In both the endowment effect and sunk cost effect consumer tend to overestimate opportunity costs.

Consider two different scenarios, both at a pizza place. In the first scenario you are offered a basic pizza, with the chance to add ingredients, like sausage and ham. Depending on your taste, you might even add pineapple. We call this an additive condition.

In the second scenario you are offered a fully loaded pizza, with a chance to remove ingredients. We call this a subtractive condition.

What condition would increase the likelihood of you ending up getting a pizza with more ingredients? 

Results from the “A tale of two pizzas” experiment by Irwin P. Levin et al., has shown that the subtractive condition will likely lead you to end up eating a pizza with more ingredients. Removing one topping is perceived as a loss, while adding it, as a gain.

This is a clear example of loss aversion, one of the most important (and recently most controversial) findings in behavioural economics, discovered by Kahneman & Tversky in 1979, and encapsulated in the expression “losses loom larger than gains”. 

The response to losses is stronger than the response to corresponding gains. For instance, we are more upset about losing $10 than we are happy about finding $10. It is thought that the pain of losing is psychologically about twice as powerful as the pleasure of gaining. And the displeasure of losses makes us go to greater lengths to avoid them rather than take risks to obtain gains.

Loss aversion is a result of many factors, including; individual neurological makeup, socioeconomic status, and cultural background. Yet, it manifests in many aspects of our lives, with implications for relationship, career choice, financial decision-making, and consumer behaviour. For example, since we tend to focus more on negative consequences, in marital interactions it generally takes at least five kind comments to offset for every one critical comment (Baumeister et al, 2001).

Loss aversion is driven by fear, and has been used to explain a myriad of biases and fallacies, like the status-quo bias, scarcity, and the endowment effect among others. 

Status quo refers to our resistance to change. And it is thought that when we think about change, we tend to focus more on what we might lose rather than on what we might get. Loss aversion can also be triggered by scarcity (in particular scarcity of quantity and time. Time-limited offers and dwindling supplies work because we fear losing the opportunity to acquire products and offerings at a discounted price in the future.  

In make it valued we have discussed how people tend to value objects they own more (the endowment effect). The strong connection between the two behavioural design strategies is obvious: once we have built a strong sense of ownership over an object, an idea, a service or a digital product, our perceived value increases, and we are more reluctant to let go. 

Let’s look at 3 practical techniques we can leverage to influence behaviour. 

Let’s look at 3 practical techniques we can leverage to influence behaviour. 

SUNK COST FALLACY

Why do managers continue to invest time and money into failing projects that they’ve already invested resources in?

Why might you continue training for an upcoming marathon despite your knee pain because you have already spent months training for it?

And why it is very unlikely to leave IKEA without buying anything, after having spent a lot of time driving to its inconvenient store location?

Welcome to sunk costs. 

The Sunk Cost Fallacy describes our tendency to follow through on an endeavour if we have already invested time, effort or money into it, whether or not the current costs outweigh the benefits.

While it is unlikely IKEA has chosen store locations to make it effortful to reach, the sunk cost fallacy can be leveraged intentionally. 

For example, our preference to avoid losses compared to acquiring gains explains why trial periods work. While subscribing for a trial does not cost money, in reality we invest our time, energy and effort in getting used and accustomed to the product (for example in the setup and configuration). We build a sense of ownership, so that when the trial period is over, it’s  hard to pull everything back and quit. This tends to happen because scaling back, whether on software trials, expensive cars, or bigger houses, is an emotionally challenging decision.

The investment required is obviously context dependent. For example, research shows that new Amazon Prime members, who use video service in their free trial period, convert at a higher rate than those who do not use this part of the service. 

In both the endowment effect and sunk cost effect consumer tend to overestimate opportunity costs.

Free Trial, Amazon Prime

Sunk costs can also be applied in behavior change strategies. The website Stickk, for example, allows people to commit to a positive behavior change (e.g. quit smoking), which may be coupled with the fear of loss—a cash penalty in the case of non-compliance.

In both the endowment effect and sunk cost effect consumer tend to overestimate opportunity costs.

Stickk

EMPHASISE FUTURE RISKS

Loss aversion is commonly used by companies to persuade potential buyers to purchase their products.

This is seen with insurance companies whose business models heavily rely on individuals’ need for security and their desire to avoid losses and risk.

That is why insurance websites often display a long list of unlikely and costly (at times even catastrophic) outcomes that individuals might encounter if not insured. When compared against the cost of these events, the premiums tend to look very small.

Consumers tend to overestimate the probability of these events, and their desire to avoid that unlikely loss makes them more inclined to pay a high premium. For example gopetplan.com, a dog and cat insurance lists expensive vet bills in an effort to convince users to buy a dog insurance policy.

In both the endowment effect and sunk cost effect consumer tend to overestimate opportunity costs.

gopetplan.com

PUNISHMENT 

 

In Make it Rewarding we highlight the importance of positive reinforcements to encourage a behaviour.  In contrast, punishment is used to discourage undesirable behavior.

Punishment can be positive or negative. Positive punishment entails adding an undesirable stimulus to decrease a behavior. An example is scolding a student to get him/her to stop texting in class. In negative punishment, we remove a pleasant stimulus to decrease a behavior. For example, when a child misbehaves, a parent can take away a favorite toy (note that psychology has amply demonstrated that physical punishment is harmful in child development with long-term consequences). 

