Loss Aversion / Fairness / Endowment Effect Mental Model (Deprival Superreaction Syndrome)

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Loss Aversion / Fairness / Endowment Effect Mental Model: Executive Summary

If you only have three  minutes, this introductory section will get you up to speed on the loss aversion / fairness / endowment effect mental model.

The concept in one quote:

Loss aversion is the single most powerful tool in the behavioral economist’s arsenal. - Richard Thaler Click To Tweet

(from “Misbehaving” – M review + notes)

A brief explanation of loss aversion / fairness / the endowment effect: humans hate losing things; losses are twice as painful as gains are pleasurable.  When we possess something, it becomes part of our “endowment,” and thanks to loss aversion, we like and value it more than we would if we didn’t own it – in other words, we will resent having it taken away from us more than we would appreciate it being given to us.  

Key takeaways/applications: people have a very strong intrinsic sense of “fairness” that is usually related to their right to what they believe they’re entitled to; if you violate this sense of fairness, it can provoke “deprival superreaction syndrome.”

Three brief examples of loss aversion / fairness / the endowment effect:

Saving face. 

A major problem in relationships both personal and professional is sunk costs and commitment bias, as discussed in Tavris/Aronson’s “ Mistakes were Made (but not by me) ( MwM review + notes); people hate to feel like they’ve “lost” something when they’ve put a lot of time and effort into it.

As explored by Fisher, Patton, and Ury in “ Getting to Yes ( GTY review + notes), having enough empathy to put yourself in the other party’s shoes to understand that loss aversion – and finding ways to mitigate it by helping people come to solutions where they don’t feel like they have to give anything up – results in far more successful negotiation outcomes.

The easiest path to higher investment returns: checking your portfolio less frequently.  Research demonstrates that the more frequently you check your portfolio (and thereby see losses), the more pain you feel – and the more likely you’ll be to make bad decisions at the worst times.

Whoa now, that’s a little more than a playground scuffle.  

In Richard Rhodes’ “ The Making of the Atomic Bomb ( TMAB review + notes), he observes that fairness is one of the fundamental principles that drove the nuclear arms race:

“The basic reason for this assertion is that justice, which most human beings interpret essentially as fairness, is demonstrably a concept of the deepest importance to people all over the world.

Relating this to the axiom of proliferation, it is manifestly the case that the attempts over the years of those who own nuclear weapons to assert that their security justifies having those nuclear weapons while the security of others does not, has been an abject failure.”  

In other words: it’s not fair that you get to have a nuke and I don’t.

If this sounds interesting/applicable in your life, keep reading for unexpected applications and a deeper understanding of how this interacts with other mental models in the latticework.

However, if this doesn’t sound like something you need to learn right now, no worries!  There’s plenty of other content on Poor Ash’s Almanack that might suit your needs. Instead, consider checking out our learning journeys, our discussion of the inversionBayesian reasoning, or cognition / intuition / habit / stress mental models, or our reviews of great books like “ Polio: An American Story” ( PaaS review + notes), “ Other Minds” ( OthM review + notes), or “ Scale” ( SCALE review + notes).

Loss Aversion / Fairness / Endowment Effect: A Deeper Look At Deprival Superreaction Syndrome

Let’s mix it up a bit.  Usually, I start with the first premises and work my way to the conclusions.  Let’s use inversion and work backward from deprival superreaction syndrome to fairness to the endowment effect to loss aversion.

Anyone who’s ever been around kids has seen deprival superreaction syndrome at work.  Here’s Charles Schulz’s take on it:

This panel illustrates a real behavioral tendency that, as we’ll explore, extends well beyond children.  (So as not to pick on Lucy, we should remember that Linus behaves much the same way when deprived of his blanket.)

Deprival superreaction syndrome is almost always accompanied by shouts of “it’s not fair!” – which leads us to believe that people have something called a sense of fairness.

To investigate that, let’s stick with children for now.  First of all, as Richard Thaler quips in “ Misbehaving ( M review + notes):

“Economists thought that fairness was a silly concept mostly used by children who don’t get their way.”

