A Practicum in Behavioral Economics 6 Laboratory Experiments Additional Differences Between Homo economicus and Homo sapiens

CHAPTER . LABORATORY EXPERIMENTS ADDITIONAL DIFFERENCES BETWEEN HOMO AND HOMO SAPIENS As mentioned previously , this chapter presents additional laboratory experiments designed to test the implications of the theories advanced in Chapter . Here , we learn about the classic advances made by behavioral economists and the main concepts underscored by Prospect Theory concepts such as mental accounting , Ambiguity and Competency Effects , fairness , regret and blame , as well as loss aversion , reference dependence , and the Endowment Effect . MENTAL ACCOUNTING ( VERSION ) Consider the following two experiments proposed by and ( 1984 ) Experiment BEHAVIORAL ECONOMICS

Imagine that you have decided to see a new movie at your local cinema . You went online ahead of time , purchased a ticket for 10 , and then printed the ticket to take with you to the cinema . As you enter the cinema , you discover that you have lost the ticket . The ticket can not be recovered . Would you pay 10 at the box for another ticket ?

Experiment Imagine that you have decided to see a new movie at your local cinema , which costs 10 for a ticket . As you approach the box to pay for a ticket , you discover that you have lost 10 . Would you still pay 10 for a ticket to the movie ?

Homo would recognize that , regardless of whether he had the 10 ticket in hand but lost it or 10 in cash beforehand , once at the cinema the 10 reduction in his income is whats known as a sunk He would therefore ignore this put it out of his instead answer the question , Is watching this movie worth 10 to me at this moment ?

If the answer is yes , then he purchases the ticket and watches the movie . If the answer is no , he heads back home and does not watch the movie . Most importantly , 168 ARTHUR Homo answer to the question is not dependent on whether he lost the ticket itself ( as in Experiment ) or the cash ( as in Experiment ) Homo would not be guilty of narrowly framing his answer on whether it was a ticket or cash that was lost ) As a result , we would expect the percentage of Homo choosing to pay for another ticket in each experiment to be roughly 50 . Based on samples of roughly 200 subjects each for two similar experiments , and found that 46 of the subjects in Experiment answered yes , they would pay 10 at the box office for another ticket , while in Experiment , 88 answered The authors conclude that going to the cinema is normally viewed as a transaction in which the cost of the ticket is exchanged for the experience of seeing the movie . Buying a second ticket increases the cost of seeing the movie to a level that many Homo sapiens find unacceptable . In contrast , the loss of cash is not posted to the mental account of the movie , and it affects the purchase of a ticket only by making the individual feel slightly less affluent This evidence suggests that Homo sapiens is prone to mental accounting while Homo is not . MENTAL ACCOUNTING ( VERSION ) Consider the following experiments proposed by and ( 1984 ) Heath and Soll ( 1996 ) present evidence from three similar accounting experiments that reach the same conclusions as and sapiens tend to be avid mental accountants . BEHAVIORAL ECONOMICS PRACTICUM 169

Experiment Imagine that you are about to purchase a jacket for 70 and a pair of earbuds for 30 ( from the same department store ) The electronics salesperson informs you that the earbuds you want to buy are on sale for 15 at the other branch of the store , which is a drive across town . Would you make the trip to the other store ?

Experiment Imagine that you are about to purchase a jacket for 30 and a pair of earbuds for 70 ( from the same department store ) The electronics salesperson informs you that the earbuds you want to buy are on sale for 55 at the other branch of the store , which is a drive across town . Would you make the trip to the other store ?

A Homo participating in Experiment would recognize the same thing as a Homo participating in Experiment saves 15 by making the trip to the other store . Further , we can say that Homo would not distinguish between 15 saved on a relatively cheap expensive pair of earbuds , and thus , we would expect 50 of the Homo in each experiment to choose to make the trip to the other store . 170 ARTHUR

All else equal , we should expect the full cost of traveling to the other store to exceed the 15 savings for half of the Homo who would therefore choose not to make the trip . When it comes to Homo sapiens , and found that 68 of their roughly 100 subjects in Experiment I chose to make the trip to the other store , while only 29 of their subjects in Experiment chose to make the trip . This is another example of mental accounting , whereby Homo sapiens relate the savings associated with making the trip to a reference point that is determined by the context in which the decision arises . In this case , a larger percentage of Homo sapiens interpreted the savings on the cheaper pair of earbuds to be worth the trip to the other store . Apparently , saving money on a cheaper pair of earbuds is more valuable than saving the same amount of money on a more expensive pair . This example relates to what Thaler ( 1980 and 1985 ) calls transactional utility , whereby consumers base their purchase decisions on whether they derive value from the belief that they are getting a good deal rather than just the utility derived from the actual item purchased , or what Thaler calls utility . The extent to which purchasing decisions are driven by transactional utility helps explain why stores consistently mark certain products as being on For example , consumers are more likely to buy a product marked on sale for when it regularly sells for than they are to buy the same product simply marked as . The product may be for sale at the same price , but consumers feel they are getting a better deal when it is on sale than when they pay a regular price . BEHAVIORAL ECONOMICS PRACTICUM 171

Could there be a better explanation for these experimental results , perhaps something more conclusive to say about a possible reference point ?

Looking again at the two experiments , we see that the price differential in Experiment results in a considerably larger percentage gain in savings than the differential in Experiment ( specifically , the 50 savings in Experiment is more than double the approximately 20 savings in Experiment ) Thus , to the extent that and subjects based their decisions in this context on percentage savings rather than the actual dollar amount saved , we would expect deviations from Homo decision . It may be that several of the experiments subjects behaved as if their reference point for making a choice was percentage rather than actual savings . MENTAL ACCOUNTING ( VERSION ) Consider the following experiment Two avid sports fans plan to travel 25 miles to see their favorite basketball Utah a game at Arena . One of the fans , Patricia , already paid for her ticket . The other , Peter , was on his way to purchase a ticket when he got one free from a friend . A huge blizzard is announced for the night of the game . Which statement best describes the likely outcome of this situation ?

A Patricia is most likely to brave the blizzard to see the game . 172 ARTHUR Peter is most likely to brave the blizzard to see the game . Both are equally likely to brave the blizzard to see the game . Because both Patricia and Peter have tickets to see the game , Homo that each will simply Weigh the expected benefit of braving the blizzard to see the game ( Which is the psychic joy associated with watching the Jazz compete against the opposing team at the Center ) against the expected cost ( the danger of Venturing out into the blizzard ) Not that this is really germane to the issue at hand ( its more a nod to the among you ) but the costs of parking and gasoline to power their Vehicles , as Well as auto insurance and depreciation of their vehicles and their opportunity costs of the time spent traveling to and from the Center and watching the game itself are not added to their expected costs because Homo correctly assumes that Patricia and Peter already accounted for those costs When the tickets were purchased and accepted for free , respectively . Regardless , Homo would choose statement Those of you who BEHAVIORAL ECONOMICS PRACTICUM 173

chose statement A suffer from the Sunk Cost Effect . You are mental accountants . Theres no known explanation for those of you who chose statement and ( 1998 ) test a slight variation of this experiment One year ago , Adams paid 40 cash for a ticket to a basketball game to be played later this week . Yesterday , Baker paid 40 cash for a ticket to the same game . Both men have equally anticipated this game . On the day of the game , there is a snowstorm . Who is more likely to brave the storm and attend the game , Adams who paid for his ticket long ago , or Baker who just recently incurred the 40 expense ?

