effect very interesting and easy to get to grips with as i can see how i would be influenced in it within my own decisions. The wiki is due in next week and our group is doing it on decision framing, my part is to generally analyse decision making as a whole and make some concluding remarks!

Decision Framing

In preparation for the lecture this week our group had to read the article by Mandel, 'Gain-loss framing and choice'. Unfortunately i was not present in the lecture as i was ill, however i had completed all the readings and made all the notes so i will let you know what i came to learn about decision framing from this paper.

The paper is mainly based around the idea of the disease problem in which Tversky and Kahneman came up with. Depending on the way in which the question is 'framed' for example based on either 'lives saved' or 'lives at risk' participants are likely to go for two different answers. If the question is based on the number of lives that can be saved and a sure option is available we would naturally be risk adverse and choose that option, as who wants to risk lives when we can at least 100% save say 200? However on the other hand when asked in a different format i.e. 400 will die people are reluctant to go for the sure thing as the question is framed around lives that are at risk. We tend to be a lot more risk seeking if there is a small opportunity that we can save some lives, however improbable that is.

One of the explanations for this brought up in the paper was that when the statement is 200 lives saved. It doesn't clarify the fact that yes 400 people will die. As people can't see the whole picture they are more likely to believe that yes there is a chance that more will be saved and 200 are definitely saved, but 400 aren't definitely going to die. When missing information is then filled in Kuhberger found that no framing effect was found.

This paper was a lot easier to digest than past weeks and i found myself understanding what i was reading first time around and being able to adapt to it a lot better. I'm not sure whether this topic makes a lot more sense to me or if from reading past papers in the last couple of weeks on expected utility theorys and prospect theorys that it is all making sense at last.

I have discussed with my group about what was done in the lecture and we are beginning our group wiki project on the topic of 'decision framing' this week.

Lecture 3+4 : Measuring Utility

For this week's lecture we were asked to do the reading by Brandstatter, 'The Priority Heurisitic: Making Choices without Trade-Offs.' The reading was at first describing the Expected Utility and Value theories therefore giving us a bit of a refresh from Cognitive Psychology 2 module last year. It then however carried on to the prospect theory in which i know feel i have grasped a lot better than i did last year. It carried on to talk about this new idea of the priority heuristic. The expected utility and value theories were a bit easier to digest than the prospect theory and i was more aware of the basis of the theory of them, however after the class discussion the prospect theory was a lot clearer to me. With the prospect theory losses loom large than gains, so it takes into account that yes people do risk seek just as much if they think they are going to lose a lot of money as if they were going to win a lot. In the expected utility theory it didnt take into account that losses could be accounted for also. Decisions are made by basing their choices on a weighting function and a value of the prospect. It also accounts for the fact that small probabilities are over weighted and large ones are underweighted when making a decision.

An example of this would be a lottery ticket, the actual amount you spend is more than the probability of what you would be expected to win. Yet every week millions of people buy these tickets spend at least a £1.00 holding out for the small hope that they might win big.In class we then went on to discuss measuring utilities and conducted an exercise on utility functions. By asking questions relating to a series of choices i then plotted my results on two graphs, one for certainty equivalence and one for probability equivalence below.

You can see that with certainty equivalence in order to be indifferent between a lottery ticket with a 50/50 chance of winning £1000 or nothing the sum that would make me indifferent had to be £200. Any more and i would have definitely taken the money! Also when it came to the choice of either £1000 or £200 the sum of money i would get for certain was a lot higher at £500 as i was more willing to take a risk knowing i wasn't going to lose and get nothing, so it needed to be a larger amount to make me indifferent.

With the probability equivalence graph you can see that when more money is involved again the probability has to be higher for me to consider the risk in an equal light to the certain amount. However i'm never really game unless the probability is fairly high!! This is just my opinion but being a student money is precious and my decision making is NOT risk based!! As how it may have been a few years ago when i didn't have too much to gamble with and no debt!

The reading for next week is on decision framing, my group is reading the one by Mandel, Gain-loss, framing and choice. I'm hoping that im going to enjoy this and grasp it much easier than the previous two lectures as our group is struggling to decide which topic to do for our mid term wiki!!