Avoidance of Loss

Rather than giving equal weight to gains and losses, (as per the graph based on Expected Utility), individuals actually treat them differently: A loss is more devastating than the equivalent gain is gratifying. In other words, avoiding a loss is perceived as more valuable than acquiring a gain. It seems that people’s “in-built” value function is non-linear (i.e., not like the graph based upon Expected Utility).

This is illustrated by responses to Question 1:

Question 1

Which of these two options would you prefer?

Version A:

Choice 1: A sure loss of $800,

Choice 2: An 85% chance of losing $1000 and a 15% chance of losing nothing.

Version B:

Choice 1: $800 for sure.

Choice 2: An 85% chance of gaining $1000 and a 15% chance of gaining nothing.

Question

What is the Expected Utility associated with each of these choices? Therefore, what would be the “rational choice” for each sheet?

Version A:

Choice 1: -$800 x 1 = -$800

Choice 2: -$1000 x 0.85 + 0 x 0.15 = -$850

Choice 1 is associated with a smaller negative utility, and should be chosen.

Version B:

Choice 1: $800 x 1 = $800

Choice 2: $1000 x 0.85 + 0 x 0.15 = $850

Choice 2 is associated with a larger positive utility, and should be chosen.

Question

Which option did you choose on the questionnaire? Which option do you think people would choose for the other questionnaire?

On both versions A and B, people select the option that is inconsistent with expected utility theory, which is Choice 2 in Version A and Choice 1 in Version B (in both cases the option that does not maximise expected utility). Why does this happen?

In Version B (where people tend to go for a sure thing) this makes sense because the difference between gaining nothing and gaining $800 is close to the difference between gaining nothing and gaining $1000. In other words, the added benefit of the extra $200 is not worth the risk of gaining nothing. In Version A, people tend to go for the “risky” option because substantially more value is lost from 0 to $800 than from $800 to $1000. So, losing $800 for sure is far worse than 85% chance of losing $1000.

Another way to think about this outcome is that it implies a 15% chance of losing nothing (Version A) is valued more than a 15% chance of gaining nothing (Version B): People are risk seeking when it comes to avoiding loss, but risk averse when it comes to acquiring gain.

Brainstorm

Can you think of examples of yourself or other people seeking risk when trying to avoid losses, and avoiding risk when acquiring gain?