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Journal of Economic Behavior and Organization l (1980) 3960. North-HollandTOWARD A POSITIVE THEORY OFC O N S U M E R CHOICERichard T H A L E R *Cornefl University, ithaca, N Y 14853, USARecei,)ed October 1978, final version received June t979The economic theory of the consumer is a combination of positive and normative theories. Sinceit is based on a rational maximizing model it describes how consumers should choose, but it isalleged to also describe how they do choose. This paper argues that in certain well-definedsituations many consumers act in a manner that is inconsistent with economic theory. In thesesituations economic theory will make systematic errors in predicting behavior. Kahneman andTversky's prospect theory is proposed as the basis for an alternative descriptive theory. Topicsdiscussed are: underweighting of opportunity costs, failure to ignore sunk costs, search behavior,choosing not to choose and regret, and precommitment and self-control.1. IntroductionEconomists rarely draw the distinction between normative models ofconsumer choice and descriptive or positive models. Although the theory isnormatively based (it describes what rational consumers should do)economists argue that it also serves well as a descriptive theory (it predictswhat consumers in fact do). This paper argues that exclusive reliance on thenormative theory leads economists to make systematic, predictable errors indescribing or forecasting consumer choices.In some situations the normative and positive theories coincide. If aconsumer must add two (small) numbers together as part of a decisionprocess then one would hope that the normative answer would be a goodpredictor. So if a problem is sufficiently simple the normative theory will beacc6ptable. Furthermore, the sign of the substitution effect, the most*The author wishes to acknowledge the many people who have made this paper possible.Colleagues, too numerous to name individually, at the Center for Naval Analyses, CornellUniversity, The National Bureau of Economic Research-West, Decision Research, and theUniversity of Rochester have contributed importantly to the final product. Special thanks go toDaniel Kahneman, Amos Tversky, H.M. Shefrin, Thomas Russell, and particularly Victor Fuchswho has supported the research in every possible way. Of course, responsibility for remainingdeficiencies is the author's. He also wishes to acknowledge financial support from the KaiserFamily Foundation, while he was a visiting scholar at NBER-West.

40R. Thaler, Toward a positive theory of consumer choiceimportant prediction in economics, has been shown to be negative even ifconsumers choose at r a n d o m [-Becker (1962)]. Recent research hasdemonstrated that even rats obey the law of d e m a n d [Kagel and Battalio(1975)].How does the normative theory hold up in more complicated situations?Consider the famous birthday p r o b l e m in statistics: if 25 people are in aroom what is the probability that a t least one pair will share a birthday?This problem is famous because everyone guesses wrong when he first hearsit. Furthermore, the errors are systematic - - nearly everyone guesses too low.(The correct answer is greater than 0.5.) For most people the problem is aform of mental illusion. Research on j u d g m e n t and decision making underuncertainty, especially by Daniel K a h n e m a n and Amos Tversky (1974, 1979),has shown that such mental illusions should be considered the rule ratherthan the exception. 1 Systematic, predictable differences between normativemodels of behavior and actual behavior occur because of what HerbertSimson (1957, p. 198) called 'bounded rationality':'The capacity of the h u m a n mind for formulating and solving complexproblems is very small compared with the size of the problems whosesolution is required for objectively rational behavior in the real world - or even for a reasonable approximation to such objective rationality.'This paper presents a g r o u p of economic mental illusions. These are classesof problems where consumers are particularly likely to deviate from thepredictions of the normative model. By highlighting the specific instances inwhich the normative model fails to predict behavior, I hope to show thekinds of changes in the theory that will be necessary to make it moredescriptive. Many of these changes are incorporated in a new descriptivemodel of choice under uncertainty called prospect theory [ K a h n e m a n andTversky (1979)]. Therefore I begin this paper with a brief summary ofprospect theory. Then several types of predicted errors in the normativetheory are discussed. Each is first illustrated by an anecdotal example. Theseexamples are intended to illustrate the behavior under discussion in amanner that appeals to the reader's intuition and experiences. I havediscussed these examples with hundreds of friends, colleagues, and students.Many of the examples have also been used as questionnaires - - I caninformally report that a large majority of non-economists say they would actin the hypothesized manner. Yet I am keenly aware that more formal testsare necessary. I try to provide as many kinds of evidence as possible for eachtype of behavior. These kinds of evidence range from questionnaires, toregressions using market data, to laboratory experiments, to market1Some of these studies have recently been replicated by economists. See Grether and Plott(1979) and Grether (1979).

