The Royal Swedish Academy of Sciences has decided that the Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel, 2002, will be shared between
Daniel Kahneman
Princeton University, USA
…
and
Vernon L. Smith
George Mason University, USA
So why do people think it worthwhile to save $5.00 on a $10.00 item but not on a $500.00 item? After all, $5.00 is $5.00 regardless of the total price of the item, no?
(Of course I think that way too, but now an economist can explain to me why I think that way.)
I am not an economist, but I did recently complete a grad level econ course. As it was explained (and as you said), prospect theory attempts to describe anomolies in human behavior. We were interested in its application to finance, and how people’s risk averseness varies depending on whether they are facing a loss or gain.
The example we were given:
Choose one of the follwing
$500 cash
a 50/50 chance at $1500 or $0
Most people will choose the sure thing, even though the expectation is higher for the other ($750). This is fairly normal risk aversion. However, they found that the same people, if given the following choice
lose $500
a 50/50 chance at losing $1250 or $0
will choose the costlier (expectation -$750) 2nd option. People tend to take bigger and worse risks when facing a negative outcome.
There are all sorts of interesting directions this has gone, from economics to epidemiology (people obsessing over crime, but not healthy eating). A Google search will turn up tons. Most of it, no doubt, explained better than I have.
They see the former as 50% off while the latter is only 1% off. They look at how much money they are saving relative to the purchase price. Depending on the circumstance, you could argue that people who can afford the $500 item are less concerned about saving $5 than people in the pool from which the $10 item is studied.
As for costly small-scale insurance for appliances, I would say that it’s the hard-sell customers get from the salesmen who get a bonus for selling this tripe.
BTW, your better off asking a behavioral psychologist than an economist (unless your asking Ludwig von Mises). Most economists are only beginning to take into account irrational behavior. Someday they may even come to the conclusion that investors don’t act rationally either and that randomn walk is bunk.
This is just a guess on my part, but could it have to do with the percentage of the total price that the $5 is equal to? Since $5 is half of $10 it is only 1% of $500. Since 1% is obviously not as much as 50%, maybe people don’t think of it the same way?
And upon preview KidCharlemagne beats me to the punch. :smack:
Prospect Theory says, first, that people judge utility based on changes from their current state (or some other status quo), and not based on their total assets after the decision. That is, they see it in terms of gains and losses, not final outcomes. There can be framing effects, where people make different decisions, depending on which state they view to be the status quo.
Second, the utility curve around the status quo, with perceived utility on the y-axis and material gain on the x-axis, is concave towards the x-axis on both sides of the origin (the status quo), and losses hurt more than gains help (you also might want to read this site). The general shape of the curve (though not the precise values) is similar to y=sqrt(x) for x>0 and y=-2.5sqrt(-x) for x<0. The difference between a $5 cost and a $10 cost on this curve is huge, compared with the difference between a $500 cost and a $495 cost. Retailers, though, will try to sell the purchase as a $5 savings on a $500 cost, since the gain of receiving $5, added to the loss of $500, is less of a loss than the loss of $495.
Third, people’s subjective probabilities differ from objective probabilities. The subjective difference between a sure thing (p=1) and a 95% chance is much bigger than the difference between a 47% chance and a 42% chance. With subjective probabilities on the y-axis & objective probabilities on the x-axis, the curve (scroll down to see the graph, and read the site if you want) increases steeply going right from the origin, then levels off (to a slope of maybe .5) in the .3-.7 range of objective probability, then increases steeply again up to the point (1,1).
There are plenty of examples of how these utility and probability curves can lead to decisions that don’t maximize expected value, or decisions that can be manipulated by changing irrelevant aspects of the problem. I won’t go into those just now, but you could look at an earlier thread where I discussed some of this (though it was off-topic there).
I think that the behavior described in Arnold Winkelried’s cite is not so unreasonable as it seems at first. After all, we purchase $10 items much more frequently than we purchase $500 items. Therefore, the effort put towards saving $5 on $10 purchases may result in saving a very large sum over the course of a lifetime, but making an effort to save $5 on $500 purchases may not be worth it because the total amount saved by this strategy is small.