Other thoughtful people in other fields had a more insightful – and realistic – take on the matter.  For example, Stephen Covey’s classic “ The 7 Habits of Highly Effective People ( 7H review + notes) mentions fairness as one of the basic human principles, right up there with honesty and integrity:

I am referring, for example, to the principle of fairness, out of which our whole concept of equity and justice is developed.  

Little children seem to have an innate sense of the idea of fairness even apart from opposite conditioning experiences.

There are vast differences in how fairness is defined and achieved, but there is almost universal awareness of the idea.

Let’s go back to Lucy above.  She says it’s not fair.  What’s not fair?  Lucy’s mother promised her a party, and now Lucy is being told she can’t have one.

There’s actually an important angle on expectations here that I discuss in the  margin of safety mental model, but we’ll ignore that for now.  What’s clear is that Lucy believed that she had a right to have that party – it was part of her “endowment” – her possessions and rights.

And when something we have, something we have a right to have, is taken away from us, that’s not fair.  The idea of fairness is that we believe we have a right to have the things that we feel we’re entitled to have.  That’s the principle that Covey noted we are “universally aware” of.

Now, the corollary to this is that Lucy didn’t always have this party as part of her endowment.  The comic specifies that it was “promised” – so it became part of her endowment upon that promise being made.

So how does Lucy’s emotional state now compare to her emotional state before that?  Presumably, when Lucy’s mother originally promised her that party, Lucy took it in stride.

That is to say: upon being promised the party, she probably didn’t jump up and down with glee and give her mother a hundred hugs and kisses.  She almost certainly didn’t go above and beyond to do extra chores for the next week; she probably didn’t even stop picking on poor Linus for the next five minutes.  Later that afternoon, she probably still put Charlie Brown at risk of spinal cord injury and permanent paralysis by pulling the football away.

So it’s clear that the pain and suffering felt by Lucy upon being told that she can’t have a party far exceeds any pleasure that she experienced when she was promised the party.

In other words, losses are felt more strongly than gains – loss aversion.  This is intuitive, but it’s also scientifically proven: research by psychologists and behavioral economists has consistently demonstrated that we feel losses twice as acutely as gains.

If we come to possess something – even something as trivial as a coffee mug that’s handed to us by an experimenter – it because part of our endowment, and is thus subject to the endowment effect: we value it more highly now that we have it than we would if we’d been offered it, without having it, in the first place.

Richard Thaler’s “ Misbehaving ( M review + notes) – my favorite book – deeply explores the concepts of loss aversion, the endowment effect, and fairness.  Among Thaler’s intriguing conclusions: the “Coase Theorem” underlying much of law is dead wrong.

And the reason that employers lay off a portion of their workforce – rather than cutting everyone’s pay across the board – is that cutting wages make workers […] angry, whereas when workers are cut, they are not around to complain.

There are plenty of examples of this among adults.  Meredith Wadman’s fascinating “ The Vaccine Race ( TVR review + notes) contains a nice example of fairness.  A scientist, Leonard Hayflick, had spent a significant amount of time developing a cleaner, safer set of cells for manufacturing vaccines – the “WI-38” cells.

For various (stupid) reasons, the government had stood in the way of commercial use of WI-38s at every turn.  But the WI-38s were technically government property, and Hayflick, at one point, who’d been working with them for so long – they were like his babies – decided to take possession of them and do what he liked with them.  “Steal” is perhaps legally appropriate, but most readers of the book will have a hard time taking the government’s side.

The government didn’t care for a while, then suddenly came after Hayflick with a vengeance.  He, naturally, thought this was totally unfair:

“Because of the government’s decade long cold-shouldering of WI-38s, it is hard not to feel sympathy with Hayflick’s sense of irony and outrage that the same government now claims the cells to be its own precious property.”  

Nor was it merely Hayflick who felt this way – so did many of his fellow scientists.  Wadman’s “ The Vaccine Race ( TVR review + notes) quotes Maurice Hilleman, a superstar vaccine developer at Merck, as stating:

He should have been celebrated as a scientific hero instead of being persecuted.”

Thaler wasn’t kidding when he called loss aversion a powerful tool.  We’ll explore just how powerful it is, but as a quick note: in the  structural problem solving model, I discuss how Thaler’s “Save More Tomorrow” plan took advantage of loss aversion – along with  activation energystatus quo bias, and  hyperbolic discounting – to help people save 3x as much for retirement without taking any lifestyle cut.