A Baker is most likely to brave the snowstorm to see the game . Adams is most likely to brave the snowstorm to see the game . Both men are equally likely to brave the snowstorm to see the game . Similar to the previous experiment with Patricia and Peter , We would expect Homo to pick statement When it comes to braving the same snowstorm , it shouldn matter who paid when . As and explain , the timing of Adams and Baker ticket purchases should have no impact on their decision to attend the basketball game . Each 174 ARTHUR

should accept that the 40 already spent is a sunk cost and base his decision to go to the game solely upon the perceived incremental costs and benefits of going . Facing the same incremental costs and benefits , Adams and Baker likelihood of attending the game should be equal . But when it comes to Homo sapiens , all bets are off . and hypothesize that , in keeping with the prevailing wisdom , both Adams and Baker will be prone to the Sunk Cost Effect on purchasing their respective tickets . However , Adams will have gradually adapted to his upstream ticket purchase over the year , thus diminishing the Sunk Cost Effect on his decision of whether to attend the game . The authors call this a Payment Depreciation Effect . To the contrary , has had little time before the game to adapt to the cost of his perceive the full Sunk Cost Effect of his purchase when deciding Whether to attend . Consequently , and predict that Baker will therefore be more likely to attend the game . The authors test their hypothesis in a series of field experiments with individuals at a shopping mall and laboratory experiments with students . They find support for the Payment Depreciation Effect in a variety of . For example , in a laboratory experiment with over 40 students at the University of Colorado , and presented the subjects with three tasks spread over three weeks . The first two tasks entailed a short and a long survey , each involving a subject evaluation of popular soft drinks . The short survey was designed to require minimal effort and was expected to take approximately five minutes to complete . Thus , in completing the short survey the subject experienced BEHAVIORAL ECONOMICS PRACTICUM 175

virtually no cost . In contrast , the long survey was designed to require considerable effort and was expected to take approximately 30 minutes to complete . Therefore , completing the long survey exacted a high cost on the subject . These first two tasks were separated in time by three weeks with the order of the two surveys randomized across half of the subjects first completed the short survey , then experienced the week delay , and then completed the long survey ( delay condition in terms of having incurred the high cost ) while the remaining subjects first completed the long survey , then experienced the delay , and then completed the short survey ( delay condition in terms of having incurred the high cost ) Upon completing the second survey , and paid each subject and then presented the subject with a third and final ostensibly unrelated exercise in which the subject faced a gamble . The subjects were told they could bet up to , in increments of , on a single roll of a pair of dice . They were told that if they rolled a seven or greater , they would double their bet , but if they rolled a number less than seven , they would lose their bet . They were asked to indicate the amount they were willing to gamble , after which they were asked to roll the dice . Based on the outcome of that roll , the amount they had indicated was either added to or subtracted from their payment they had earlier received for completing the second survey . In keeping with their hypothesis about the Payment Depreciation Effect , the authors expected the subjects in the delay condition to experience less of a Sunk Cost 176 ARTHUR

Effect and , therefore , be more likely to gamble more of their payment than subjects in the condition . The authors ultimately found that larger numbers of subjects experiencing the delay condition wagered more of their compensation payment on the gamble than subjects experiencing the condition . The majority of the subjects experiencing the delay condition wagered between and , while slightly more than half of the subjects experiencing the condition wagered between and . MENTAL ACCOUNTING ( VERSION ) Consider the following experiments conducted by and ( 1998 ) Experiment Imagine that you are planning a vacation to the Caribbean that will occur six months from now . The vacation will cost a total of . Which of the following two options would you choose for the vacation ?

A Six monthly payments of 200 each during the six months before the vacation . Six monthly payments of 200 each during the six months beginning after you return from the vacation . BEHAVIORAL ECONOMICS PRACTICUM 177 Experiment Imagine that , six months from now , you are planning to purchase a clothes washer and dryer for your new home . The two machines together will cost . Which of the following two options would you choose for the two machines ?

A Six monthly payments of 200 each during the six months before the machines arrive . Six monthly payments of 200 each during the six months beginning after the machines arrive . When presented with Experiment , the authors found that 60 of the roughly 90 participants ( visitors to the Conservatory in Pittsburgh ) opted for the earlier payments described in option A despite and estimate of an implicit interest penalty equaling approximately 50 per participant . However , in Experiment , 84 of the same subjects preferred to postpone payments until the washer and dryer arrive ( and thus begin paying each month for the next six months after delivery ) Thus , and found that Homo sapiens prefer to decouple payments for durable goods such as washing machines ( and thus prorate their payments as their benefits from using the goods occur over time ) but not necessarily for goods such as vacations , whose benefits do not extend over time ( fond memories of the experience notWithstanding ) This . While and research focuses on how consumers make purchasing and payment decisions , and Thaler ( 1988 ) 178 ARTHUR

suggests that Homo sapiens their mental accounts according to the type of good in question . DISCOUNTING and ( 1992 ) compared the outcomes of two experiments to understand how Homo sapiens tune their time discounting behavior . The two experiments are as follows Experiment Suppose you bought a on a special installment plan . The plan calls for two payments one this week and one in six months . Which of the following two options would you choose for the ?

A An initial payment of 160 and a later payment of 110 . An initial payment of 115 and a latter payment of 160 . consider how consumers essentially decouple their sources of wealth to afford their purchases . and Thaler Behavioral Hypothesis suggests that consumers either mentally or physically ( or both ) classify their wealth into one of three accounts current income , current wealth , and future wealth . Current income is a account that is meant to be spent in the shorter term ( Current wealth is meant to accumulate over time to enable the purchase of more expensive items than would normally be covered . And future wealth is money saved for future consumption ( retirement savings ) BEHAVIORAL ECONOMICS PRACTICUM 179

Experiment Suppose you bought a on a special installment plan . The plan calls for two payments of 200 one this week and one in six months . Happily , however , the company has announced a sale that applies retroactively to your purchase . Which of the following two options would you choose for the ?

A A rebate of 40 on the initial payment and a rebate of 90 on the later payment . A rebate of 85 on the initial payment and a rebate of 40 on the later payment . As the authors point out , since options A and options are the same across Experiments and in terms of payment levels and delivery times , we would expect to see no systemic differences in responses from Homo participants across the two experiments . When it comes to Homo sapiens , however , and find that a higher percentage of the 85 students who participated in the two experiments opted for the lower discount ( greater earlier payment ) represented by option A of Experiment the question is framed as a loss ( a payment ) than as a gain ( a rebate ) as in option A of Experiment . Specifically , 54 of the subjects participating in Experiment stated a preference for option A over . However , only 33 of the subjects preferred option A over in Experiment . To explain these results , the authors argue that in 180 ARTHUR

Experiment subjects discount future payments less ( future payments loom larger in a subject mind ) which leads subjects to base their choice upon the size of the total A total payment of 270 is less than option total payment of 275 . In Experiment , however , the outcomes are framed as gains and are smaller in magnitude , both of which contribute to relatively high discounting of the rebates received in the future , leading to a preference for option which offers a greater initial rebate . Hence , when it comes to discounting the future , Homo sapiens choices are by context , in this case , whether options are framed as future payments due or future rebates to be received . As we well know , Homo is not swayed by this type of IMPROBABLE EVENTS Consider the following two experiments proposed by ( 2011 ) Experiment Choose between lotteries A and A chance to win win for certain . See ( 1987 ) for additional experiments on issues pertaining to discounting . BEHAVIORAL ECONOMICS PRACTICUM 181

