Before we get to the fascinating psychological phenomenon that is loss aversion, let's talk about Behavioral Economics. It's a field that's growing like crazy, and in coming posts I will be tackling different behavioral economics principles, and how we can use them to motivate people to conserve energy.
Traditional economic theory says that people are rational and logical, and because of that, the decisions we make are calculated for our own best interest. In other words, given the opportunity, we will always maximize our own gains. In this perspective, humans are thought of as Homo Economicus.
But people are clearly not always rational. We make decisions when we’re emotional, we have all kinds of biases, we are often generous and altruistic in ways that benefit others at a cost to ourselves. Behavioral economics incorporates psychological principles into traditional economics, and tries to understand in a predictable, systematic way when and why we don’t always make the rational decision and do what’s best for ourselves.
A fantastic example of a behavioral economic principle is loss aversion, or the general preference people have for avoiding losses. So, here you’re looking at a graph.
Traditional economic theory says that people are rational and logical, and because of that, the decisions we make are calculated for our own best interest. In other words, given the opportunity, we will always maximize our own gains. In this perspective, humans are thought of as Homo Economicus.
But people are clearly not always rational. We make decisions when we’re emotional, we have all kinds of biases, we are often generous and altruistic in ways that benefit others at a cost to ourselves. Behavioral economics incorporates psychological principles into traditional economics, and tries to understand in a predictable, systematic way when and why we don’t always make the rational decision and do what’s best for ourselves.
A fantastic example of a behavioral economic principle is loss aversion, or the general preference people have for avoiding losses. So, here you’re looking at a graph.
On the x-axis is loss and gain, usually in terms of money. If you gain money, you shift to the positive side of the x-axis, and with a loss, you shift to the negative side. Then the Y-axis is “value”, which you can think of as happiness. Picture yourself starting at the intersection of these axes, with your current level of happiness and your current amount of money. Now, think of yourself gaining $100, so moving right along the X axis, and therefore gaining some happiness and moving up the Y axis. This is represented by the pink dot on the upper right. Now conversely, think of yourself losing $100, and therefore losing happiness. This is represented by the dot on the lower left. Traditional economics predicts that that $100 is worth an equal amount of happiness to you, whether you win it or lose it. If you gain $100 you go up 10 points on the happy scale, if you lose $100 you go down 10 points, and that’s what’s shown on the blue prediction line.
Well, it turns out that’s not so much the case. Here we have the same graph, but instead of the prediction line in the last slide, we have the real results of experimental data, by the behavioral economics geniuses Daniel Kahneman and Amos Tversky (cites below). Tons of studies have been conducted to get at this relationship between gain, loss, and happiness. And it turns out, gaining $100 may make us pretty happy, but LOSING $100 makes us REALLY, disproportionately upset. A loss gives us more displeasure than an equivalent gain gives us pleasure, and so it’s the case that humans are loss averse – we want to avoid losses even more than we want to gain gains. Knowing that led experimenters to predict that whether we frame a situation in terms of loss or gains will affect people’s decisions. To test this, we often use what’s called the Asian Disease Problem. It goes a little something like this:
Half of the participants are given the choices on the LEFT, which are framed in terms of gains. Note that these choices, Program A and Program B, have the same expected value, which is that on average, 200 people will be saved. But given these choices, about ¾ of people, or 72%, choose the sure thing, to save 200 people. That’s not really surprising, because people are generally risk averse.
The other half of the participants are given the choices on the RIGHT, which are framed in terms of losses. These choices, C and D, ALSO have the same expected value (200 people will be saved). But given these options, over ¾ of the people chose the risk, rather than the sure thing. Given our risk aversion, this is interesting, no?
But the critical comparison is really Program A vs. Program C – the simple shift in phrasing, from “200 people will be saved” to “400 people will die”, even though they mean the exact same thing in this context, made an incredible difference in the decision. People who saw the loss frame were much more willing to be risky, to gamble with lives, to avoid that loss.
The other half of the participants are given the choices on the RIGHT, which are framed in terms of losses. These choices, C and D, ALSO have the same expected value (200 people will be saved). But given these options, over ¾ of the people chose the risk, rather than the sure thing. Given our risk aversion, this is interesting, no?
But the critical comparison is really Program A vs. Program C – the simple shift in phrasing, from “200 people will be saved” to “400 people will die”, even though they mean the exact same thing in this context, made an incredible difference in the decision. People who saw the loss frame were much more willing to be risky, to gamble with lives, to avoid that loss.
This is important to know. It means that the way we frame the information we give to people makes a big difference in how they’re going to respond to it.
So how should we take advantage of this for energy efficiency? Smart meters and in-home feedback displays are one clear possibility - rather than showing people their costs racking up, we can show them that, starting with a budget, their money is going down. SRP, my utility here in Arizona, has implemented a pre-paid card system that works with an in-home display to show how much money you have remaining, and it's actually stressful to see it get closer to zero (I've been there). Cycling through the displays, I found that piece of information to be more motivating than the other information on how much I'm spending per hour, how many killowatts I've used this month, and so on. And it may not just be me; SRP pre-paid customers tend to save ~$12/month on energy, compared to customers who receive a normal bill. These savings probably result from a combination of immediate feedback (see last post) and loss aversion.
Then there are the messages we use to encourage consumers to purchase energy saving products. Rather than saying, "Replacing all of your normal light bulbs with CFLs will save you $7/month," the message could be, "If you don't replace your light bulbs with CFLs, you're losing $7/month."
I'd love to get your ideas on how loss aversion can be used to encourage conservation. Such a powerful strategy can surely have important implications for reducing energy use.
So how should we take advantage of this for energy efficiency? Smart meters and in-home feedback displays are one clear possibility - rather than showing people their costs racking up, we can show them that, starting with a budget, their money is going down. SRP, my utility here in Arizona, has implemented a pre-paid card system that works with an in-home display to show how much money you have remaining, and it's actually stressful to see it get closer to zero (I've been there). Cycling through the displays, I found that piece of information to be more motivating than the other information on how much I'm spending per hour, how many killowatts I've used this month, and so on. And it may not just be me; SRP pre-paid customers tend to save ~$12/month on energy, compared to customers who receive a normal bill. These savings probably result from a combination of immediate feedback (see last post) and loss aversion.
Then there are the messages we use to encourage consumers to purchase energy saving products. Rather than saying, "Replacing all of your normal light bulbs with CFLs will save you $7/month," the message could be, "If you don't replace your light bulbs with CFLs, you're losing $7/month."
I'd love to get your ideas on how loss aversion can be used to encourage conservation. Such a powerful strategy can surely have important implications for reducing energy use.
Kahneman, D., & Tversky, A. (1984). Choices, values, and frames. American Psychologist, 39(4), 341-350.
Tversky, A., & Kahneman, D. (1981). The framing of decisions and the psychology of choice. Science, 211(4481), 453-458.