Punishment, especially when it is immediate, can be an effective way to decrease undesirable behavior.

Consider the recent behaviour intervention launched by Mumbai traffic police. 

Mumbai traffic police have launched a campaign to address the noise pollution problem (and related physical and health problems) on the city’s roads. The campaign, called “Punishing Signal” uses special decibel meters connected to traffic signals across the city. When the decibel exceeded a dangerous 85dB, the signal timer would reset itself, forcing the people to wait longer at the signal. This is meant to ‘punish’ them for their impatience.

The campaign has creatively leveraged aversion with a touch of humour, as drivers would not expect such a thing to happen.

When leveraged ethically and creatively, loss aversion can be a powerful strategy for product and behaviour change designers.

In particular, products that empower us by enabling us to leverage our own tendency to avoid losses (such as Stickk), and health campaigns and interventions that creatively show us the negative consequences of our actions can be powerful forces for positive individual and social change. 

Massimo's Note:  David McCann, Behavioural and Business Strategist and Founder of BCX Design, contributed to this article.

50. In the endowment effect and the sunk cost effect, consumersunderestimate:a. motivationb. expected utilityc. opportunity costsd. selectiveprocessinge. the diminishing sensitivityeffect

Prospect theory assumes that losses and gains are valued differently, and thus individuals make decisions based on perceived gains instead of perceived losses. Also known as the "loss-aversion" theory, the general concept is that if two choices are put before an individual, both equal, with one presented in terms of potential gains and the other in terms of possible losses, the former option will be chosen.

  • The prospect theory says that investors value gains and losses differently, placing more weight on perceived gains versus perceived losses.
  • An investor presented with a choice, both equal, will choose the one presented in terms of potential gains.
  • Prospect theory is also known as the loss-aversion theory.
  • The prospect theory is part of behavioral economics, suggesting investors chose perceived gains because losses cause a greater emotional impact.
  • The certainty effect says individuals prefer certain outcomes over probable ones, while the isolation effect says individuals cancel out similar information when making a decision.

Prospect theory belongs to the behavioral economic subgroup, describing how individuals make a choice between probabilistic alternatives where risk is involved and the probability of different outcomes is unknown. This theory was formulated in 1979 and further developed in 1992 by Amos Tversky and Daniel Kahneman, deeming it more psychologically accurate of how decisions are made when compared to the expected utility theory.

The underlying explanation for an individual’s behavior, under prospect theory, is that because the choices are independent and singular, the probability of a gain or a loss is reasonably assumed as being 50/50 instead of the probability that is actually presented. Essentially, the probability of a gain is generally perceived as greater.

Tversky and Kahneman proposed that losses cause a greater emotional impact on an individual than does an equivalent amount of gain, so given choices presented two ways—with both offering the same result—an individual will pick the option offering perceived gains.

For example, assume that the end result of receiving $25. One option is being given $25 outright. The other option is being given $50 and then having to give back $25. The utility of the $25 is exactly the same in both options. However, individuals are most likely to choose to receive straight cash because a single gain is generally observed as more favorable than initially having more cash and then suffering a loss.

Although there is no difference in the actual gains or losses of a certain product, the prospect theory says investors will choose the product that offers the most perceived gains.

According to Tversky and Kahneman, the certainty effect is exhibited when people prefer certain outcomes and underweight outcomes that are only probable. The certainty effect leads to individuals avoiding risk when there is a prospect of a sure gain. It also contributes to individuals seeking risk when one of their options is a sure loss.

The isolation effect occurs when people have presented two options with the same outcome, but different routes to the outcome. In this case, people are likely to cancel out similar information to lighten the cognitive load, and their conclusions will vary depending on how the options are framed.

Consider an investor who is given two pitches for the same mutual fund. The first advisor presents the fund to Sam, highlighting that it has an average return of 10% for the last three years. Meanwhile, a second advisor tells the investor that the fund has had above-average returns over the last decade, but has been in decline for the last three years.

Prospect theory says that although the investor has been pitched the exact same mutual fund, they are likely to buy from the first advisor. That is, the investor is more likely to buy the fund from the advisor that expresses the fund's rate of return in terms of only gains, while the second advisor presented the fund as having high returns, but also losses.

Prospect theory says that investors value gains and losses differently. That is, if an investor is presented an investment option based on potential gains, and another based on potential losses, the investor will choose an investment where potential gains are presented.

It's useful for investors to understand their biases, where losses tend to cause greater emotional impact than the equivalent gain. The prospect theory helps describe hows decisions are made by investors.

Prospect theory is part of the behavioral economic subgroup. It describes how individuals make decisions between alternatives where risk is involved and the probability of different outcomes is unknown. There is a certainty effect exhibited in the prospect theory, where people seek certain outcomes, underweighting only probable outcomes.

Prospect theory was first introduced in 1979 by Amos Tversky and Daniel Kahneman, who later developed the idea in 1992. The pair said that the prospect theory was better at accurately describing how decisions are made, compared to the expected utility theory.

Kahneman and Tversky proposed that losses have a greater emotional impact than a gain of the same amount. They said that, given choices presented two ways—with both offering the same result—an individual will pick the option offering perceived gains.

Prospect theory says that individuals will accept an investment when the gains are presented, versus the losses. That is, investors weigh potential gains more than potential losses.