An experimental test of loss aversion and scale compatibility

This paper studies two important reasons why people violate procedure invariance, loss aversion and scale compatibility. The paper extends previous research on loss aversion and scale compatibility by studying loss aversion and scale compatibility simultaneously, by looking at a new decision domain, medical decision analysis, and by examining the effect of loss aversion and scale compatibility on "well-contemplated preferences." We find significant evidence both of loss aversion and scale compatibility. However, the sizes of the biases due to loss aversion and scale compatibility vary over trade-offs and most participants do not behave consistently according to loss aversion or scale compatibility. In particular, the effect of loss aversion in medical trade-offs decreases with duration. These findings are encouraging for utility measurement and prescriptive decision analysis. There appear to exist decision contexts in which the effects of loss aversion and scale compatibility can be minimized and utilities can be measured that do not suffer from these distorting factors.Decision analysis, utility theory, loss aversion, scale compatibility, health

Painful Regret and Elation at the Track

We present an empirical study of loss aversion in the Hong Kong horse betting market. We provide evidence of the presence of loss aversion in a context of complete absence of the favourite-longshot bias. This would suggest that, since loss aversion is a psychological bias, the favourite-longshot bias may not necessarily be caused by psychological issues and may be due, for instance, to informational asymmetry. We investigate different types of bettors and their attitude towards loss aversion. Our data set enables us to distinguish approximately among insiders, unsophisticated outsiders and sophisticated outsiders. The results show clearly that even sophisticated bettors are beset by loss aversion, while even unsophisticated outsiders display no favourite-longshot bias. Thus, our paper provides evidence that loss aversion may be an attitude innate rather than learned, regardless of the level of sophistication in designing economic behaviour or the extent of information asymmetry. Chen et al (2006) show that capuchin monkeys display biases when faced with gambles, including loss aversion, and provide evidence that loss aversion extends beyond humans. The present work supports the idea that loss aversion may be a more universal bias, arising regardless of experience and culture and demonstrates that loss aversion is displayed even by those bettors regarded in the market as “smart money”. Further, we find that more sophisticated and experienced bettors display a higher level of loss aversion. This result is consistent with the findings of Haigh and List (2005), who show that professional traders in financial markets exhibit more loss aversion than do students.

Individual-level loss aversion in riskless and risky choices

Loss aversion can occur in riskless and risky choices. Yet, there is no evidence whether people who are loss averse in riskless choices are also loss averse in risky choices. We measure individual-level loss aversion in riskless choices in an endowment effect experiment by eliciting both WTA and WTP from each of our 360 subjects (randomly selected customers of a car manufacturer). All subjects also participate in a simple lottery choice task which arguably measures loss aversion in risky choices. We find substantial heterogeneity in both measures of loss aversion. Loss aversion in the riskless choice task and loss aversion in the risky choice task are highly significantly and strongly positively correlated. We find that in both choice tasks loss aversion increases in age, income, and wealth, and decreases in education.Loss aversion, endowment effect, field experiments

Envy and Loss Aversion in Tournaments

In tournaments, the large variance in effort provision is incompatible with standard economic theory. In our experiment we test theoretical predictions about the role of envy and loss aversion in tournaments. Our results confirm that envy implies higher effort while loss aversion increases the variance of effort. Moreover, we show that standard theory provides a good explanation for competitive behavior when envy and loss aversion do not play a role in the decision making process.Tournament, Envy, Loss Aversion

Probability Distortion and Loss Aversion in Futures Hedging

We analyze how the introduction of probability distortion and loss aversion in the standard hedging problem changes the optimal hedge ratio. Based on simulated cash and futures prices for soybeans, our results indicate that the optimal hedge changes considerably when probability distortion is considered. However, the impact of loss aversion on hedging decisions appears to be small, and it diminishes as loss aversion increases. Our findings suggest that probability distortion is a major driving force in hedging decisions, while loss aversion plays just a marginal role.Marketing,

A consistency test of the time trade-off

This paper tests the internal consistency of time trade-off utilities. We find significant violations of consistency in the direction predicted by loss aversion. The violations disappear for higher gauge durations. We show that loss aversion can also explain that for short gauge durations time trade-off utilities exceed standard gamble utilities. Our results suggest that time trade-off measurements that use relatively short gauge durations, like the widely used EuroQol algorithm (Dolan 1997), are affected by loss aversion and lead to utilities that are too high.Cost-Utility Analysis, Time Trade-Off, Loss Aversion

Principal agent problems under loss aversion: an application to executive stock options

Executive stock options reward success but do not penalise failure. In contrast, the standard principalagent model implies that pay is normally monotonically increasing in performance. This paper shows that, under loss aversion, the use of carrots but not sticks is a feature of an optimal compensation contract. Low risk aversion and high loss aversion is particularly propitious to the use of options. Moreover, loss aversion on the part of executives explains the award of at the money options rather than discounted stock or bonus related pay. Other features of stock option grants are also explained, such as resetting or reloading with an exercise price equal to the current stock price

The Nature of Risk Preferences: Evidence from Insurance Choices

We use data on households' deductible choices in auto and home insurance to estimate a structural model of risky choice that incorporates "standard" risk aversion (concave utility over final wealth), loss aversion, and nonlinear probability weighting. Our estimates indicate that nonlinear probability weighting plays the most important role in explaining the data. More specifically, we find that standard risk aversion is small, loss aversion is nonexistent, and nonlinear probability weighting is large. When we estimate restricted models, we find that nonlinear probability weighting alone can better explain the data than standard risk aversion alone, loss aversion alone, and standard risk aversion and loss aversion combined. Our main findings are robust to a variety of modeling assumptions.

Uncertain Demand, Consumer Loss Aversion, and Flat-Rate Tariffs

The so called flat-rate bias is a well documented phenomenon caused by consumers' desire to be insured against fluctuations in their billing amounts. This paper shows that expectation-based loss aversion provides a formal explanation for this bias. We solve for the optimal two-part tariff when contracting with loss-averse consumers who are uncertain about their demand. The optimal tariff is a flat rate if marginal cost of production is low compared to a consumer's degree of loss aversion and if there is enough variation in the consumer's demand. Moreover, if consumers differ with respect to the degree of loss aversion, firms' optimal menu of tariffs typically comprises a flat-rate contract.Consumer Loss Aversion; Flat-Rate Tariffs; Nonlinear Pricing; Uncertain Demand

Uncertain Demand, Consumer Loss Aversion, and Flat-Rate Tariffs

The so called flat-rate bias is a well documented phenomenon caused by consumers' desire to be insured against fluctuations in their billing amounts. This paper shows that expectation-based loss aversion provides a formal explanation for this bias. We solve for the optimal two-part tariff when contracting with loss-averse consumers who are uncertain about their demand. The optimal tariff is a flat rate if marginal cost of production is low compared to a consumer's degree of loss aversion and if there is enough variation in the consumer's demand. Moreover, if consumers differ with respect to the degree of loss aversion, firms' optimal menu of tariffs typically comprises a flat-rate contract