Behavioral Finance

1. Behavioral Finance Economics 437

2. Utility function issues • Endowment Effects • Endowment Effect • Status Quo Effect • Intransitivities • Allais Effect • Time Consistency

3. Endowment Effect • Knetsch and Sinden (1984): $ 2 or a lottery ticket • Participants are “endowed” with either $ 2 or a lottery ticket. When offered to switch or trade, few chose to switch. • Kahneman, Knetsch and Thaler (1990) • Mugs and Pens

4. Kahneman, Knetsch and Thaler (1990) • Mugs sell at Cornell bookstore for $ 6 • Give every other participant a mug, let everyone examine the mugs • Announce that there will be four market trials to determine the market price of the mugs, but only one trial, selected randomly, will be “binding” • What does economic theory predict will be the outcome? • When markets clear, mugs will be owned by those who value them the most • Divide the participants into “mug lovers” and “mug haters” (in equal numbers) • Since mugs were assigned at random, on average half of the mug lovers will be given a mug and half will not. This implies that half of the mugs should trade, with mug haters selling to mug lovers

5. Kahneman, Knetsch and Thaler (1990) -- Conclusions • There were 22 mugs distributed, so the predicted number of trades was 11. • In the four market trials, trades were: 4, 1, 2 and 2 • Median owner was unwilling to sell for less than $ 5.25 • Median buyer was unwilling to pay more than $ 2.25 to $ 2.75

6. Another Version of Same Experiment • 77 students at Simon Fraser U were randomly assigned to three situations: • Sellers, given an SFU coffee mug (then asked would they sell at prices ranging from $ .25 to $ 9.25) • Buyers (then asked would they buy at prices ranging from $ .25 to $ 9.25) • Choosers (then asked to choose either receiving a mug and receiving that amount of money for each price from $.25 to $ 9.25) • Result: • Note that sellers and choosers are in objectively identical situations • Median reservations prices: • Sellers $ 7.12; Choosers $ 3.12; Buyers $ 2.87 • Conclusion: low volume of trade is produced mainly by owner’s reluctance to part with their ‘endowment.’

7. Similar Experiment: Pens vs Dollars Pens 5 Dollars $ 4.50

8. Status Quo Effects • Samuelson and Zeckhauser (1988) • Subjects told: You inherit a large sum of money in cash. What to do, if choices are: moderate-risk company, high-risk company, treasury bills, municipal bonds • Same as above except: A significant portion of your inheritance is not in cash, but instead is invested in a moderate-risk company (assuming no taxes or transaction costs) • Second Experiment: new health care plans offered at Harvard (only new faculty accepted them – they were the default option for new faculty) • Hartman, Doane and Woo • A survey of California electric power consumers revealed two groups: those who felt they had very reliable service and those who had relatively unreliable service • Each group was asked to state a preference among six combinations of service reliabilities and rates (with one combination described as the status quo) (highest reliability with full rates; lowest reliability 30 percent discount in rates) • Results: • Highest reliability group: 60.2 % favored status quo; 5.7% chose lowest reliability • Lowest reliability group: 58.3 % favored status quo; 5.8% selected highest reliability

9. Status Quo/Endowment Bias Commodity A From position t, X and Y are indifferent From position X, X is preferred to Y From position Y, Y is preferred to X X Y t Commodity B

10. The End