Experiment Choose between lotteries A and A chance to lose lose for certain Ok , you know the drill . Lets start with what Homo would do here . She would calculate the expected payoffs from the two lotteries in each experiment and choose accordingly . Hence in Experiment , Lottery would certainly be chosen since ( and in Experiment , Lottery A would be chosen since ( reports that in an experiment with roughly 100 subjects , 72 chose Lottery A in Experiment and 83 chose Lottery in Experiment marked deviation from what we expect of omniscient Homo . The results from Experiment highlight Homo sapiens proclivity to gamble , while the results from Experiment suggest why we tend to purchase insurance against possible loss . and ( 1979 ) go a step further in interpreting these results . They point out that the two experiments demonstrate what they call Possibility and Certainty Effects . On the one hand , lotteries consisting of extremely low probabilities of 182 ARTHUR

winning ( are still enough to tempt individuals with the possibility of winnings ( the Possibility Effect , as demonstrated in Experiment ) On the other hand , lotteries consisting of extremely high probabilities of losing ( 95 100 ) are enough to scare individuals into choosing alternatives with lower probabilities , even if those alternatives are associated with high losses ( the Certainty Effect , as demonstrated in Experiment ) As part of their Prospect Theory ( discussed earlier in Chapter ) and point out that Homo sapiens are prone to interpret these extremes as depicting discrete shifts in a lottery odds , and thus , the lottery expected payoff is essentially ignored . In our minds , we Homo sapiens tend to overweight small probabilities ( improbable events ) and underweight moderate and high probabilities ( more likely events ) Based upon their accumulated laboratory experiences over the years , and ( 1992 ) eventually proposed decision weights , as shown in the table below ( 2011 ) Recall from Chapter that these weights are derived from a formula that effectively transforms a lottery objective probabilities of the outcomes into their corresponding subjective probabilities , or decision weights . i 10 ' 20 ' so so 90 95 i 93 ' 99 100 132 135 251 we The row of Probabilities represents objective probabilities that could conceivably define a given lottery . The row of Decision Weights represents subjective probabilities that and ( 1992 ) suggest we Homo sapiens tend to subconsciously substitute for BEHAVIORAL ECONOMICS PRACTICUM 183

the objective ones . Note that for lower objective probabilities , the corresponding decision weights are larger ( reflecting our penchant for of improbable events ) while for to probabilities , the weights are smaller ( our penchant for more likely events ) AMBIGUITY AND COMPETENCY EFFECTS Consider the following experiments conducted by Heath and ( 1991 ) Experiment Choose between lotteries A and A Ajar contains 50 red marbles and 50 green marbles . Blindly draw a marble and guess its color . If your guess is correct , you win 100 . Ajar contains 100 red and green marbles in unknown proportion . Blindly draw a marble and guess its color . If your guess is correct , you win 100 . Experiment Choose between lotteries A and A A stock is selected at random from the New York Stock Exchange . You guess whether its price 184 ARTHUR

will have gone up or down at close tomorrow . If your guess is correct , you win 100 . A stock is selected at random from the New York Stock Exchange . You guess whether its price went up or down at close yesterday . You can not check any news sources . If your guess is correct , you win 100 . Given that Homo has no particular color preference , he will be indifferent between Lotteries A and in Experiment . This is because the added information provided in Lottery A is superficial in terms of affecting the outcome associated with drawing a marble from the jar . Thus , given any sample of Homo , we would expect 50 to choose Lottery A and 50 to choose Lottery . In his run of this experiment , 1961 ) found a larger percentage of Homo sapiens chose Lottery A than Lottery in what came to be known as the Paradox . Why ?

postulates that , although , the added information provided in Lottery A gives the impression of Lottery A seeming less ambiguous than Lottery . Thus , Homo sapiens tend to submit to what has also come to be known as an Ambiguity . In a more recent laboratory experiment , 2007 ) presented subjects with four different boxes , each containing some configuration of red and black balls . The subjects were tasked with imagining themselves choosing a box and then guessing which color ball would be randomly chosen from the box . If she guessed the color correctly , the subject would win . Box contained five red balls and five black balls . Box contained 10 balls total , but it was unknown BEHAVIORAL ECONOMICS PRACTICUM 185

Similarly , in Experiment , Homo recognizes that Lotteries A and are effectively identical . Given the prohibition in Lottery on ones ability to check the newspaper or check online , the outcome common to each change in a randomly chosen stock unaffected by whether the price change occurred yesterday or tomorrow . Thus , given any sample of Homo , we would again expect 50 to choose Lottery A and 50 to choose Lottery . Lo and behold , in their experiment with roughly 200 subjects , Heath and found that 67 chose Lottery A . Why ?

The authors postulate that Homo sapiens naturally prefer appearing competent or , alternatively stated , prefer not to appear incompetent . By choosing a lottery where the outcome is still to be determined in the future , we perceive ourselves as running less risk of appearing incompetent if the worst outcome occurs ( we guess that the stock price will rise when instead it falls ) than how many were red and black . For Box a number between zero and 10 would first be randomly chosen to determine the number of red balls ( the remainder would be black balls ) And for Box a fair coin would be tossed to determine whether all the balls in the box would be black or all red . Subjects were given the chance to sell bets on each respective box by announcing the amounts they were willing to accept ( to forego the bets . Since ( was the most a subject could win if they were to actually choose a box and then correctly guess the color of a ball chosen from the box , the subject received if she guessed incorrectly , and ( there was effectively a 50 chance of guessing the color correctly regardless of the box chosen , a Homo subject would accept for each of the boxes . If subjects succumbed to the Paradox , then their would be higher for Box or than for Box given the greater amount of ambiguity associated with the former two boxes . The author found the but one subject stated a higher for Box than either Box or . 186 ARTHUR

if we choose the worst outcome of a lottery where , technically speaking , the outcome has already occurred . In other words , Homo sapiens tend to submit to what has come to be known as a Competency Effects THE DECOY EFFECT Consider the following experiments proposed by ( 2008 ) Experiment Suppose The Economist magazine runs the following advertisement announcing a new deal on . Competency and Ambiguity effects play out in another interesting context . Thaler et al . 1997 ) conducted an experiment where subjects were instructed to choose what percentage of their funds to invest in a relatively risky asset ( larger expected return but with more risk ) versus a relatively safe asset ( lower expected return but with less risk ) The experiment consisted of two treatments . The first treatment required subjects to make their respective decisions every period about their portfolio allocation the second treatment allowed subjects to make decisions only once per eight periods . Subjects in the first treatment placed more than 50 of their portfolio in the safe asset over the course of the experiment . In contrast , subjects in the second treatment placed only between 30 and 40 of their portfolios in the safe asset . Thus , by simply increasing the frequency with which subjects were required to evaluate the performance of their portfolios , the researchers found that subjects became more sensitive to risk . Could this be evidence of a Competency Effect , or is it more an instance of ignorance is bliss ?

Either way , Thaler et al . 1997 ) identify this quirky behavior as evidence of narrowly bracketed investment . BEHAVIORAL ECONOMICS PRACTICUM 187 annual subscription rates . New subscribers have three options . subscription for 59 . Includes online access to all articles published in The Economist since 2010 . subscription for 125 . Includes print copies of The Economist for the current year . subscription for 125 . Includes online access to all articles published in The Economist since 2010 and print copies of The Economist for the current year . You have decided that you would like to begin reading The Economist , and thus must choose one of the three options . Which option would you choose ?

Experiment Suppose The Economist magazine runs the following advertisement announcing a new deal on annual subscription rates . New subscribers have two options . subscription for 59 . Includes online access to all articles published in The Economist since 2010 . subscription for 125 . Includes online access to all articles published in The 188 ARTHUR

Economist since 2010 and print copies of The Economist for the current year . You have decided that you would like to begin reading The Economist , and thus must choose one of the two options . Which option would you choose ?

Clearly , all Homo participating in these two experiments who wish to have print versions of The Economist will choose the subscription for 125 . It doesn matter that the option is missing in Experiment . Homo who wish to have print copies of the magazine would never choose that option as long as the option is available . They get more for their money with the option and would therefore never pass it up . This is What found for Experiment when 100 of his students at MIT Sloan School of Management were presented with the three options . Sixteen students chose the option and 84 chose the option . No students chose the option . However , when a different group of 100 students participated in Experiment , 68 chose the option and only 32 chose the option . What happened ?

As describes it , this result is the economic equivalent of the theory of relativity relativity that exposes predictably irrational choice behavior among Homo sapiens . In this particular case , the mere presence of the subscription in Experiment served as BEHAVIORAL ECONOMICS PRACTICUM 189

a decoy that sent 84 of the students to the internet option . The absence of the decoy in Experiment led the students in that experiment to choose differently . Only 32 students chose the internet subscription . This Decoy Effect is a special case of economic relativity . And as points out , these types of effects mirror the way Homo sapiens mind is are prone to consider things around us in a relative sense . This holds true not only for physical things , such as toasters , bicycles , puppies , restaurant entrees , and spouses but also for experiences such as vacations , educational options , emotions , attitudes , and points of view . Homo , on the other hand , thinks and acts in a world of absolutism . THE EFFECT Consider the following two experiments proposed by et al . 2007 ) Experiment Suppose you are given to participate in this experiment . You are presented with the choice of purchasing a for 75 cents or a Kiss for 25 cents . You can choose one or the other , or neither . What will you choose to do ?

