Loosely related, A Better Explanation Of The Endowment Effect
Phrasing this in terms of utility functions is misleading. I suggest thinking in terms of a Schelling Point strategy, as David Friedman describes in his account of why property rights exist. Most utility functions will generate strategies such as this under many conditions.
Could you explain the rational justification for loss aversion ? (If possible, write a top-level post on this.)
As Patrick said, loss aversion is present on the scales small enough for the DMU to not matter. Slightly more mathematically, when, given the utility function x->U(x), the gain vs loss utility ratio for the same change in the argument is small: Δx << U’(x)/U”(x). It does not invalidate the author’s point though, that there exists a phenomenon that is better described as the utility hysteresis: one ends up with less utility after gaining 2x and then losing x than after just gaining x.
The validity of the author’s point seems to depend on what is the best way to interpret the phrase “losses hurt more than equivalent gains”. Two ways that you could interpret it in which it would be a consequence of loss aversion but not of DMU:
“Having your wealth decrease from X to Y decreases your satisfaction more than having your wealth increase from Y to X increases it.”
“The pain of a small loss is significantly more than the pleasure of a small gain.”
It seems to me that most of the quotes at the end, if you interpret them charitably, mean something like the above. So the post seems like a nitpick to me. It’s great to explain the difference between loss aversion and DMU for people who don’t necessarily know about them, but it’s not clear to me that it means that the quoted people were actually wrong about something.
I would also disagree with point #3, e.g. the last sentence of the Economist quote seems valid as an intuitive explanation of loss aversion but not of DMU.
In short, the author is wrong. Diminishing marginal utility only really applies when the stakes are on the order of the agent’s total wealth, whereas the loss aversion asymmetry holds true for relatively small sums.
See e.g. a nice paper by Matthew Rabin which quantifies the extent to which diminshing marginal utility is too weak an effect to explain actually-observed risk aversion, by proving statements like this: “If you would turn down a 50:50 gamble between gaining $101 and losing $100 on account of diminishing marginal utility, then you would also turn down a 50:50 gamble between gaining all the money in the world and losing $10,000.”
DMU is only rational when applied to the larger sums. It’s pretty believable that much of what’s called loss aversion is a broken heuristic in human brains, which mis-implements DMU by picking way-too-small reference classes. IMO, hyperbolic discounting is a related evolved heuristic which conflates value discounting and future uncertainty.
That makes a lot of sense to me. Aversion to small losses makes a ton of sense as a blanket rule, when the gamble is:
lose: don’t eat today
win: eat double today
don’t play: eat today
Our ancestors probably faced this gamble since long before humans were even humans. Under those stable conditions, a heuristic accounting for scale would have been needlessly expensive.
I don’t think you read the author right. He is not saying that loss aversion is explained by diminishing marginal utility, he’s saying precisely the contrary.
I mean...he quotes Kahneman; claiming the guy doesn’t know the implications of his own theory.
Losses hurt more than gains even at scales where DMU predicts that they should not. (because your DMU curve is approximately flat for small losses and gains) Loss aversion is the psychological result which explains this effect.
This is the author’s conclusion:
“So, please, don’t go around claiming that behavioral economists are incorporating some brilliant newfound insight that people hate losses more than they like gains. We’ve known about this in price theory since Alfred Marshall’s 1890 Principles of Economics.”
Sorry nope. Alfred Marhall’s Principles would have made the wrong prediction.
I don’t think you read the author at all. The whole post is about structural qualitative differences between “people hate losses more than they like gains” (DMU) and loss aversion. He is not saying DMU explain loss aversion. He is not saying Alfred Marshall’s Principles would have made the right prediction. What he is saying is that loss aversion is much less intuitive than the pop science version of loss aversion.
I read him, he is just incorrect. “People hate losses more than they hate gains” is not explained by DMU. They dislike losses to an extent far greater than predicted by DMU, and more importantly, this dislike is largely scale invariant.
If you go read papers like the original K&T, you’ll see that their data set is just a bunch of statements that are predicted to be equally preferrable under DMU (because marginal utility doesn’t change much for small changes in wealth). What changes the preference is simply whether K&T phrase the question in terms of a loss or a gain.
So...unsurprisingly, Kahneman is accurately describing the theory that won him the Nobel prize.
The author explain very clearly what the differences are between “people hate losses more than they like gains” and loss aversion. Loss aversion is people hating losing $1 while having $2 more than they like gaining $1 while having $1, even though it both case this the difference between having $1 and $2.