Endowment and Mental Accounting Flashcards
Endowment effect - Richard Thaler
Loss aversion - once we have something giving it up would be a loss (2:1 coefficient)
mugs distributed to half the participants in an experiment
buyers had to use their own money to buy the minds
average selling price was about double the average buying price and there were very few trades
“the higher price that sellers set reflects the reluctance to give up an object they already own” - TF&S
- we experience the endowment effect due to inertia, a desire to maintain the status quo
- to stick with what one has unless there is a very good reason to switch
is the endowment effect universal?
not always
- it relates to goods that one has that one intends to use
- won’t feel loss as a shoe salesman when selling shoes as he holds the goods for exchange
“there is no loss aversion on either side of routine commercial transactions” -TF&S
How can retailers take advantage of the endowment effect?
- 30 days money back guarantee
- prime free trial
“if we are not sure whether or not we should get a new sofa, the guarantee of being able to change our minds later may push us over the hump so that we end up getting it” - Ariely
From Misbehaving on loss aversion -sunk cost fallacy
if Boris pays £1000 to an indoor tennis club so he could play during the winter and then gets tennis elbow he’s more likely to continue to play
if he didn’t pay for membership and a friend calls him and asks him to play he’s more likely to say no
- if you buy expensive shoes on the Internet and they’re uncomfortable you’re more likely to wear them even though they hurt
- rationally the money you’ve spent is already gone and should not be taken into account
one should be looking forward at what the expected utility should be
- could explain why flopped expensive footballers still get game time
- when you buy a ticket and don’t use it, it feels like a loss
Health club example
from Misbehaving
members at a health club billed twice a year and club found attendance went up after the billings as members did not want to recognise a loss
Attendance then tailed off over time
Concept of ‘free’ - experiment by Shampanier, Mazar & Ariely
gave a choice between:
- 1 cent for Hershey (27%)
- 15 cents for Lindt (73%)
then given:
- Hershey for free (only 1 cents difference)
- 14 cents for Lindt
69% chose Hershey
“since nothing has changed in relative terms, the response to the price reduction should have been exactly the same”
- Free is so appealing as it relates to loss aversion as it allows us to consume without any loss
“the difference between one cent and zero is huge” - Ariely
Using free in social policies and the market
In the market:
- coke ‘zero’
- Free same day delivery’
Policies:
- no road tax for energy efficient cars
- no charges for important medical check ups
Mental accounting
you have spent £50 to see a band and get there and have lost your ticket. Unlikely to take out another £50 to buy another ticket
if you had taken out £100 before and lose £50 when you get there you are more likely to buy a ticket
Why the difference in behaviour?
- in the first scenario we lost a theatre ticket and the loss was against this mental account
if we use up the money for this budget, we see it as gone
- In the second scenario we lost money and this was a separate mental account than the account for the tickets, therefore we are more likely to buy the ticket
Mental accounting violates another first principle of economics and rationality
wealth often separated into different mental accounts that are kept separate rather than fungible
we thus make inconsistent and poor decisions
- neoclassical economics treats money as fungible and that it should be spent on maximising returns
Hastings and Shapiro Experiment
study into consumption of petrol when prices change. Focusing on the switch from regular to premium petrol
Focused on 2008 when price of petrol fell by 50%
- if a household is spending $80 a week on normal petrol and the price drops 50%, so that they are only spending $40 on petrol, that frees up $40 to spend elsewhere
- but households created a mental account for their petrol money, now had more money to spend on their petrol and upgraded to a higher quality gasoline
“shift towards higher grades of gasoline was fourteen times greater than it would be expected in a world in which money is treated as fungible” - Misbehaving
- there was also no attempt to upgrade other quality of goods despite increase in wealth
“house money” again
mental account for money won, person will pocket winnings and play freely with the house money as they have a mental account for money
“blatant a violation of the rules of that money is fungible” - Misbehaving
Wealth is also separated into mental accounts
- money in pocket is easy to spend
- then comes money in current account
- money in savings account more reluctant to spend
e. g we see savings accounts at low interest rates and borrowing at high interest rates - we are reluctant to dip into savings to pay off a debt even though that would be rational
Just noticeable difference
e.g you’re buying an iron and it costs £45 but a salesperson says you can get it for 30 in a shop 15 mins walk away - you’re likely to walk the 15 mins
if you’re then about to buy a £1000 TV and the same situation occurs you’re less likely to walk the 15 mins
- rationally money is fungible so you should walk in both cases
- but you are more likely to walk for the iron because of a just noticeable difference