41R. Thaler, Toward a positive theory of consumer choiceinstitutions that exist apparently to exploit these actions. I hope to gathermore evidence in future experimental research. For readers who remainunconvinced, I suggest they try out the examples on some non-economistfriends.2. Prospect theoryNot very long after expected utility theory was formulated by yonNeumann and Morgenstern (1944) questions were raised about its value as adescriptive model [Allais (1953)]. Recently Kahneman and Tversky (1979)have proposed an alternative descriptive model of economic behavior thatthey call 'prospect theory'. I believe that many of the elements of prospecttheory can be used in developing descriptive choice models in deterministicsettings. Therefore, I will present a very brief summary of prospect theoryhere.Kahneman and Tversky begin by presenting the results of a series ofsurvey questions designed to highlight discrepancies between behavior andexpected utility theory. Some of these results are presented in table 1. Aprospect is a gamble (x, p, y, q) that pays x with probability p and y withprobability q. If q 0 that outcome is omitted. A certain outcome is denoted(z). N refers to number of subjects who responded, the percentage who choseeach option is given in parentheses, and majority preference is denoted by *Subjects were also given problems such as these:Problem II. In addition to whatever you own you have been given 1,000.You are now asked to choose betweenA: (1,000, 0.5) and(16)B: (500)(84)N 70.Table 1Preferences between positive and negative prospects?Positive prospectsProblem 3N 95Problem 4N 95Problem 7N 66Problem 8N -66Negative prospects(4,000, 0.80)(20) (3,000)(80)*Problem 3'(4,000, 0.20)(65)* (3,000, 0.25)(35)Problem 4'(3,000, 0.90)(86)* (6,000, 0.45)(14)Problem 7'(3,000, 0.002) (6,000, 0.001)(27)(73)* Source: Kahneman and Tversky (1979).N 95N 95(92)* ( - 3,000)(8)( - 4,000, 0.20) (-- 3,000, 0.25)( - 4,000, 0.80)(42)( - 3,000,0.90)N 66(8)Problem 8'( --N 663,000, 0.002)(70)*(58) ( - 6,000, 0.45)(92)*6,000, 0.001)(30) ( --

42R. Thaler, Toward a positive theory o[ consumer choiceProblem 12. In addition to whatever you own, you have been given 2,000.You are now asked to choose betweenC: (-1,000, 0.5)(69)The results ofgeneralizations.theseandD: ( - 5 0 0 )(31)questionnairesledN 68.tOthefollowingempirical(1) Gains are treated differently than losses. (Notice the reversal in signs ofpreference in the two columns in table 1.) Except for very smallprobabilities, risk seeking is observed for losses while risk aversion isobserved for gains.(2) Outcomes received with certainty are overweighted relative to uncertainoutcomes. (Compare 3 and 3' with 4 and 4'.)(3) The structure of the problem may affect choices. Problems 11 and 12 areidentical if evaluated with respect to final asset positions but are treateddifferently by subjects.Kahneman and Tversky then offer a theory that can predict individualchoices, even in the cases in which expected utility theory is violated. Inexpected utility theory, an individual with initial wealth w will value aprospect (x, p; y, q) as E U p U ( w x ) q U ( w y )if p q l . In prospecttheory the objective probabilities are replaced by subjective decision weights (p). The utility function is replaced by a value function, v, that is definedover changes in wealth rather than final asset position. For 'regular'prospects (i.e., p q 1 or x O y or x- 0 y) then the value of a prospectis given byV(x,p;(1)If p q 1 and either x y 0 or x y 0 thenV(x, p; y, q) v ( y ) Tc(p)[v(x) - v(y)].(2)The value function is of particular interest here since I will discuss onlydeterministic choice problems. The essential characteristics of the valuefunction are:(1) It is defined over gains and losses with respect to some natural referencepoint. Changes in the reference point can alter choices as in Problems 11and 12.(2) It is concave for gains and convex for losses. The shape of the valuefunction is based on the psychophysical principle that the difference

R. Thaler, Toward a positive theory of consumer choice43between 0 and 100 seems greater than the difference between 1,000 and1,100 irrespective of the sign of the magnitudes. This shape explains theobserved risk-seeking choices for losses and risks averse choices forgains. 2(3) It is steeper for losses than for gains. 'The aggravation that oneexperiences in losing a sum of money appears to be greater than thepleasure associated with gaining the same amount. '3A hypothetical value function with these properties is pictured in fig. 1.VALUE[LOSSES./U/-GAINSFig. 1. A hypothetical value function.Insurance purchasing and gambling are explained through the rc functionwhich is regressive with respect to objective probabilities and hasdiscontinuities around 0 and 1. For details, of course, the reader isencouraged to read the original paper.3. Opportunity costs and the endowment effectExample 1. Mr. R bought a case of good wine in the late '50's for about 5a bottle. A few years later hxs wine merchant offered to buy the wine backfor 100 a bottle. He refused, although he has never paid more than 35 fora bottle of wine.Example 2. Mr. H mows his own lawn. His neighbor's son would mow itfor 8. He wouldn't mow his neighbor's same-sized lawn for 20.Example 3. Two survey questions: (a) Assume you have been exposed to adisease which if contracted leads to a quick and painless death within a2The loss function will be mitigated by the threat of ruin or other discontinuities. SeeKahneman and Tversky (1979, p. 279).3Kahneman and Tversky (1979, p. 279).

