loss aversion

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Among economists, Pay-as-you-Drive (PAYD) automobile insurance has been an intriguing idea for a number of years. The idea is straightforward: Drive more, pay more. Proponents say PAYD can lower the social costs of driving—think carbon emissions and traffic congestion—by leading people to shoulder the true burden.

On the industry side, Progressive has been one of the most aggressive innovators with PAYD insurance. It first began offering a voluntary PAYD program called MyRate in six states in 2008. Three years later, thanks to inexpensive, if not quite cheap wireless technology, the idea is now available nationwide through an initiative called Snapshot. Progressive gives a discount to policyholders based on information about their driving habits collected over a month-long period. Drivers put a sophisticated little tracking device in their cars for six months. At the end of the first month, certain “good drivers” may be eligible for a discount of up to 30 percent based on that “snapshot” of driving behavior. (At the end of the six months, Progressive uses all the data to calculate a renewal rate.)

As Steven Levitt notes, the interesting part of PAYD insurance programs, which are voluntary, has always been how to structure the incentives for participation. The concern is that only low-mileage drivers will sign up.

The clearest winners are (low-mileage users), who can drive the same distance they used to drive and pay less. What’s less obvious is whether Progressive will be a winner; there are, in fact, a couple of situations in which Progressive could lose out. If all (PAYD) accomplishes is to give Progressive’s low-mileage customers the rate cut they deserve, then Progressive is doing little more than lowering its own revenues. It could, of course, try to compensate by raising rates on all its high-mileage (drivers), but then there’s nothing to stop (them) from buying…insurance elsewhere. (Of course, losing its riskiest customers to other companies might also prove profitable for Progressive.)

Where Snapshot is most likely to give Progressive an edge is if it can help the company better forecast the future liabilities it will be on the hook for. That means better predicting accidents. To do that, however, Progressive needs to get all kinds of drivers, not just low-mileage users, to try it and feed the data back to home base. To appeal to all drivers, Progressive has had to move beyond traditional economics and consider behavioral economics as well.

To encourage customers to test out Snapshot, Progressive draws from the lessons of overconfidence and loss aversion. Humans are overconfident creatures, especially when it comes to driving. Ninety three percent of people think they are above average drivers. Even among bad drivers, accidents are not the modal driving experience, and there’s always someone else to blame for them.

Snapshot is primarily a program about usage, but it’s sold as a program about “good driving.”

On its web site, Progressive doesn’t shy away from calling Snapshot “usage-based insurance.” But its media advertisements headlined by cheery customer service rep “Flo,” refer to driving behavior more generally. “Just plug it in and it keeps track of your good driving habits,” Flo explains. “So the better you drive, the more you save.”

What makes a good driver? The speed you drive at and the locations you drive to and from are not part of the equation. Taking speed off the table eases some customer fears since speeding is the most salient mark of good (or bad) driving. Taking driving location off the table eases fears of those who worry about privacy and whether Progressive is tracking their every move. The device doesn’t have a GPS.

Instead, “good driving” depends on 1) Time of day you drive, 2) Number of miles you drive, and 3) How hard you brake (“bad drivers” brake hard). What’s common about all three items? Drivers have very little control over them. When and how far your drive depends largely on where you live and work, which are both quite sticky in the short term. And how hard you brake is primarily an automatic reaction built up over years of commuting. For any single braking experience you can push the pedal more smoothly, but maintaining that consistency over an entire month if you are a hard braker is a bit like trying not to blink for a minute.

According to the Wall Street Journal, a Progressive executive admitted that one of these items predicts accident potential as well as all the usual demographic markers like age, gender and marital status. Although the executive didn’t say which one, the peak time for accidents is between midnight and 4 a.m. If there is one habit worth trying to change over your month with Snapshot, it could be the itch to party. At least think about taking a taxi or hitching a ride with your friend.

Progressive doesn’t think overconfidence, by itself, is enough to get people to try out Snapshot. So it has to remove any risk of losses by promising drivers they won’t pay any more for insurance than they are paying now. Freed of potential losses, overconfidence can kick in, prompting “good” and “bad” drivers to give it a shot and see what kind of a discount they get. After all, they can’t be penalized for any “bad” behaviors. But since Snapshot is about “good” and “bad” driving risk, not “good” and “bad” driving skill, Progressive doesn’t even care if you are involved in an accident while using the device since your risk profile is determined by calculations based on driving patterns. (Theoretically, you could be involved in a minor fender bender with Snapshot and Progressive would never know.)