190 ARTHUR Experiment Suppose you are given to participate in this experiment . You are presented with the choice of purchasing a for 50 cents or getting a Hershey Kiss for free . You can choose one or the other , or neither . What will you choose to do ?

Despite having no prior information about the preferences of any given Homo for Hershey kisses , We should nevertheless expect that if 50 , 25 , and 25 individuals out of a sample of 100 Homo , respectively , were to select the truffle , Hershey kiss , and neither in Experiment , then roughly the same respective numbers will be selected by Homo in Experiment . Why ?

Because the difference in prices between the and Hershey kiss is the same in each experiment ( 50 cents ) Rationally speaking , Homo interprets the two experiments as offering the same choice . To see this , suppose Homo Harry estimates the amount of utility he expects to get from the and the kiss ( suppose its 150 and 50 , respectively ) and then the disutility he gets from paying for each . Without loss of generality , suppose each cent paid is a . In Experiment , this means that Harry would receive a net utility ( or , net benefit ) of 150 75 75 by choosing the , and 50 25 25 by choosing the Hershey kiss . Harry therefore gains 75 25 50 by choosing the . In Experiment , BEHAVIORAL ECONOMICS PRACTICUM 191

the net benefit from choosing the truffle is 150 50 100 and the net benefit from choosing the kiss is 50 50 . Again , Harry gains 100 50 50 by choosing the . As far as Harry is concerned , the choices in each experiment are identical . Not so Homo sapiens . et al . ran similar experiments with roughly 400 students at the MIT campus and obtained some surprising results . et prices in Experiment were 15 cents for the and cent for the kiss , and in Experiment , the prices were 14 cents for the and for the kiss ( thus , the choices in each experiment are again identical ) To test just how strong the pull of a free Hershey kiss might be , the authors had a subgroup of the 400 students instead choose between a truffle and a free Hershey kiss in Experiment . et al . found that 36 of the students chose the , 14 the Hershey kiss , and 50 chose neither in Experiment . However , in Experiment , only 19 of the students chose the and 42 chose the free kiss . The percentage of students choosing the free kiss was roughly the same ( 40 ) in the version of Experiment where the price of the dropped to 10 cents rather than 14 cents . This pull of the free Hershey kiss is what et al . call the Price Effect . Apparently , the difference between 15 cents , on the one hand , and 14 or 10 cents on the other is small . But the difference between cent and zero is huge . What gives ?

2008 ) puts it this way Most transactions have an upside and a downside , but when something is FREE ! we forget the downside . FREE ! gives us such an emotional charge that we perceive what 192 ARTHUR is being offered as immensely more valuable than it really is . Why ?

its because humans are intrinsically afraid of loss . The real allure of FREE ! is tied to this fear . Theres no visible possibility of loss when we choose a FREE ! item ( its free ) But suppose we choose the item thats not free . now theres a risk of having made a poor possibility of a loss . And so , given the choice , we go for what is free ( 60 ) Sounds like a case of loss VIVIDNESS OF PROBABILITY Consider the following experiments conducted by ( 2011 ) Experiment Suppose you are a psychiatrist at a psychiatric hospital . You are in charge of evaluating whether it . But thats not all , folks ! et al . 2018 ) report on experiments where the Effect works in the opposite direction . Lowering the price to zero ( in this case of Starburst Fruit Chews ) actually leads to a net decrease in the total amount demanded in the market . This occurs when the limit on the total supply of the good in question is either known with certainty or perceived by the consumer , in either case , the good effectively becomes a shared resource . The authors conclude that participants in these experiments applied a simple rule to their choice behavior . Once the candy was priced at zero , they chose to sacrifice their own desires for the benefit of others . As ( 2008 ) points out , these results suggest why , when we are dining outwith friends , taking the last slice of pizza feels so wrong . BEHAVIORAL ECONOMICS PRACTICUM 193

is safe to discharge Thomas from the hospital . Thomas has a history of violence . You have received the following assessment from a criminal expert concerning the risk associated with releasing Thomas from the hospital Patients similar to Thomas are estimated to have a 10 probability of committing an act of violence against others during the several months after Will you deny Thomas discharge ?

Experiment Suppose you are a psychiatrist at a psychiatric hospital . You are in charge of evaluating whether it is safe to discharge Thomas from the hospital . Thomas has a history of violence . You have received the following assessment from a criminal expert concerning the risk associated with releasing Thomas from the hospital Of every 100 patients similar to Thomas , 10 are estimated to commit an act of violence against others during the several months after Will you deny Thomas discharge ?

Since the statistics provided in both 194 ARTHUR experiments ( blue font ) are identical , we would expect the same sample percentages of Homo across Experiments and to answer yes and no and 50 , respectively . Such is not the case with samples of Homo sapiens ( surprise , surprise ) reports that in his experiments , only 21 answered yes in Experiment , while 41 answered yes in Experiment . speculates that fewer subjects answered yes in Experiment because of the Vividness of the probability provided in Experiment , as opposed to the relatively undramatic ( for lack of a better word ) number provided in Experiment . For whatever reason , 10 conjures more of an impact in our minds than 10 out of Who knew ?

ENVY AND GUILT ( OR INEQUALITY AVERSION , OR ) Since we have been exploring effects driven by human emotion ( perceived ambiguity and competency ) this is as good a place as any to investigate what behavioral economists have to say about the emotions envy and guilt . There is no experiment here , just some economic . In Chapter , we will explore how these emotions manifest themselves as fairness in behavioral games . Here , we take a little detour and investigate what BEHAVIORAL ECONOMICS PRACTICUM 195

envy and guilt actually look like in the context of a standard neoclassical Recall from Chapter that the typical Homo utility function looks something like , where , represents individual , wealth level ( yes , in Chapter was used to represent is wealth make the notational change here to be consistent with the ensuing discussion ) To represent the potential effects of envy and guilt on Homo sapiens utility function , and Schmidt ( 1999 ) propose an alternative specification , ar , 117 , a , yr ar , max um where represents another individual wealth level , i 75 , oz , represents individual is marginal disutility from envy , and individual is marginal disutility from Let unpack and Schmidt utility function . First of all , note that at its base , 14 ( is increasing in individual is wealth level just like Homo , except that now is utility increases with wealth rather than Via the square root of wealth . Next , consider the term , max ajj xi , This says that to the extent that individual wealth exceeds individual . I almost said , in the context of the world of Homo However , I chose not to for the simple , albeit technical , reason that Homo is , by definition , devoid of human emotions such as envy and guilt . The model that we present here assumes our Home has complete information . See Cartwright ( 2018 ) for a model with incomplete information . We explain why the upper bound on I , is 05 rather I a bit further below . 196 ARTHUR

is , individual is utility decreases by a constant factor of 017 . If instead individual is wealth exceeds , then there is no negative effect on utility because then zero is larger than a negative number . Can you guess what human emotion this term is accounting for ?

Yep , it envy . Now consider the term , max . You will note that the order of subtraction in this term is reversed from the previous term . Now , to the extent that individual is wealth exceeds individual , individual utility decreases by a constant factor of . If instead individual is wealth exceeds , then there is no negative effect on is utility because then , again , zero is larger than a negative number . This term accounts for the human emotion of guilt . As you know , we economists like to draw graphs ( how does that saying go , a graph is worth a thousand words ?

