Loss aversion has been under fire in the economics literature recently (see here and here). As one of the foundations of behavioural economics, this is a big deal. So, I was interested to read this recent paper by Ryan Oprea (University of California, Santa Barbara), published in the journal American Economic Review (ungated earlier version here). Oprea essentially tests the key tenets of Prospect Theory, that when faced with a risky choice such as a lottery, people are risk averse when it comes to gains, but risk seeking when it comes to losses. Oprea's argument is that we observe that behaviour in lottery experiments, not because it is real, but because it is an artefact of the complexity of the lotteries that the research participants are faced with.
Here's what Oprea did:
In each task in our experiment, we elicit subjects’ dollar valuations for a set of 100 “boxes,” each of which contains some dollar amount. For example, in one of our tasks (called G90), we ask subjects to value a set consisting of 90 boxes that each contain $25 and 10 boxes that each contain $0. Acquiring a set of boxes influences the subject’s earnings in the experiment according to a payoff rule, and we compare how subjects value these sets under two contrasting payoff rules.
By opening one of the boxes from the set at random and paying the subject the amount inside, we turn the set into a lottery (i.e., G90 becomes a risky prospect of earning $25 with probability 0.9), and the dollar value the subject attaches to it becomes a certainty equivalent: the certain dollar amount the subject judges to be equivalently valuable to the risky lottery.
Using those results, Oprea replicates the key results from Prospect Theory, which he refers to as the 'fourfold pattern' of risk (a term that actually comes from Kahneman and Tversky), as well as loss aversion. Then:
Our contribution is to compare these valuations to the valuations of what we call “deterministic mirrors” of the same lotteries. A deterministic mirror of a lottery consists of the same set of 100 boxes used to describe the lottery but is characterized by a different payoff rule: instead of paying the dollar amount in one of the 100 boxes selected at random as a lottery does, a mirror pays the sum of the rewards in all of the boxes, weighted by the total number of boxes. Thus, instead of paying $25 with probability 0.9 (as a lottery does), the mirror of G90 pays 0.9 × $25 = $22.50 with certainty.
In other words, the 'deterministic mirror' of a lottery retains all of the complexity associated with the choice, but eliminates all of the risk (because the amount received is certain, rather than risky). So, if the 'fourfold pattern' is real and arises from the riskiness of the lottery, it should disappear in these experiments. Instead, using data from 673 research participants (and with similar results in a second sample of 489 research participants):
...we find that
(i) The fourfold pattern arises in the valuations of deterministic mirrors just as it does in lotteries, and with roughly the same strength. Importantly, this means that we find strong evidence of what is usually called “probability weighting” in settings without probabilities.
(ii) Loss aversion arises in deterministic mirrors even though at the relevant margins they cannot actually produce losses. Thus, we find strong evidence of what is usually called “loss aversion” in settings without risk of loss.
(iii) Across subjects, the severity of each of these anomalies in lotteries is strongly predicted by their severity in deterministic mirrors, suggesting that the behaviors in the two settings are strongly linked, deriving from a common behavioral mechanism (which, clearly, cannot be grounded in risk or risk preferences).
In other words, Oprea finds strong evidence that it is complexity that drives the 'fourfold pattern' of risk in lottery experiments, because when risk is removed (but complexity remains), the 'fourfold pattern' is still there. On top of that, loss aversion remains even when there is no risk of loss. So, loss aversion may also be an artefact of complexity of lottery experiments. Oprea concludes that:
First, theories of risk preferences designed to explain these anomalies (e.g., prospect theory) are unlikely to contain much normative content and therefore should not be accommodated in the inference of welfare or the design of policy. Second, our finding of systematic departures from neoclassical benchmarks in perfectly deterministic settings suggests that many of our descriptive theories of preferences for risk are really descriptive theories of the way people evaluate complex things.
That's a really nice way of saying that behavioural economists may need to reconsider some of their key theories, because the lab experiments they have been using to verify them do not stand up to this scrutiny. And Oprea's results may also help to explain some of the recent anomalies in the loss aversion literature (see here and here).
Oprea's results are important, and even though the working paper version of this article has already been cited over 50 times, I still don't think this research has received the attention that it deserves (and see Eric Crampton's take here). However, it may not be time to throw away behavioural economics or loss aversion entirely. Oprea notes that:
We do not claim, for instance, on the basis of these data that risk preferences or even loss preferences do not exist but only that they are unlikely to be reliably revealed in lottery valuations.
That is an important caveat. Behavioural economists may simply need to find a new way of demonstrating the 'fourfold pattern' of risk, and loss aversion, without resorting to complex lotteries. These effects may still be real. After all, there is a lot of real-world behaviour that is very consistent with loss aversion (see my various posts on that topic here).
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