In essence, Progressive doesn’t want a snapshot of your driving habits. It wants a snapshot of its overall customer base, assuming that base looks a lot like the overall car insurance market. It wants Snapshot to work less like a camera and more like a random sample. From that perspective, the success of economists’ preferred auto insurance depends on whether some non-economists can get the behavioral economics of offering the product just right.

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An entire King of Queens episode devoted to behavioral finance and economics. Doug gets a Christmas bonus. He and Carrie decide not to spend their windfall (mental accounting). Doug wants to put it in the bank, while Carrie pushes for a high-flying internet stock (herd behavior). The stock goes up for one day, but quickly falls. They don’t sell because it’s too painful. They hold out, hoping the stock will recover (loss aversion). The stock continues to fall and they finally sell at the bottom. Then they notice news about government approval, the stock rallies, and they buy back in (availability bias). It’s all wrapped up in a syrupy sitcom message about the meaning of Christmas.

Hat tip: Rodrigo Sanchez.

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Assorted links

1) Honey, they shrunk our consumer products.

2) Mitigating the “regret premium” – in general, people aren’t willing to exchange lottery tickets even with a bonus.

3) Follow up on Kirkland House post. Trayless cafeterias result in 25 percent less food waste, according to a study of 25 campuses by food services provider Aramark. Hat tip: Scott Talan.

4) Should you peel a banana like a monkey? Nudge blog reader Matthew Hook says yes.

5) Behavioral economists advising on yet-to-be-released personal finance software. Stay tuned.

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Tim Harford explains:

The UK’s Office of Fair Trading (OFT) has been turning to behavioural economists for advice on such tactics, and has found that there is no pricing scheme more pernicious than “drip pricing”. Under the scheme, customers agree to pay a price only to discover that there is a charge for delivery; another charge for paying by credit card, and another for insurance. Drip pricing taps into the endowment effect, because customers feel that they have already made the decision to purchase; it creates loss aversion because customers commit time and effort to the search before being hit with extra charges; and it is a form of complex pricing which makes it hard to compare offers.

Hat tip: Simoleon Sense

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About ten years ago, a pair of economists published a study on loss aversion in the residential housing market (gated version here). Homeowners, they found, held out for more money, about 25-35 percent above the expected selling price, and ended up paying for it — either by not selling or by having their property languish on the market for months before a sale. But is that so unexpected? These were just regular homeowners.

In a new study of commercial real estate, Sheharyar Bokhari and David Geltner of MIT find that supposedly sophisticated commercial investors exhibited similar degrees of loss aversion during the recent housing bubble. In fact, the more sophisticated the investor, the larger the loss aversion, they find. The consequence to the investors was the same. More money spent (lost) in making a sale because of how much longer their property sat on the market.

Despite loss aversion at the individual level, the authors do not find that it had much impact at the market level. In other words, its impact on average transaction prices and trading volume during the boom and bust was minimal. So both behavioralists and neoclassicalists can take comfort when they read it.

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Nudge blog reader and Booth School grad Faysal Mokadem thinks there is a way to reframe credit card statements to keep people from overspending. Instead listing the balance as a positive amount, Mokadem wants to list it as a negative.

For instance, say I have a credit limit of $10,000 and I have spent $8,500 throughout the month. Usually a credit card statement would read: – Credit $8,500. Available balance $1,500. This lets people feel that they have room to spend…

What if I had the following statement: You are -$8,500 and you can go down to -$10,000.

Framing the statement this way makes feel that you should move up to zero, rather than trying to stay below $10,000.

Mokadem says he tries to read his statements this way in order to motivate himself to keep his debt down. “Instead of feeling that I have a right to spend up to my available balance, I feel that I am under water or really in debt,” he says.

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In a recent post, the Nudge blog linked to a piece pointing out how Amazon’s pricing strategy for e-books is causing a headache for Apple. Of relevance to this example is a 1986 paper by Richard Thaler, Daniel Kahneman, and Jack Knetsch, “Fairness as a Constraint on Profit Seeking: Entitlements in the Market,” (gated copy here). In it, the authors develop the concept of a reference transaction in notions of fairness. A reference transaction is “a relevant precedent that is characterized by a reference price or wage, and by a positive reference profit to the firm.” Amazon’s $9.99 price for best-seller e-books was a money loser for the company, but that doesn’t mean its customers know that. After all, what does it cost to electronically publish a book? Blogs are free! As the authors point out, “The reference transaction provides a basis for fairness judgments because it is normal, not because it is just.” The $9.99 price has been around as long as the Kindle, which is long enough to be normal.