So , lets consider what and Schmidt ( 1999 ) utility function looks like in the form of an indifference curve ( recall our introduction to this curve in Chapter ) In the case of Homo sapiens ( who tend to experience the emotions of envy and guilt ) the indifference curve for individual ' looks some important respects , much different . Most significantly , to account for envy and guilt , individual is indifference curve must now incorporate the level of some other individual wealth , as per and Schmidt utility function . For those of you with a stronger background in economics , you will note that the formula defining an individual indifference curve solves as , if , 35 , and , a , BEHAVIORAL ECONOMICS PRACTICUM 197

which results in an indifference curve for individual looking like that depicted in Figure . Figure . Indifference Curve for Envious or Homo sapiens xi xi Note that this indifference curve now depicts the interpersonal tradeoff between the two individuals wealth levels , 55 , and , rather than the tradeoff between the two physical quantities , and 171 , exhibited by individual i alone . Recall that when wealth levels are such that as , individual ' is prone to feelings of guilt and is thus confined to the region above the hashed line in the graph . From our formula for the indifference curve above , we see that the slope of the indifference curves line segment in this region of the graph is equal to ( The value of this fraction in turn measures the ( constant ) rate at which individual i is willing to sacrifice , or transfer , some of her 198 ARTHUR

wealth to individual to assuage her guilt at having more wealth ( note that any point above the line indicates that individual is wealth exceeds individual ) The larger is , the more steeply sloped is the line segment , implying that individual i feels a greater sense of guilt from her wealth differential with individual , and thus , is willing to transfer even more of her wealth to per unit of wealth . You might be wondering what the terminology per unit of wealth means in this instance . Given that a dollar of wealth to individual iis equal to a dollar of wealth to individual , doesn this mean that must equal , implying that , wealth transfers occur on a basis in dollars ) In the present context , the answer is In cases where ' individual so guilty that she would willingly transfer more than of her wealth for each of wealth individual receives . Talk about feeling ! In contrast , when wealth levels are such that , and therefore , individual i is prone to feelings of envy , individual ' is confined to the region below the hashed line in Figure . Again , appealing to our formula for the indifference curve above , we see that the slope of the indifference curves line segment in this region of the graph is equal to oz , 05 , The value of this fraction in turn measures the ( constant ) rate at which individual i believes his own wealth should be compensated as individual wealth increases . Note that larger values of indicate larger feelings of envy . However , the upper bound on 051 ' is equal to ( rather than , as for because , as can be seen in the graph , if 04 , then the indifference curves associated line BEHAVIORAL ECONOMICS PRACTICUM 199

segment will automatically cross into the guilt region ( where mi ) and thus , be inconsistent with feelings of envy . In other Words , individual is Wealth can not be such that she simultaneously feels envy and guilt about individual wealth level . FAIRNESS IN THE CONTEXT OF FRAMING Consider the following two experiments conducted by ( 201 ) Experiment A company is making a small . It is located in your hometown , which is currently experiencing a recession with substantial unemployment but no price . The company decides to decrease wages and salaries by this year . On a scale from to , with being very fair and being very unfair , how do you rate this action by the company ?

Experiment A company is making a small . It is located in your hometown , which is currently experiencing a recession with substantial unemployment and price 200 ARTHUR of 12 . The company decides to increase wages and salaries by only this year . On a scale from to , with being very fair and being very unfair , how do you rate this action by the company ?

Confronted with these two experiments , Homo is not fooled by what known as money She knows the difference between nominal and real changes and the importance of making decisions based upon the latter . As a result , Homo recognizes that both experiments ask her to rate the fairness of a company decision in the face of a recession that is effectively costing the employees ( those employees who have been able to retain their jobs with the company during the recession ) of their incomes in real terms . In Experiment , this loss in real income results from the decision to reduce wages and salaries by in the face of no price . In Experiment the loss occurs as a result of the company raising wages and salaries by in the face of 12 price . Thus , in separate samples of Homo , we would expect roughly equal percentages of subjects to choose numbers across the two samples , and for the distribution of percentages to be roughly uniform across the numbers ( 20 choosing , 20 choosing , You probably wont be too surprised to learn that when ran this experiment with his students , 62 chose or in Experiment while only 22 chose or BEHAVIORAL ECONOMICS PRACTICUM 201

in Experiment . Clearly , context matters here for Homo sapiens . In this case , the context the principle of dual entitlement in the mind of Homo sapiens , a principle where both the employer and employees are entitled to levels of benefit provided by some reference The context in Experiment is framed as being less unfair than the context in Experiment simply because the company in Experiment appears to be doing something more to protect its employees wages and salaries in the face of than the company in Experiment . After all , the company in Experiment is increasing wages and salaries , not lowering them . Unfortunately , the larger percentage of students rating the company in Experiment as being more unfair have been framed . They suffer from money illusion . et al . ran additional experiments to measure Homo sapiens penchant for fairness in other . For example , the authors posed the following experiment to approximately 200 adult residents in the Vancouver metropolitan area of British Columbia , Canada A football team normally sells some tickets on the day of their games . Recently , interest in the next game has increased , and tickets are in great demand . The team owners can distribute the tickets in one of three ways . Auction The tickets are sold to the highest 202 ARTHUR

bidders . Lottery The tickets are sold to the people whose names are drawn . Queue The tickets are sold on a served basis . Rank these three options from most to least fair . Being a devoted practitioner of hard , cold economic efficiency , Homo would rank the auction first , as this would allocate the tickets to the fans willing to pay the most for them , and queueing last , as this is the most economically wasteful way to allocate resources . To Homo , economic efficiency and fairness are one and the same . et participants completely reversed Homo ranking . The great majority of the sample ranked queueing as fairest and the auction as the least fair . In a second set of experiments , the authors contacted adult residents living in the Vancouver and metropolitan areas and posed the following two experiments to two separate samples of participants Experiment A landlord rents out a single small house to a tenant who is living on a income . A higher rent would mean the tenant would have to move . Other BEHAVIORAL ECONOMICS PRACTICUM 203

small rental houses are available on the market . The landlord costs have increased substantially over the past year , and the landlord raises the rent to cover the cost increases when the tenant lease is due for renewal . Rate the decision to raise the rent as either . Acceptable . Somewhat unfair . Very unfair Experiment A small photocopying shop has one employee who has worked in the shop for six months and earns 17 per hour . Business continues to be satisfactory , but a factory in the area has closed and unemployment has increased . Other small shops have now hired reliable workers at 14 per hour to perform jobs similar to those done by the employee . The owner of the shop reduces the employee wage to 14 per hour . Rate the shop owner decision to lower his employee wage as either . Completely fair . Acceptable 204 ARTHUR

. Somewhat unfair . Very unfair While we would expect Homo to rate the decisions by both the landlord in Experiment and the shop owner in Experiment as completely fair , what about Homo sapiens ?

Given what we ( think we ) know about their penchant for fairness , we might expect Homo sapiens to rate both the landlord and shop owner as very unfair or at least somewhat Surprisingly , Homo sapiens are not that predictable . While the great majority of participants rate the shop owner as somewhat unfair or very unfair , they View the landlord as being completely fair or Whats going on here ?

et al . propound two rules governing the fairness judgments made by participants in the respective experiments . In Experiment , it is acceptable for the landlord to maintain her profit level at its reference level by raising rent as necessary , even when doing so causes considerable loss or inconvenience for the tenant . To the contrary , in Experiment it is unfair for the shop owner to exploit an increase in his market power to alter his profit from its reference level at the direct expense of an employee . As these experiments demonstrate , Homo sapiens consider fairness to be . BEHAVIORAL ECONOMICS PRACTICUM 205

REGRET AND BLAME Consider the following experiments proposed by ( 201 ) Experiment Winona very rarely picks up hitchhikers . Yesterday she gave a man a ride and was robbed . Alfred frequently picks up hitchhikers . Yesterday he gave a man a ride and was robbed . Which of the or Alfred experience greater regret over the episode ?

Experiment Winona almost never picks up hitchhikers . Yesterday she gave a man a ride and was robbed . Alfred frequently picks up hitchhikers . Yesterday he gave a man a ride and was robbed . Which of the or Alfred be criticized by others more severely over the episode ?

