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Authors: Richard H. Thaler
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“When is a cost a loss?” Although it had long been on my mind, my “discovery” of prospect theory heightened that interest. Recall that the value function displays loss aversion: when starting from zero, it is steeper going down than going up. Losses hurt about twice as much as gains make us feel good. This raises the question: if you pay $5 for a sandwich, do you feel like you just lost $5? For routine transactions, the answer is clearly no. For one thing, thinking that way would make you miserable. Because losses are weighed about twice as heavily as gains, even trading a ten-dollar bill for two fives would be viewed as a loss with this sort of accounting. “Losing” each of the five-dollar bills would be more painful than the pleasure associated with receiving the $10. So what does happen when you make a purchase? And what in the world was Maya thinking when she bought that gigantic quilt?
Eventually I settled on a formulation that involves two kinds of utility: acquisition utility and transaction utility . Acquisition utility is based on standard economic theory and is equivalent to what economists call “consumer surplus.” As the name suggests, it is the surplus remaining after we measure the utility of the object gained and then subtract the opportunity cost of what has to be given up. For an Econ, acquisition utility is the end of the story. A purchase will produce an abundance of acquisition utility only if a consumer values something much more than the marketplace does. If you are very thirsty, then a one-dollar bottle of water is a utility windfall. And for an Econ who owns a double bed, the acquisition utility of a quilt that fits the bed would be greater than one that hangs two feet over the side in every direction.
Humans, on the other hand, also weigh another aspect of the purchase: the perceived quality of the deal. That is what transaction utility captures. It is defined as the difference between the price actually paid for the object and the price one would normally expect to pay, the reference price . Suppose you are at a sporting event and you buy a sandwich identical to the one you usually have at lunch, but it costs triple the price. The sandwich is fine but the deal stinks. It produces negative transaction utility, a “rip-off.” In contrast, if the price is below the reference price, then transaction utility is positive, a “bargain,” like Maya’s extra-large quilt selling for the same price as a smaller one.
Here is a survey question that illustrates the concept. Two groups of students in an executive MBA program who reported being regular beer drinkers were asked one of the two versions of the scenario shown below. The variations appear in parentheses and brackets.
You are lying on the beach on a hot day. All you have to drink is ice water. For the last hour you have been thinking about how much you would enjoy a nice cold bottle of your favorite brand of beer. A companion gets up to go make a phone call and offers to bring back a beer from the only nearby place where beer is sold (a fancy resort hotel) [a small, rundown grocery store]. He says that the beer might be expensive so asks how much you are willing to pay for the beer. He says he will buy the beer if it costs as much or less than what you state. But if it costs more than the price you state, he will not buy it. You trust your friend, and there is no possibility of bargaining with the (bartender) [store owner]. What price will you tell him?
There are several things to notice about this example, which was fine-tuned to deal with the objections I anticipated hearing from economists. Crucially, the consumption act is identical in the two situations. The respondent gets to drink one bottle of his favorite brand of beer on the beach. He never enters or even sees the establishment from which the beer has been purchased, and thus does not consume any ambience, positive or negative. Also, by ruling out any negotiation with the
Eventually I settled on a formulation that involves two kinds of utility: acquisition utility and transaction utility . Acquisition utility is based on standard economic theory and is equivalent to what economists call “consumer surplus.” As the name suggests, it is the surplus remaining after we measure the utility of the object gained and then subtract the opportunity cost of what has to be given up. For an Econ, acquisition utility is the end of the story. A purchase will produce an abundance of acquisition utility only if a consumer values something much more than the marketplace does. If you are very thirsty, then a one-dollar bottle of water is a utility windfall. And for an Econ who owns a double bed, the acquisition utility of a quilt that fits the bed would be greater than one that hangs two feet over the side in every direction.
Humans, on the other hand, also weigh another aspect of the purchase: the perceived quality of the deal. That is what transaction utility captures. It is defined as the difference between the price actually paid for the object and the price one would normally expect to pay, the reference price . Suppose you are at a sporting event and you buy a sandwich identical to the one you usually have at lunch, but it costs triple the price. The sandwich is fine but the deal stinks. It produces negative transaction utility, a “rip-off.” In contrast, if the price is below the reference price, then transaction utility is positive, a “bargain,” like Maya’s extra-large quilt selling for the same price as a smaller one.
Here is a survey question that illustrates the concept. Two groups of students in an executive MBA program who reported being regular beer drinkers were asked one of the two versions of the scenario shown below. The variations appear in parentheses and brackets.
You are lying on the beach on a hot day. All you have to drink is ice water. For the last hour you have been thinking about how much you would enjoy a nice cold bottle of your favorite brand of beer. A companion gets up to go make a phone call and offers to bring back a beer from the only nearby place where beer is sold (a fancy resort hotel) [a small, rundown grocery store]. He says that the beer might be expensive so asks how much you are willing to pay for the beer. He says he will buy the beer if it costs as much or less than what you state. But if it costs more than the price you state, he will not buy it. You trust your friend, and there is no possibility of bargaining with the (bartender) [store owner]. What price will you tell him?
There are several things to notice about this example, which was fine-tuned to deal with the objections I anticipated hearing from economists. Crucially, the consumption act is identical in the two situations. The respondent gets to drink one bottle of his favorite brand of beer on the beach. He never enters or even sees the establishment from which the beer has been purchased, and thus does not consume any ambience, positive or negative. Also, by ruling out any negotiation with the
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