Monthly Archives: December 2011

A New Year’s Gift: Practical Implications, Round 1

Behavioral economists come up with catchy labels for research findings, like “loss aversion” and the “endowment effect”, but as we have seen these labels don’t actually explain anything because they are not part of a conceptual framework within which they make sense. As a result, they give us no practical guidance in deciding what to do about these “irrational” tendencies. This post will use our alternative formulations to provide just such guidance.

What are we to do about the fact that people value what they have over the same thing belonging to someone else? About the fact that buyers of stock are overly reluctant to sell it at a loss, and that champions of projects continue to fund them when clear-eyed analysis says that pulling the plug is the better course? We begin by recognizing, as previous posts demonstrate, that such behavior is not “irrational”; in fact, in light of the person’s circumstances, the behavior makes sense. Once we see the sense it makes, we’re in a position to do something sensible about it. Continue reading A New Year’s Gift: Practical Implications, Round 1

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What’s Really Going on With “Sunk Cost”

“Sunk cost” is tricky stuff.

It is a standard accounting term, referring to the investment already made in an asset or project. When deciding how to value the asset currently, or whether to invest further in the project, we are firmly admonished to ignore “sunk cost”, and to make our evaluations based on its current market value (or expected future value). This is sound advice, rational to the core, and is perfectly in accord with classic economic theory.

So what’s the rub? To the consternation of accountants, economists and financial advisors everywhere, when we look at actual investment decisions, people routinely do NOT ignore sunk costs. What they have already invested is typically a factor – sometimes a determining factor – in what they decide to invest now. Talk about “irrational”! And since behavioral economists do talk about “irrational” they account for this and many other common deviations from rational practice by invoking the “Endowment Effect.”

In the first post of this series, “Take the Cash and Let the Credit Go”, we saw how “loss aversion” is an ad-hoc account of research data that merely labels the phenomenon but in no way explains it, and gave an alternative formulation that actually predicts the research findings. In this post we will subject the “Endowment Effect” to the same treatment, with an interesting twist: exactly the same conceptual structure that predicts loss aversion also predicts the Endowment Effect! This is our first solid clue that we are on to something really different and powerful here. (And there’s a good deal more where these come from, as we shall see as this series unfolds.) Continue reading What’s Really Going on With “Sunk Cost”