Because Homo ignores possible reference points ( is reference independent ) and narrowly frames decisions like this , he is not by Winona and Alfred past experiences with hitchhikers . Thus , Homo would have no reason to assign 206 ARTHUR greater regret to Winona or Alfred in Experiment , or more criticism ( blame ) to one or the other in Experiment . When it comes to assigning greater regret and more blame , Homo essentially two fair heads then assign greater regret and more blame to Winona , tails assign them to Alfred . We would consequently expect respective samples of Homo to assign greater regret and more blame 50 to Winona and Alfred . experiments with his students resulted in 88 assigning greater regret to Winona , and 77 assigning more blame to Alfred . Therefore , appears that Homo sapiens are prone to using a social norm as their reference point when deciding how to apportion regret and blame to people like Winona and Alfred . In this case , the norm is do not pick up The logic for how this norm cum reference point could be driving Homo sapiens choices in these experiments goes something like this Because Alfred has frequently ( and presumably knowingly ) this norm in the past , he had it coming to him , and thus , should have seen it Alfred is , therefore , not entitled to feel as much regret as does Winona , who , by contrast , has rarely if ever the norm . Winona was less to see the robbery coming and feels greater regret at having transgressed a norm that she has traditionally followed . Because Alfred has traditionally transgressed the norm and had the robbery coming to him , he effectively deserves to be more severely criticized . Hopefully , you see that , as compelling as this logic seems , it is misguided . With respect to regret , the question pertains to what We think Winona and Alfred BEHAVIORAL ECONOMICS PRACTICUM 207

will feel about themselves after having been robbed ( think Regret Theory from Chapter ) not what we think they are entitled to feel . Similarly , regarding the apportionment of blame , we know nothing about the people who will be judging the two victims , in particular , how they tend to judge others behaviors . In the end , then , this is a case where narrowly framing the situations and avoiding the use of reference points would actually help Homo sapiens reach more judicious judgments . ASYMMETRIC REGRET Consider the following thought experiment conducted by ( 201 ) Cheryl owns shares in Company A on the New York Stock Exchange . During the past year , she considered switching to owning Company stock , but she decided against it . She now learns that she would have been better off by if she had switched to Company stock when she had considered doing so . Wilbur used to own shares in Company on the New York Stock Exchange . During the past year , he switched to stock in Company A . He now learns that he would have been better off by if he had kept his stock in Company . Who feels greater regret ?

Similar to how she interpreted the human emotion of regret in the previous experiment , Homo will 208 ARTHUR again ignore potential reference points and narrowly frame her judgment ( she will not abide by the strictures of Regret Theory ) In the final analysis , Cheryl and Wilbur both lost by choosing to hold stock in Company A . It doesnt matter that Cheryl held onto the stock rather than switching to stock in Company , or that Wilbur switched from owning stock in Company to owning stock in Company A . They both lost , and should therefore both feel the same amount of regret . Not so with Homo sapiens . reports that 92 of his subjects assigned a greater sense of regret to Wilbur than to Cheryl . The reference point here pertains to whether an investor decides to switch ownership in a stock or not . The logic goes something like this When the value of their stock in a given company falls , investors who exhibit inertia and choose not to sell their ownership in that stock beforehand later experience less regret than investors who instead choose to purchase ownership in that stock beforehand . In this case , the proverb fools rush in where angels fear to tread implies that when what the fools rushed into costs them money , they should feel more regret than the angels who lost the same amount of money by instead exhibiting more patience . Yeah , right . Their propensity for broad framing and has apparently again led Homo sapiens astray ( apparently being an important word here ) Perhaps subjects should have instead flipped fair coins and tried not to reason their ways to answers . Or not . Could there be a more compelling logic for results ?

One could argue that , to the extent subjects believed Cheryl and Wilbur are prone to what we BEHAVIORAL ECONOMICS PRACTICUM 209 previously learned in Chapter is called the Endowment Effect , then the subjects were justified in concluding that Wilbur suffers more regret than Winona . An Endowment Effect occurs when the intrinsic value associated with owning something ( a given commodity ) is large enough to induce the owner to unwittingly overprice the commodity in a market Therefore , if Wilbur is susceptible to the Endowment a retroactive Endowment Effect associated with the shares he once owned in Company it is very likely he is suffering more regret than Winona by having forfeited that endowment . Because she never actually owned stock in Company , Winona is perforce precluded from the opportunity to suffer an Endowment Effect . It is important to note that this is not a case of two wrongs making a While it may be wrong for Wilbur to exhibit an Endowment Effect , it is not wrong for subjects to assume that he does . Indeed , one could argue that to the extent subjects made this assumption , they made the correct not just because they honored the assumption but also because ( as will be discussed in Section ) Homo sapiens really are prone to this effect . THE GENDER GAP Differences in the choice behaviors between men and women have been the subject of an immense body of research especially with respect to altruistic tendencies . The Endowment Effect is a special case of the Anchoring Effect we encountered earlier ( remember the question asking you to guess Gandhi age when he died ?

As pointed out in this book preamble , the Anchoring Effect is itself a special case of Framing Effect . So much nomenclature , so little time ! 210 ARTHUR ( et , 2018 and , 2001 , 2001 ) and empathy and forgiveness ( Toussaint and Webb , 2005 ) While the existence of a gender gap is a for Homo , after all , can be thought of as a genderless is generally believed to be a prolific distinguishing feature of the Homo sapiens experience . In an innovative laboratory experiment , and ( 2007 ) measure a gender gap in how men and women respond to competition . Participants solve two sets of math problems , first under a noncompetitive scheme and then under a competitive tournament scheme . Participants are then asked to select which of these two compensation schemes they want to have applied to their next set of math problems ( whether they would avoid competition by choosing the scheme or compete with other group members in a tournament ) This combination of performance and choice of compensation scheme enabled the authors to determine if men and women of equal performance choose the same compensation scheme . Each math problem involved adding up five numbers without the aid of a calculator , but with scratch paper if desired . The numbers were randomly drawn and each problem was presented in the following manner , where the participants are instructed to fill in the sum in the rows blank box BEHAVIORAL ECONOMICS PRACTICUM 211

Add the numbers in the boxes as quickly as you can , and write your answer in the sixth blank box . 21 35 48 Once a participant submits an answer on the computer , a new problem appears jointly with information on whether the former answer was correct . This process continues for five minutes . A record of the participants number of correct and wrong answers remains on the screen as progresses through the set of problems . Their final scores are determined by the number of correctly solved problems in the . and ( 2007 ) chose this approach because it requires both skill and effort and because there was no prior evidence in the extant literature of gender differences in ability on easy math tests . The authors were , therefore , able to rule out performance differences as an explanation for gender differences in the choice of competition level ( choice between the noncompetitive and competitive tournament schemes ) Participants were randomly divided into groups of four , each group seated in a row . Participants were informed that they were grouped with the other people in their row . Each group consisted of two women and two men . Although gender was not discussed at anytime , 212 ARTHUR

participants could see who the other people in their group were and were thus aware of their groups gender mix . A total of twenty groups participated in the experiment ( 40 men and 40 women total ) Each participant received a fee and an additional for successfully completing the experiment . Participants were instructed to complete four separate sets of math problems ( four separate tasks ) and were told that one of these tasks would be randomly chosen for payment after the experiment . While each participant could track their own performance on any given task as the math problems were completed , they were not informed of their relative performance to everyone else in their group until the end of the experiment ( upon conclusion of the fourth task ) Under the scheme , participants earned per correct answer . Under the tournament scheme , the participant who correctly solved the largest number of problems in the group received per correct answer while the other participants received no payment . In case of ties , the winners were chosen randomly from among the high scorers . Task was presented to each participant under the scheme , and Task was presented under the tournament scheme . These initial tasks were meant to serve as baseline measures of each participant performance under the two schemes . Under Task , participants selected whether they wanted to be paid according to the or the tournament scheme before engaging in the task . A participant choosing the tournament received per correct answer if her score in Task exceeded that of the other group members in Task tournament they had previously completed . BEHAVIORAL ECONOMICS PRACTICUM 213