Reference transactions can change, and they will in the e-book world. Until then, since consumers are used to the current $9.99 price, the standard rules of prospect theory will apply. That means price increases are likely to lead to dissatisfaction, particularly since its not clear that the costs of electronic book publishing are any different now than they were three years ago. Why? Because of how Amazon marketed the first e-books.

Amazon can’t go back and re-run history, but it can learn for the future. When selling a new, or little used, product, it’s better to offer two prices. The first price is the price you’d charge for the product if it were popular and profitable. For Amazon in 2007, this might mean the price it would like to charge consumers in a 2010 world where e-books are no longer so strange. The second price is the discount price. This strategy is similar to the kinds of introductory trial prices that cable companies offer, although without the explicit time frame to start and end them. When the company decides it can no longer keep subsidizing the product, it ends the discount. Plain and simple.

This isn’t what Amazon did, though. $9.99 wasn’t a special discount price. Amazon didn’t make a big deal that the standard retail e-book best-seller price was $16.99, and that it was offering a 40 percent discount. $9.99 was just…the retail price. Raising prices usually irks consumers. But as any good student of prospect theory knows, taking away discounts is much easier for consumers to swallow than raising prices — even though it’s effectively the same thing — because of loss aversion and some consumers’ understanding of the retail price as the reference price. This logic even applies for hot products. The original retail price acts as the reference point against which consumers judge the price increase. Since they already thought they were gaining something with the discounted price, it hurts a bit less when it’s taken away, compared with simply jacking up the discount price when it’s not framed as a discount.

It turns out that Amazon’s actions aren’t just affecting Amazon at the moment. They are a costly externality for Apple as it tries to figure out a pricing strategy for books on the iPad. Unlike Amazon, Apple is starting fresh, which means it can adopt the two price strategy on iBooks. It hasn’t so far, but there’s still time.

Addendum: Amazon did advertise its Kindle book prices relative to the hardcover list price. But that wasn’t a useful reference point since customers did not see the two products as identical.

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John List (of the University of Chicago) and Tanjim Hossain run an experiment in a high-tech Chinese factory where workers’ bonuses are framed as “gains” and “losses.” Both frames boost productivity, but the loss frame boosts it slightly more.

Our study revolves around using insights gained from one of the most influential lines of behavioral research—framing manipulations—in an attempt to increase worker productivity in the facility. Using a natural field experiment, we report several insights. For example, conditional incentives framed as both “losses” and “gains” increase productivity for both individuals and teams. In addition, teams more acutely respond to bonuses posed as losses than as comparable bonuses posed as gains. The magnitude of the effect is roughly 1%: that is, total team productivity is enhanced by 1% purely due to the framing manipulation. Importantly, we find that neither the framing nor the incentive effect lose their importance over time; rather the effects are observed over the entire sample period.

The full paper is gated, unfortunately.

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1) Yale’s Dean Karlan says it’s not a surprise that taxes on junk food are more effective than subsidies for healthy food at changing consumer habits. It’s about loss aversion: “People are just more responsive to price increases than decreases.”

2) Colleges are trying Trayless Tuesdays. Is yours?

3) San Francisco has adopted a public school matching algorithm similar to the one mentioned in the school choice chapter of Nudge. Hat tip: Market Design, which notes “the nice thing is that the underlying choice architecture will make it safe for parents to state their true preferences however the priorities are adjusted.”

4) Pepsi is cutting sugary drinks from schools around the world.

5) More women are asking surgeons to remove a healthy breast along with a cancerous breast, even though removing the healthy breast doesn’t change their odds of survival, says the New York Times. Why? “But women who have opted for the procedure say it’s not about the statistics. Once they receive a breast cancer diagnosis, they never again want to experience the stress of a mammogram or biopsy.”

Addendum: A pilot project using Netflix like technology to predict which patients need checkups and send them email alerts. Hat tip: Marginal Revolution.

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1) Taxes are more effective than subsidies in cutting calorie consumption. Hat tip: Farnam Street.

2) Airport security and snow removal have the availability heuristic in common. Hat tip: Mike Dariano.

3) Computer science professors want to develop “privacy nudges” that alert people to the long-run costs of turning over their personal data to private companies.

4) Loss aversion and the endowment effect at work in ticket prices for Sunday’s gold medal hockey game. Hat tip: David Karp.

5) Embracing small failures can help you learn and succeed.

6) McKinsey releases a marketer’s guide to behavioral economics. Hat tip: Simoleon Sense.

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