Sound too good to be true?  It’s not – it’s part of the reason Thaler won the Nobel Prize for his work.  Other great applications of loss aversion are discussed in Thaler’s “ Nudge ( NDGE review + notes) with coauthor Cass Sunstein.  One hilarious example is discussed in the  salience model.

Loss Aversion / Fairness / Endowment Effect Incentives: Why Is It The Deprival “Super” Reaction Tendency?

Charlie Munger, the father of the mental models approach, has made it clear that he views incentives as one of the most powerful models around.  He quips that he’s been in the 95th percentile of understanding it for most of his life, and yet he’s still underestimated its power.

I think the reason Munger refers to loss aversion as the deprival “super” reaction tendency is that this is one of the few models that can kick the sh*t out of incentives, almost every time.

Don’t believe me?  There’s quantitative proof.  One of Thaler’s conclusions, in the aforementioned “ Misbehaving ( M review + notes), is that the “Coase Theorem” is wrong.  The Coase Theorem, basically, underlies much legal thinking, and assumes that parties will come to the equitable, utility-maximizing conclusion.

Here’s the problem: in tense situations like divorce court, it’s a well-replicated finding that people will hurt themselves for the sake of spiting others – enforcing “fairness,” in other words.  

 Mistakes were Made (but not by me) ( MwM review + notes) provides some great examples of this in the real world.  Thaler overviews some laboratory experiments as well: in controlled lab experiments called the “Ultimate Game,” a Proposer is given a small amount of money (like $10) that they must split with the Responder.  So the proposer could choose to split it 50/50, or they could choose to split it 80/20.

It turns out that people will often turn down what they perceive as “unfair” offers – many below 30% are rejected, for example – which makes no sense in light of conventional utility or incentives theory.  Think about it: imagine a Proposer offered you two bucks.  As a Responder, your incentives are:

A: accept offer, get $2 that I didn’t have before

B: reject offer, get nothing

From a utility standpoint, A would seem to be clearly superior.  So why isn’t it chosen?

The answer appears to be that “tit for tat” is the long-run equilibrium strategy; Thaler notes that people – given the opportunity – usually like to be fair.  But people don’t like to be suckers, so if they play with cheaters long enough, they’ll adapt. However, if you take them out of the situation and put them in a new one where they won’t be taken advantage of, they revert to fair behavior.

Indeed, I was intrigued to find out that fairness and loss aversion tendencies have been found in other animals.  You ever tried to take a food bowl from a dog, or seen how one responds when you try to take the other one on a walk without it?

More seriously, Jennifer Ackerman’s “ The Genius of Birds ( Bird review + notes) observes that crows – which have been shown to exhibit reciprocity bias, giving favored humans gifts – will:

“balk at doing work for less reward than a peer is getting.”

Again, this doesn’t seem to make sense in a short-range utility or incentives context – presumably, the researchers are still giving the crows a nice treat for their effort.

Endowment effect and deprival superreaction syndrome crop up in other animals, too – Charles Duhigg’s “ The Power of Habit ( PoH review + notes) observes that a monkey who expected juice to arrive (i.e., it was part of his endowment) started throwing a fit if it did not:

“When the juice didn’t arrive or was late or diluted, Julio would get angry and make unhappy noises, or become mopey […] when Julio anticipated juice but didn’t receive it […] desire and frustration erupted inside his skull […] that joy became a craving that, if unsatisfied, drove Julio to anger or depression.”

Presumably Julio liked the juice, but probably not as much as he hated it being taken away.

We’re going to move on to some specific framing applications, but what are the lessons here?

One of the major ones is that fairness and loss aversion are both deeply biologically engrained, and very strong.  So you don’t want to mess with them.

Yet business executives from Coca-Cola to Netflix to Uber forget that consumers are humans, not econs.  In business school, the right answer is profit-maximizing – charge what the market will bear.

But consumers tend to view market prices as part of their endowment (as we’ll explore in more depth in a minute), so when Coca-Cola trialed dynamic vending machine prices, people revolted.