Otherwise , he received no payment . Again , in case of ties , the winners were chosen randomly . Thus , participants choosing to play in a tournament in Task are competing against other participants who had already participated in the two previous tasks , which enabled and to rule out the possibility that women might shy away from competition because by winning the tournament they would impose a negative externality on the other group members . Lastly , under Task , the participants were not presented with a new set of math problems . Rather , if this task was randomly selected for payment at the end of the experiment , a participant compensation would depend upon the number of correct answers he provided under Task scheme . In Task , a participant could choose which compensation scheme he wanted applied to his or her past performance in Task , piece rate or tournament . A participant would therefore effectively win a Task tournament if his or her Task performance had been the highest among the other participants in the group for that task . Before making their choices in Task , participants were reminded of their respective Task performances . Thus , Task allowed and to see whether gender differences in the choice of compensation scheme appeared even when no future and past tournament performance was involved . The authors could determine whether general factors such as overconfidence , risk , and feedback aversion caused a gender gap in the choice between the noncompetitive and competitive tournament schemes . At the end of the experiment , before learning about their performance relative to the groups other participants , each participant was asked to guess her 214 ARTHUR

ranking ( in terms of the number of correctly solved problems ) in Tasks and , respectively . Each participant picked a rank between and and was paid for each correct guess . As expected , the authors found no statistically significant gender gap in performance under either the or tournament schemes , with both sexes performing significantly better in a tournament . As a result , and conclude that there is no gender difference in the probability of winning the Task tournament . More importantly for this particular experiment , the absence of a gender gap in the performance of Tasks and raises the expectation that a subsequent gender gap in Task should likewise not be observed . However , this expectation was not of women and 73 of men selected the tournament , a statistically significant result . Moreover , as the figure below demonstrates , at each Task performance level , men are more likely to enter the tournament in Task ( the figures vertical axis measures the percentage of the group entering the tournament ) Even women who score in the highest ( best ) performance quartile chose to enter the tournament at a lower percentage than men in the lowest ( worst ) performance quartile . BEHAVIORAL ECONOMICS PRACTICUM 215

I ) I quartile Best ( and 2007 In other words , while women shy away from competition , men are drawn to it . Turning to Task , recall that although this choice is very similar to that of Task , Task choice eliminates the prospect of having to subsequently participate in a competition . Thus , only in Task could a gender gap in preference for competition have played a role in the choice of compensation scheme . As the figure below shows , there is no statistically significant gender gap in the choice of compensation scheme in Task based upon perceived ranking in Task . A higher percentage of women than men who guessed their Task ranking to be low ( at level ) chose the tournament scheme in Task , while the percentages were reversed for those participants who guessed their Task rankings to be high ( at levels I and ) But because the two lines in the figure remain close together , these differences are not statistically significant ( we should treat the groups respective choices as being no different from one another ) 216 ARTHUR

Worst rank I Best rank ( and 2007 This result from Task cements the authors finding that women shy away from actual competition slated to occur at a future point in time , not implicit competition based upon their interpretations of how their past performance compares with others . TESTING FOR THE EXISTENCE OF AN ENDOWMENT EFFECT Here is an experiment you and your fellow students can use to test the extent to which you exhibit an Endowment experiment facilitated by your instructor , of 10 Ten of you have been given a coffee cup with your 10 . The inspiration for this experiment is drawn from et al . 1990 ) BEHAVIORAL ECONOMICS PRACTICUM 217

university logo . You are henceforth known as sellers . Ten of you have not been given this item . You are henceforth known as Buyers . Each of the Sellers will now write on their piece of paper their Seller Price , the price at which they would willingly sell their coffee cup to one of the Buyers . Each of the Buyers will now write on their piece of paper their Buyer Price , the price at which they would willingly buy a coffee cup from one of the Sellers . Sellers prices will be ranked from highest to lowest and then compared with the lowest ranking of Buyers prices to determine which trades will occur via paired bids . For example , suppose from a class with 10 students , We randomly select five to be sellers and five to be buyers of the coffee cup . Each buyer and seller writes his or her price on a sheet of paper , and the outcome is tallied . 218 ARTHUR

Seller Sellers Buyers Buyer Price Price In this market , an equilibrium occurs where Buyer pays Seller for Seller cup , Buyer pays Seller for Seller cup , Buyer pays Seller for Seller cup , and Buyer pays Seller for Seller cup . Seller does not end up selling and Buyer does not end up purchasing a coffee cup . To see this , first note that Buyer offer price ( or willingness to pay ( exceeds Seller asking price ( or willingness to accept ( which is the largest value among the group of sellers . Thus , Buyer and Seller are matched , and Seller is paid his . Next , since Buyer just matches Seller ( which is the next highest value ) Buyer and Seller are matched . The next highest value is exhibited by Buyer , and since this value exceeds Seller ( not Seller 35 ) Buyer is matched with Seller . Finally , Buyer just matches Seller , so Buyer and Seller are matched . In the end , no such matches can be found for Buyer and Seller . This is good information to have . But a question BEHAVIORAL ECONOMICS PRACTICUM 219

remains is there evidence of an Endowment Effect in this market ?

The answer is ( most likely ) no since four out of five possible sales were ultimately consummated . Although there is no threshold for determining whether the effect has occurred , it seems safe to say that wherever one might put the threshold , or 80 of possible sales consummated ) would lie above it . Or , to put it another way , in a market characterized by a relatively strong Endowment Effect exhibited by its sellers , one would expect most sellers values to exceed buyers values , resulting in few sales ultimately being made . Indeed , if pressed to nail down a threshold , one can really do no better than to metaphorically a coin ( to choose a 50 threshold ) which , in the case of our example market , means that only one or two consummated sales would have indicated the existence of an Endowment Effect . HOMO AND THE ENDOWMENT EFFECT In Chapter we introduced the graphical concept of an indifference curve . We mentioned that the stylized version of this , everywhere sloping , and convex to the be used to represent Homo preferences over any two commodities . It turns out that this framework , as demonstrated in et al . 2007 ) can be used to reach an interesting conclusion about Homo susceptibility to the Endowment Effect . In Figure below , two indifference curves are drawn for our individual whom we name Ted , each curve 220 ARTHUR

corresponding to a different level of utility , 110 and 111 . Recall that the relative locations of the two curves indicate that 710 ( ie , the curve drawn for utility level 111 corresponds to a set of bundles yielding a higher level of utility than the set of bundles denoted by the curve drawn for 110 ) Figure . Homo and the Endowment Effect 01 For sake of example ( but without loss of generality ) Ted two indifference curves have been drawn for two commodities denoted as at and Commodity is a private good that Ted has to purchase directly with his income . Commodity is a public good that Ted Also recall that ( because Homo abides by the two rationality axioms introduced earlier ( in particular , transitivity ) and ( if We further assume that Homo preferences are what known as monotone , then the two indifference curves can never cross . The monotone property also ensures that an indifference curve never slopes upward . BEHAVIORAL ECONOMICS PRACTICUM 221

receives from the government without having to make a direct payment out of his income ( more wilderness area for Ted to explore near his home , cleaner air for Ted to breath , We assume that commodities and are the only two commodities Ted Also identified in Figure are points A , level for commodity , and levels and for commodity . Finally , for future reference we note that because Ted can only spend his income on commodity , he ends up spending all of his income on , which means he stuck with consuming level at regardless of whether he consumes level or of commodity . Therefore , the higher is located on the vertical axis , the larger is Ted income level , all else equal . Okay . We are now ready to show why Ted , our Homo , exhibits an Endowment Effect . We start by assuming that Ted initially consumes at point A ( bundle ( where he attains utility level 110 . Now , let the level of the public good increase from to . Note that because Ted is constrained to consume level 30 of commodity , we know that he now consumes at point where he attains the higher level of utility 111 . It makes sense that Ted is happier at point because he is now consuming the same amount of commodity IL at 17 that he was originally consuming at point A , and he also gets to consume more of commodity ( lucky him ) It turns out that vertical distance AC in Figure represents Ted for this move from point A to point . How so ?

