An anomaly in economics occurs when an empirical outcome is challenging to justify, or when it requires unrealistic assumptions for its explanation using the underlying theories. In simpler terms, it pertains to a real-life scenario that contradicts or departs from the conventional theory.
The anomalies discussed by Kahneman et al. (1991) are the endowment effect and status quo bias, which demonstrate a lopsided value in which the pain of losing something (disutility) is stronger than the joy of gaining the equivalent item (utility), known as loss aversion. In general, these anomalies of the endowment effect and status quo bias demonstrating the loss aversion pose a challenge when trying to account for them within the framework of the rational choice model that assumes agents possess stable, clearly defined preferences and consistently make rational choices of maximizing utility in markets that eventually achieve equilibrium.
In particular, the core consequence of the endowment effect anomaly is an amplified reluctance to part with one’s owned items, underscoring that discomfort associated with perceived losses is more pronounced than the regret of missing out on potential gains. Therefore, viewpoints of fairness are significantly influenced by whether the situation is framed as a gain deduction or an actual loss, indicating that individuals do not consistently maintain stable and well-defined preferences.
Moreover, a status quo bias emerges when individuals are pronouncedly inclined to stick with the existing state (status quo), primarily because the drawbacks of departing from it seem more substantial. When an alternative is designated as the new status quo, it tends to gain considerable acclamation, and the perceived disadvantages of making a change appear to outweigh the benefits. Such instances contrast the traditional assumption of maintaining a consistent preference order since the preference order is contingent on the current reference point.
Additionally, loss aversion suggests that individuals react more strongly to the aspect in which they perceive losses concerning their reference point. While the conventional theory of rational choice assumes that utility primarily stems from the level of wealth rather than changes relative to a reference point, it is essential to recognize that utility is contingent on changes, not absolute levels of wealth. Consequently, a specific difference between two choices will exert a more significant influence when it is perceived as a distinction between two disadvantages relative to the reference point rather than two advantages.
The Prospect Theory’s three cognitive principles offer potential explanations for various anomalies, including the evaluation based on a neutral reference point, diminishing sensitivity, and loss aversion. Firstly, assessments are made relative to a reference point that typically aligns with the status quo but can represent one’s expected outcome or perceived entitlement. Gains are situations where outcomes exceed the reference point, while losses occur when they fall below it. Secondly, the principle of diminishing sensitivity can be applied to the evaluation of changes in wealth, clarifying that distinctions become increasingly challenging to discern as individuals move farther from their reference point. For example, the subjective distinction between $1,000 and $1,100 is much smaller than that between $200 and $300.
Lastly, the loss aversion principle can explain the different risk aversion attitudes towards gains and losses, suggesting that the response to losses is more salient than the response to corresponding gains. Hence, when directly compared or weighted against each other, the extent of utility loss associated with losses surpasses the utility increase associated with gains. The last two principles can result in risk aversion for gains and risk seeking for losses. Overall, at least two aspects of the article can be appreciated: the use of colloquial examples and relevant literature to explain anomalies and the contribution to economic rational choice theory by filling gaps in the literature stemming from unrealistic or impractical assumptions.
References
Kahneman, D., Knetsch, J. L., & Thaler, R. H. (1991). Anomalies: The endowment effect, loss aversion, and status quo bias. Journal of Economic Perspectives, 5(1), 193-206.
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