CAASPP Success - Grade 11 Reading Comprehension - Expository #1

How 3 Little Theories Shape Your Spending Habits

[1] Many economic theories dominate mainstream thinking, like supply and demand or Keynesian economics, but some lesser-known theories offer unique insights into human behavior and decision-making. These theories often emerge from the field of behavioral economics, which blends psychology with economic reasoning to explain why people sometimes make irrational choices. This text explores three specific and little-known economic theories: Prospect Theory, the Endowment Effect, and Hyperbolic Discounting. Each theory provides a fresh lens through which we can understand everyday decisions, supported by real-world studies that reveal their practical implications.

[2] Prospect Theory, introduced by psychologists Daniel Kahneman and Amos Tversky in 1979, challenges the traditional economic assumption that people always make rational decisions aimed at maximizing utility. Instead, Prospect Theory suggests that people value gains and losses differently, leading them to make decisions based on perceived gains rather than actual outcomes. A key concept in this theory is loss aversion, which implies that the pain of losing something is more intense than the pleasure of gaining something of equal value.

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[3] A study conducted by Kahneman and Tversky themselves demonstrated this theory through an experiment involving monetary choices. Participants were given two scenarios: one where they could win $100 with a 50% probability or win $50 outright, and another where they could lose $100 with a 50% probability or lose $50 outright. Although the expected value in both cases is the same, participants overwhelmingly chose the sure gain in the first scenario and preferred to gamble rather than accept the certain loss in the second. This behavior illustrates how loss aversion skews decision-making, favoring options that avoid perceived losses, even when the rational choice might differ. In daily life, Prospect Theory explains why people cling to losing stocks or why they hesitate to sell an item for less than its purchase price, despite logical reasoning suggesting they should.

[4] A classic example of Prospect Theory in action can be seen in the way individuals make decisions about selling their homes during a downturn in the real estate market. Even when the market suggests that their home has decreased in value, many homeowners hold onto their property, unwilling to sell at a loss compared to what they originally paid. This decision, often driven by the desire to avoid the psychological pain of a loss, can lead to people keeping properties that might be better sold, which ties up their finances and limits their ability to invest elsewhere. The theory explains why losses are so difficult to accept and why they impact decisions in ways that seem irrational from a purely economic perspective.

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[5] The Endowment Effect is another theory born from behavioral economics, closely related to Prospect Theory. Richard Thaler, a prominent figure in behavioral economics, first articulated this concept in 1980. The Endowment Effect posits that individuals assign more value to things merely because they own them. This phenomenon contradicts the conventional economic view that market value should dictate the worth of an object, not its ownership.

[6] Thaler's famous experiment involved a simple setup: participants were randomly assigned to one of two groups. One group received a coffee mug, while the other did not. Later, both groups were asked to determine the mug's value. Predictably, those who owned the mug demanded a significantly higher price to part with it than what those without a mug were willing to pay for it. The methodology highlighted how ownership inflated the subjective value of an object. This theory plays out in everyday scenarios like overpricing a used car simply because it belongs to you, or refusing to sell a house for market value because of the emotional attachment to it.

[7] The Endowment Effect is particularly evident in the world of online marketplaces, such as eBay or Craigslist. Sellers often list items like old furniture, electronics, or collectibles at prices far above what buyers are willing to pay. The sellers' attachment to these items and the fact that they already own them inflates their perceived value. This leads to situations where items linger unsold for long periods because the owner’s perceived value does not match the market’s willingness to pay. Buyers, unaffected by the Endowment Effect, often perceive these prices as unreasonable, while sellers feel justified in their pricing because of their personal connection to the item.

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[8] Lastly, Hyperbolic Discounting sheds light on why people often prioritize immediate rewards over future gains, even when the latter are significantly larger. Unlike the exponential discounting assumed in classical economics, which suggests people discount future values consistently over time, Hyperbolic Discounting shows that people disproportionately prefer immediate gratification, especially when the delay is short.

[9] A study by psychologist George Ainslie in 1975 offers a compelling example of this theory. Ainslie asked participants to choose between a smaller reward they could receive immediately and a larger reward they could receive after a delay. When the delay was short, participants often chose the immediate reward, even though waiting would have yielded a better outcome. However, as the delay increased, participants were more likely to wait for the larger reward, demonstrating the inconsistent discounting of future values. In real life, Hyperbolic Discounting explains why people struggle with saving money for retirement or sticking to a long-term diet plan. The immediate pleasure of spending or indulging often outweighs the abstract benefit of future rewards.

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[10] A common example of Hyperbolic Discounting can be seen in everyday financial decisions, such as choosing to splurge on an expensive dinner instead of saving that money for an upcoming bill or a future purchase. The immediate satisfaction of enjoying a meal now outweighs the future benefit of financial security. This tendency also manifests in procrastination, where the immediate ease of delaying work overrides the long-term benefits of completing tasks early. In both cases, the preference for short-term rewards often leads to long-term consequences, illustrating how Hyperbolic Discounting plays a significant role in daily decision-making.

[11] These three theories—Prospect Theory, the Endowment Effect, and Hyperbolic Discounting—highlight the complexity of human decision-making. They challenge the traditional economic models that assume rational behavior, offering a more nuanced understanding of why people often make seemingly irrational choices. By examining these theories and the studies that support them, we gain a deeper appreciation of the psychological forces at play in everyday economic decisions. These insights not only enrich economic theory but also have practical applications in fields ranging from marketing to public policy, where understanding human behavior can lead to better outcomes for individuals and society.

A study conducted by Kahneman and Tversky themselves demonstrated this theory through an experiment involving monetary choices. Participants were given two scenarios: one where they could win $100 with a 50% probability or win $50 outright, and another where they could lose $100 with a 50% probability or lose $50 outright. Although the expected value in both cases is the same, participants overwhelmingly chose the sure gain in the first scenario and preferred to gamble rather than accept the certain loss in the second. This behavior illustrates how loss aversion skews decision-making, favoring options that avoid perceived losses, even when the rational choice might differ. In daily life, Prospect Theory explains why people cling to losing stocks or why they hesitate to sell an item for less than its purchase price, despite logical reasoning suggesting they should.

A study by psychologist George Ainslie in 1975 offers a compelling example of this theory. Ainslie asked participants to choose between a smaller reward they could receive immediately and a larger reward they could receive after a delay. When the delay was short, participants often chose the immediate reward, even though waiting would have yielded a better outcome. However, as the delay increased, participants were more likely to wait for the larger reward, demonstrating the inconsistent discounting of future values. In real life, Hyperbolic Discounting explains why people struggle with saving money for retirement or sticking to a long-term diet plan. The immediate pleasure of spending or indulging often outweighs the abstract benefit of future rewards.