Misbehaving: The Making of Behavioral Economics

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Book: Read Misbehaving: The Making of Behavioral Economics for Free Online
Authors: Richard H. Thaler
that applies to why they are risk-averse for gains. In the case of problem 2, the pain of losing the second hundred dollars is less than the pain of losing the first hundred, so subjects are ready to take the risk of losing more in order to have the chance of getting back to no loss at all. They are especially keen to eliminate a loss altogether because of the third feature captured in figure 3: loss aversion.
    Examine the value function in this figure at the origin, where both curves begin. Notice that the loss function is steeper than the gain function: it decreases more quickly than the gain function goes up. Roughly speaking, losses hurt about twice as much as gains make you feel good. This feature of the value function left me flabbergasted. There, in that picture, was the endowment effect. If I take away Professor Rosett’s bottle of wine, he will feel it as a loss equivalent to twice the gain he would feel if he acquired a bottle; that is why he would never buy a bottle worth the same market price as one in his cellar. The fact that a loss hurts more than an equivalent gain gives pleasure is called loss aversion. It has become the single most powerful tool in the behavioral economist’s arsenal.
    So, we experience life in terms of changes, we feel diminishing sensitivity to both gains and losses, and losses sting more than equivalently-sized gains feel good. That is a lot of wisdom in one image. Little did I know that I would be playing around with that graph for the rest of my career.
    ________________
    *    I asked Danny why they changed the name. His reply: “‘Value theory’ was misleading, and we decided to have a completely meaningless term, which would become meaningful if by some lucky break the theory became important. ‘Prospect’ fitted the bill.”
    †    The puzzle is this: Suppose you are offered a gamble where you keep flipping a coin until it lands heads up. If you get heads on your first flip you win $2, on your second flip $4, and so forth, with the pot doubling each time. Your expected winnings are ½ x $2 + ¼ x $4 + 1/8 x $8 . . . The value of this sequence is infinite, so why won’t people pay a huge amount to play the bet? Bernoulli’s answer was to suppose that people get diminishing value from increases in their wealth, which yields risk aversion. A simpler solution is to note that there is only a finite amount of wealth in the world, so you should be worried about whether the other side can pay up if you win. Just forty heads in a row puts your prize money at over one trillion dollars. If you think that would break the bank, the bet is worth no more than $40.
    ‡    Tom Magliozzi passed away in 2014 but the show lives on in reruns, where the two brothers are still laughing.

6
    The Gauntlet
    I accepted the job at Cornell about halfway through my time at Stanford, and would start there in August 1978. I had work to do on two fronts. First, I had to produce research that showed what we could learn from the new approach I was suggesting. Second, and just as important, I had to be able to offer convincing replies to a series of one-line putdowns I would hear almost any time I presented my research. Economists had their way of doing things and would resist change, if for no other reason than that they had invested years building their own particular corner of this edifice.
    This fact was brought home to me at one early conference where I gave a talk on my recent work. During the question and answer period that followed, a well-known economist asked me a question: “If I take what you are saying seriously, what am I supposed to do? My skill is knowing how to solve optimization problems.” His point was that if I were right, and optimization models were poor descriptions of actual behavior, his toolkit would be obsolete.
    His reaction was unusually candid. The more common response, for those who engaged at all, was to explain what I was doing wrong, and what obvious factors I had

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