Behavioural Economics III

This article is part 3 in a four-part series on behavioural economics. Next article: Effect of Time (coming soon). Previous article- The endowment effect.

In the realm of decision-making, the way information is presented can dramatically influence the choices people make. This phenomenon, known as framing, plays a pivotal role in how we perceive potential outcomes, especially when it comes to risks and rewards. We shall now explore the groundbreaking work of Tversky and Kahneman, who sought to explain how different framings of identical scenarios could lead to vastly different decisions. By examining their research, we can gain insight into why we are susceptible to making poor decisions and understand the underlying psychological mechanisms that drive our preferences.

The power of framing

Imagine that the UK is preparing for the outbreak of an unusual disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. In a paper by Tversky and Kahneman, they examined the importance of how information is conveyed in two different scenarios.

In scenario 1:

• If program A is adopted, 200 people will be saved.

• If program B is adopted, there is a 1/3 probability that 600 people will be saved and a 2/3 probability that no people will be saved.

 In scenario 2:

• If program A is adopted, 400 people will die.

• If program B is adopted, there is a 1/3 probability that nobody will die and a 2/3 probability that 600 people will die.

  
  

Notice that both scenarios display the exact same information, but the way in which the information is displayed is different. So surely there should be no difference between the two scenarios?

In fact, there is a huge difference. Scenario 2 has been given a loss frame, where the loss frame emphasises the potential negative outcomes. By taking a sidestep, we can examine why this is important.

Loss aversion is the phenomenon where ‘losses loom larger gains’. In other words, if we lose something, then the negative impact of this is greater than the positive impact of an equal-sized gain. Image 1 illustrates a loss aversion function.

As illustrated in the image, a loss of £100 results in a much larger negative reaction than the positive reaction of a gain of £100. To put this into perspective, imagine it’s your birthday and someone gifts you some money. You would hopefully feel quite grateful and happy, but perhaps this feeling isn’t overwhelming. On the contrary, if you soon discover that you lost your wallet or purse, which contained the same amount of money, the psychological impact is often much more severe. Losses are perceived to be much more significant than gains.

Going back to the example involving the two scenarios, we see that in scenario 2, program A emphasises the death of 400 people compared to scenario 2, program B, which has a chance to lose more but also a chance to save everyone. Statistically, you should be indifferent between the two, but because the guaranteed loss of 400 people is so overwhelming, people would much rather gamble and take the chance.

This same reason is why gambling is so addictive. When you lose money in a gamble, you feel compelled to not accept the loss and decide to continue betting in an effort to make back what you once had.

What Kahneman and Tversky found was that in scenario 1, 72% of people chose program A, and in scenario 2, 78% of people chose program B. Clearly, how we frame a policy makes a huge difference in its popularity. By framing the information by saying “200 people will be saved” rather than “400 people will die” out of the same 600 people, our own perception is considerably different.

But on a deeper level, why might this be, and why is knowing this distinction important?

In my previous article on the endowment effect, we saw that once you own something, you feel possessive over it, and losing something that you have had to work for, like money, makes you feel as though that hard work has gone to waste. But this explanation struggles to translate into our example of people.

In researching for this article, I came across the evolutionary psychology perspective and found it to be both interesting and persuasive. From an evolutionary perspective, loss aversion can be seen as an adaptive trait. For our ancestors, losses such as losing food or shelter could have dire consequences for survival, whereas gains such as finding extra food was certainly beneficial but not as crucial for immediate survival. Therefore, we may be hardwired to avoid any losses, which has translated into modern-day loss aversion.

The reason why knowing about this is important comes up in two aspects of life.

The first is in healthcare. As demonstrated at the beginning of the article, people’s decisions can be impacted by the way in which healthcare professionals and the government frame policies. By understanding this, it allows you to make your own decision on the risks and determine whether you believe it is right for you. Similarly, policymakers can shape public opinion by highlighting the benefits or costs of action or inaction such that it meets their own political agenda. So recognising loss aversion allows for more informed decision-making.

Additionally, when it comes to the world of investing, people tend to keep hold of an investment that is performing badly or perhaps at a loss in the hopes that it will go back up in the future. If this belief is justified through analysis or good judgement, then deciding to hold may be a good decision; however, often loss aversion creates a false sense of hope similar to the example I gave for gambling. If you are a keen investor, it’s important to be aware of your own investment psychology so that it allows you to maintain an objective view of a company throughout the time you decide to remain invested.

Evidently, understanding how we think and make decisions can play an important role in improving the choices we make in our personal and professional lives. By recognising the impact of loss aversion and framing, we can become more aware of the unconscious biases that drive us to avoid losses at all costs, even when those decisions may not be in our best interest. Whether it’s in healthcare, investing, or everyday life, cultivating this awareness allows for more rational, informed choices that better align with long-term goals rather than short-term fears. In a world where information is constantly framed to sway public opinion, knowing the psychology behind our decision-making processes is a powerful tool that can help us make wiser, more deliberate decisions.

Written by George Chant

REFERENCES

Tversky A, Kahneman D. The framing of decisions and the psychology of choice. Science. 1981 Jan 30;211(4481):453-8. doi: 10.1126/science.7455683. PMID: 7455683.

Image provided by Economicshelp.org, a link to the website: https://www.economicshelp.org/blog/glossary/loss-aversion/