Uber faced similar challenges with surge pricing, as Thaler discusses in “ Misbehaving ( M review + notes).  Brad Stone’s “ The Upstarts ( TUS review + notes) provides an interesting angle on this as well.

Another impact is personal: Megan McArdle’s “ The Up Side of Down” ( UpD review + notes) observes that hunting for jobs during unemployment is painful – so, paradoxically, loss aversion can lead some people to not spend enough time searching for jobs (because it’s depressing), despite the strong  incentive of employment.

Application / impact: be aware of fairness and avoid triggering loss aversion / the endowment effect whenever possible.  Ask people to give up something they think they have a right to, and you have a ticking time bomb on your hands.  Make sure loss aversion isn’t distorting your own decisions.

Loss Aversion / Endowment Effect Framing

Framing is a subset of the schema mental model that sort of incorporates product vs. packaging: if the exact same information is presented to us in different ways, we respond to it differently, even though the presentation should be irrelevant “packaging” that we throw away (we only use the “product,” in my analogy.)

Nowhere is this better demonstrated than loss aversion and the endowment effect.  First, you have to realize some of the mathematical consequences of loss aversion: people prefer sure gains, but are risk-seeking when it comes to losses.  Richard Thaler’s “ Misbehaving ( M review + notes) covers this in depth; Megan McArdle touches on some of this in ‘ The Up Side of Down ( UpD review + notes) as well, if you want a different perspective from Thaler’s.

If you give someone the options:

A: sure gain of $5

B: 50/50 chance of a gain of $0 or $10

They’ll usually choose A.  On the other hand, if you give someone the options of:

A: sure loss of $5

B: 50/50 chance of a loss of $0 or $10

They’ll pick B.  This has to do with marginal utility; it also underlies why people like gamblers or investors get a little crazy when they’re down, which probably also gets some into commitment bias.

Here’s a real-world example: Dr. Jerome Groopman’s “ How Doctors Think cites Dr. Stephen Nimer explaining why

“Most of the patients I have encountered who refused treatment do so because they are so focused on the downside […] they are only thinking about what’s happening to them that day.”

It’s a combination of hyperbolic discounting and loss aversion / endowment effect – these patients view rough side effects of chemotherapy or similar treatments as a “sure loss” – they’re risk-seeking for losses.  Their current state of having hair, not throwing up, and not feeling super-fatigued are part of their endowment, and they don’t want to give that up – even if it means risking the cancer progressing.

Now, the obvious corollary to this is that if people are risk-seeking for losses and certainty-seeking for gains, doctors – and others presenting critical information to patients – can use framing to their advantage.

For example, if you tell people that if they don’t take a pill, they’re more likely to die – you’re triggering the stronger power of loss aversion, versus telling them if they do take a pill, they’re more likely to live.

Similarly, people will prefer a 50/50 chance of success to a 50/50 chance of failure – even though they’re mathematically equivalent.

Plenty of businesses use these techniques as well: you’ve probably seen a restaurant or other vendor, for example, offer a “cash discount.”  But you rarely see “credit card surcharges,” unless you’re dealing with a government counterparty. (I won’t make the obvious joke.)

You should be able to intuit the reasons by now.  Ignoring rounding, you can see how the following two are mathematically equivalent:

2% surcharge  ($9.80 “normal price” / $10.00 “price with card”)

2% discount ($9.80 “cash discount” / $10.00 “normal price”)

And yet consumers treat the “normal price” as part of their endowment – the normal price is what’s fair – so people don’t mind if you give them a discount.  But it sure triggers loss aversion when you hit them with a surcharge.

There are obvious parallels to the lesson I explore in my margin of safety mental model: given the power of loss aversion, and the fact that our expectations are part of our endowment (think back to Julio the juice-deprived monkey, and poor party-deprived Lucy), it’s important not to set people’s expectations too high and then underdeliver – because then you’re triggering loss aversion.

More personal framing antidotes to loss aversion are explored in the mindfulness mental model.

Application / impact: always think about loss aversion in the context of presenting information: people are risk-seeking for losses and certainty-seeking for gains; meanwhile, they heavily prefer gains to losses, so “discounts” are better than “surcharges,” and if there’s a meaningful amount of uncertainty, focus on the potential for success – not failure.