Distance AC represents the maximum The facts that we have constrained Ted to consume only two commodities and that he is essentially receiving ( for free , are innocuous assumptions made for the sake of our simple example . 222 ARTHUR amount of commodity that we could take away from Ted such that ( his consumption of commodity is maintained at level , and ( Ted is not left with fewer than his initial utility level , 110 . Hence , vertical distance AC indeed represents Ted for the change in the level of good represented by ( measured in terms of commodity ) To identify his , we instead start by assuming that Ted initially consumes at point ( bundle ( where he has attained utility level . Now , let the level of the public good decrease from to ( some of the public good has been taken away from wilderness area near his home has shrunk , or air quality has worsened , Note that because Ted is again constrained to consume level of commodity ( because his income level has remained the same ) we know that he now chooses to consume at point A where he regresses to the lower level of utility 110 . It makes sense that Ted is less happy at point A because he is now consuming the same amount of commodity at A that he was originally consuming at and is , unfortunately , consuming less of commodity ( woe to him ) Adopting a similar logic , vertical distance AD in Figure represents Ted for this move from point to point A . In this case , distance AD represents the minimum amount of commodity at we must give Ted such that this amount ( holds his consumption of commodity at level and ( does not leave Ted with less than his initial utility level , 111 . Hence , vertical distance AD indeed represents Ted for the change in the level of good represented by ( again , measured in terms of commodity ) Recall that and both measure Ted BEHAVIORAL ECONOMICS PRACTICUM 223

valuation of a given change in the amount of public good . However , the within which the measurements occur are different . presumes Ted does not initially own rights to the change in the amount of the is his maximum willingness to pay to gain ownership of that changed amount . In contrast , does presume that Ted initially owns rights to the change in the amount of the is his minimum willingness to accept the loss of ownership of that changed amount . Thus , if Ted exceeds his for the same amount of change in good , then he exhibits an Endowment Effect . This is because he would then place a higher value on amount relative to when he initially owns as opposed to when he does not . In other words , Ted places a higher value on the change in the amount of simply because he is endowed with the right to own that changed amount . Clearly , distance AD exceeds distance AC in Figure , implying Ted is greater than his for the given change in the amount of good . Thus , even a Homo like Ted exhibits an Endowment CONCLUDING REMARKS Recall that the goal of Section is to explore exactly where the standard , theory ascribed to Homo fails to adequately predict behavior we repeatedly see exhibited by Homo sapiens in laboratory and field experiments . We have learned that , in several Interestingly , to the extent that Ted indifference curves are linear ( are still , but with constant slopes rather than the slopes depicted for the stylistic case in Figure 62 ) his and Values ( distances AC and AD in the figure ) converge toward equality . 224 ARTHUR

key respects , this behavior systematically violates the theory . The violations appear in a myriad of forms as violations of axioms known as Dominance , Invariance , Independence , and Substitution , and the Principle . From these violations spring two and toward what ends ?

The question why pulls us back into the realms of cognitive and psychological sciences , realms rich in reminders of what makes Homo sapiens so exquisitely quirky and idiosyncratic and inherently fallible . And the question toward what ends propels us forward into the realm of understanding where and how theory fails to adequately explain human choice behavior . In this realm , the new theories of behavioral economics arise . Following ( 2011 ) and others , we call these quirks and idiosyncrasies , miscalculations , biases , fallacies , and We recall specific terminology such as Affect and Availability , Priming and Framing Effects , Status Quo and Confirmation Biases , Conjunction Fallacy , the Law of Small Numbers , conformity , mental accounting , and the of improbable events , among others . These are the types of human foibles distinguishing Homo sapiens from Homo . They materialize as violations of rational choice theory . As we have learned , the violations were identified in the foundational laboratory experiments conducted by Nobel Laureates Daniel and Richard Thaler , among many others , experiments that you and your classmates have now participated in yourselves . It is one thing to identify where a body of theory fails to adequately explain phenomena . It is another to revise that theory in an effort to advance not only BEHAVIORAL ECONOMICS PRACTICUM 225

the theory but also to gain a deeper understanding of the human experience itself . Toward this end , we have learned about the value function and how it can be used to depict such behaviors among Homo sapiens as reference dependence , loss aversion , and the Endowment Effect . And we have learned about the complications imposed on the theory by human emotions such as envy , guilt , regret , and blame , as well as Homo sapiens discomfiture with ambiguous circumstances and the need to feel and appear competent . STUDY QUESTIONS Note Questions marked with a are adopted from Just ( 2013 ) Which of the two utility functions represents transactional utility and why ?

and ( where represents the total amount of a good purchased , and represents the total cost incurred by the consumer in purchasing the good . Why might people be more likely to spend a small inheritance and invest a large one ?

Which quirk of Homo sapiens introduced in this chapter does this likelihood represent ?

How does the use of a credit card confound the conclusion reached by and ( 1998 ) namely that , as an example of mental 226 ARTHUR accounting , Homo sapiens seem to prefer decoupling payments for durable goods but not necessarily for ( perishable ) goods ?

Can you think of an example from your own life where you have practiced mental accounting ?

Explain . Ella is a high school student who is given each school day by her parents to be used as lunch She works a job after school , earning a small amount of spending In addition to her lunch money , Ella spends from her spending cash each week on lunch . Suppose her parents reduced Ella lunch money by per day but that she simultaneously receives a raise at her job , requiring no extra effort on her part . What would the rational choice model suggest should happen to Ella spending on lunch ?

Alternatively , what does the mental accounting framework predict ?

Each year , hundreds of thousands of people receive bypass surgery . The surgery saves their lives , but only for the long term if they adopt some important lifestyle changes such as dietary changes , quitting smoking , more physical exercise , and managing stress more effectively . Suppose Hayden the Hyperbolic Discounter , who has a hankering for eating junk food , smokes cigarettes occasionally when stressed out , and avoids regular exercise , BEHAVIORAL ECONOMICS PRACTICUM 227

decides to have coronary bypass surgery . What do you think the outcome is going to be for Hayden ?

Which experiment discussed in this chapter do these results pertain to ?

Percentile 100 80 60 Actual Test Score 40 20 Quartile . Suppose Evelyn the Environmental Economist is presenting her case in a public meeting for why raising the price of municipal water in the face of persistent drought conditions would be a good thing for the community , when someone in the audience yells out , That unfair for seniors and others living on fixed How might Evelyn frame her response in a way that dispels the audiences concerns about the fairness of a price increase ?

How would the indifference curve in Figure change when drawn for a person who suffers from guilt but not envy ?

Draw the curve . 228 ARTHUR 10 . Can you recall an example from your own life where you exhibited an Endowment Effect that ultimately led to regret ?

I . The Gender Gap experiment discussed in this chapter measured gender differences in terms of how males and females deal with competitive situations . Think of another situation where a gender gap may exist and design an experiment to test for it . 12 . It was shown in this chapter that a Homo who exhibits indifference curves exhibits an Endowment Effect . Does this result still hold if Homo exhibits linearly shaped indifference curves , as depicted in the figure below ?

Show your result using this graph . BEHAVIORAL ECONOMICS PRACTICUM 229 13 . 14 . Explain the relationship between the Decoy Effect and reference dependence . Describe a situation in your own life where you have been a victim of the Decoy Effect . Describe a negative implication of the Effect in the real world . Have you ever fallen victim to this effect in your own life ?

If so , describe the circumstances . Media Table ( Chapter ) Arthur is licensed under a BY Attribution license Figure Arthur is licensed under a BY Attribution license Figure 30 Chapter Muriel and Lise 2007 by the President and Fellows of Harvard College and the Massachusetts Institute of Technology is licensed under a All Rights Reserved license Figure 31 Chapter Muriel and Lise 2007 by the President and Fellows of Harvard College and the Massachusetts Institute of Technology is licensed under a All Rights Reserved license Figure 33 ( Chapter ) Arthur is licensed under a BY Attribution license Figure Arthur is licensed under a 230 ARTHUR

BY Attribution license Figure for Study Question ( Chapter ) Arthur is licensed under a BY Attribution license Figure for Study Question 12 ( Chapter ) Arthur is licensed under a BY Attribution license BEHAVIORAL ECONOMICS PRACTICUM 231