Loss aversion

In prospect theory, loss aversion refers to the tendency for people to strongly prefer avoiding losses than acquiring gains. Some studies suggest that losses are as much as twice as psychologically powerful than gains.

This leads to risk aversion when people evaluate a possible gain; since people prefer avoiding losses to making gains. This explains the curvilinear shape of the prospect theory utility graph in the positive domain. Conversely people strongly prefer risks that might possibly mitigate a loss (called risk seeking behavior).

Loss aversion may also explain sunk cost effects.

Note that whether a transaction is framed as a loss or as a gain is very important to this calculation: would you rather get a 5% discount, or avoid a 5% surcharge? The same change in price framed differently has a significant effect on consumer behavior. Though traditional economists consider this "endowment effect" and all other effects of loss aversion to be completely irrational, that is why it is so important to the fields of marketing and behavioral finance.

There is an important critique of the view held by economists that this behaviour is irrational. The implicit assumption of conventional economics is that the only relevant metric is the magnitude of the absolute change in expenditure. In the above example, saving 5% is considered equivalent to avoiding paying 5% extra. This is not the only rational interpretation. Another view is that the most important metric is the magnitude of the relative change in wealth of the decision-maker. Again, referring to the above example, a 5% discount is then not equivalent to avoiding a 5% surcharge. The reasoning is as follows.

Take a hypothetical item that costs 1000 currency units, or 1000 "curruns". In case (1), the buyer expects to pay 1000 curruns, but then is offered a 5% discount. The price is then 950 curruns. The change represents a 5% saving. In case (2), there is a surcharge of 5%, or 50 curruns. The buyer expects to pay 1050 curruns. Avoiding the surcharge would mean a price of 1000 curruns. The buyers sees this as a savings of 50 curruns on what they expected to pay: 1050 curruns. Thus, the perceived savings is 50/1050 x 100% = approx. 4.76%.

When the savings relative to the remaining wealth (or stock of money) is different, the value of the transaction changes accordingly. When using this interpretation, decisions made by consumers are not necessarily irrational.

In addition, it has been asserted that the effect of relative evaluation is more pronounced the greater the potential amount saved is relative to the total amount the decision-maker has to spend.

Loss aversion was first theorized by Amos Tversky and Daniel Kahneman.

See also

• status quo bias
• list of cognitive biases

References

• Kahneman, D. & Tversky, A. (1979). Prospect Theory: An Analysis of Decision under Risk. Econometrica 47, 263–291.
• Tversky, A. & Kahneman, D. (1991). Loss Aversion in Riskless Choice: A Reference Dependent Model. Quarterly Journal of Economics 106, 1039–1061.