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Loss Aversion: Good Money After Bad PDF Print E-mail
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Written by Jamy Ian Swiss   

Last week, NPR ran a story about the psychology of “loss aversion,” and its apparent influence on international policymaking. The reporter interviewed Jeffrey Berejikian, a political scientist, who has pursued innovative studies about this psychological phenomenon as it might affect international negotiations about trade and trade sanctions.

The phenomenon of loss aversion has been studied in many contexts. I tracked down a paper Dr. Berejikian co-authored in 2008, entitled “Loss Aversion as Motivation: The Case of American Trade Policy.” Therein the authors begin by pointing out that (please note that I have removed the scholarly citations for ease of reading):

“In economics and marketing, the importance of loss aversion is well understood. It affects consumer purchasing patterns ranging from athletic event tickets … to gift certificates, to pizza topping. It can reduce the volume of transitions in the market place, and it explains the premium of stock over bond returns. Individual attitudes about the value of clean air, lottery tickets), and even time available for work are contoured by loss aversion.”

As discussed in the NPR piece, loss aversion explains for example why people who lose money at a casino are more committed when they continue to bet to try to recover the initial loss, than they are when making the initial bet.

With regard to economic policies, the authors of the 2008 advise that, “research in behavioral decision theory (BDT) indicates that human choices deviate in predictable ways from the axioms of micro-economic rationality.”

Putting aside for another day the implications for free-market libertarianism and anyone who thinks that human beings (or markets), left to their own devices, invariably make rational choices, economic or otherwise, the story caught my eye because loss aversion also helps explain a behavioral phenomenon that skeptics routinely find mystifying, namely why people tend to throw good money after bad when paying psychics for promised but unfulfilled results.

This unfortunate tendency was seen in the recent prosecution, for example, of Florida psychic Rose Marks, who took noted romance novelist Jude Devereaux for millions of dollars over a period of many years. Of course, psychics use a battery of manipulative techniques to fuel their clients’ emotional dependency, but loss aversion goes far to explain why people become more committed, not less, in trying to rescue their initial investment. Along the way, cognitive dissonance also plays a key role, as victims attempt to protect themselves for having made bad choices on mistaken judgment in the first place. It’s a stew of psychological mechanisms that go far in offering genuine – and empathetic – explanations for such apparently self-destructive behavior, but far better explanations than merely blaming the victims for stupidity or gullibility.

In the political arena, the authors of the 2008 paper also “challenges the prevailing wisdom” regarding the likelihood of past Republican administrations, versus Democratic ones, to “back down” in trade sanction negotiations. Contrary to popular perception and claims about being tough on trade, Republican administrations have been more than twice as likely than Democratic ones to back down in such confrontations. And they observe that, “… the same decision-making element that affects the number of toppings chosen to grace a president’s pizza (Levin et al., 2002) also affects presidential choice in prosecuting foreign trade disputes.”

The human mind is a wonderful wet machine. But it often leads us to irrational decision-making, a phenomenon that skeptics would do well to understand. Along with, apparently, Presidents and policy advisors.

 

Jamy Ian Swiss is Senior Fellow at the JREF. He blogs regularly at randi.org.

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