44R. Thaler, Toward a positive theory of consumer choiceweek. The probability you have the disease is 0.001. What is the m a x i m u myou would be willing to pay for a cure? (b) Suppose volunteers were neededfor research on the above disease. All that would be required is that youexpose yourself to a 0.001 chance of contracting the disease. What is them i n i m u m payment you would require to volunteer for this program? (Youwould not be allowed to purchase the cure.)The results. Many people respond to questions (a) and (b) with answerswhich differ by an order of magnitude or more! (A typical response is 200and 10,000.)These examples have in c o m m o n sharp differences between buying andselling prices. While such differences can be explained using income effects ortransactions costs, I will argue that a more parsimonious explanation isavailable if one distinguishes between the opportunity costs and out-ofpocket costs.The first lesson of economics is that all costs are (in some sense)opportunity costs. Therefore opportunity costs should be treated asequivalent to out-of-pocket costs. How good is this normative advice as adescriptive model? Consider K a h n e m a n and Tversky's Problems 11 and 12.In Problem 11 the gamble is viewed as a chance to gain while in Problem 12it is viewed as a chance to avert a loss. We know the problems are vieweddifferently since the majority responses are reversed. K a h n e m a n and Tverskyincorporate this in their model by focusing on gains and losses (rather thanfinal asset positions which are identical in these two problems) and byhaving the loss function steeper than the gains function, v ( x ) - v ( x ) . T h i sshape of the value function implies that if out-of-pocket costs are viewed aslosses and opportunity costs are viewed as foregone gains, the former will bemore heavily weighted: Furthermore, a certain degree of inertia is introducedinto the consumer choice process since goods that are included in theindividual's endowment will be more highly valued than those not held inthe endowment, ceteris paribus. This follows because removing a good fromthe endowment creates a loss while adding the same good (to an endowmentwithout it) generates a gain. Henceforth, I will refer to the underweighting ofopportunity costs as the endowment effect.Clearly the endowment effect can explain the behavior in Examples 1-3. InExample 1 it works in two ways. First, as just mentioned, giving up the winewill induce a loss while purchasing the same bottle would create a (lesshighly weighted) gain. Second, the money paid for a bottle purchased mightbe viewed as a loss 4 while the money received for the sale would be viewedas a gain.4More about the psychology of spending appears in section 4.

R. Thaler, Toward a positive theory of consumer choice45The endowment effect is a hypothesis about behavior. What evidenceexists (aside from Kahneman and Tversky's survey data) to support thishypothesis? Unfortunately, there is little in the way of formal tests. Onerecent study by SRI International does provide some supporting evidence.Weiss, Hall and Dong (1978) studied the schooling decision of participants inthe Seattle-Denver Income Maintenance Experiment. They found thatvariation in the out-of-pocket costs of education had effects which were'stronger and more systematic than that of a controlled change inopportunity costs'. 5An experimental test was conducted by Becker, Ronen and Sorter (1974).They asked MBA students to choose between two projects that differed onlyin that one had an opportunity cost component while the other had onlyout-of-pocket costs. The students systematically preferred the projects withthe opportunity costs. However, some problems with their experimentaldesign make this evidence inconclusive. [See Neumann and Friedman(1978).]Other kinds of evidence in support of the endowment effect hypothesis areless direct but perhaps more convincing. I refer to instances in whichbusinesses have used the endowment effect to further their interests.Credit cards provide a particularly clear example. Until recently, creditcard companies banned their affiliated stores from charging higher prices tocredit card users. A bill to outlaw such agreements was presented toCongress. When it appeared likely that some kind of bill would pass, thecredit card lobby turned its attention to form rather than substance.Specifically, it preferred that any difference between cash and credit cardcustomers take the form of a cash discount rather than a credit cardsurcharge. This preference makes sense if consumers would view the cashdiscount as an opportunity cost of using the credit card but the surcharge asan out-of-pocket cost. 6The film processing industry seems also to have understood theendowment effect. Some processing companies (notably Fotomat) have apolicy whereby they process and print any photographs no matter how badlyexposed they are. Customers can ask for refunds (on their next trip if theywish) for any pictures they don't want. The endowment effect helps explainwhy they are not beseiged by refund requests.5Weiss, Hall and Dong (1978).6In his testimony before the Senate Committee on Banking, Housing and Urban Affairs,Jeffrey Bucher of the Federal Reserve Board argued that surcharges and discounts should betreated the same way. However he reported that 'critics argued that a surcharge carries theconnotation of a penalty on credit card users while a discount is viewed as a bonus to cashcustomers. They contended that this difference in psychological impact makes it more likely thatsurcharge systems will discourage customers from using credit cards.,'. This passage and otherdetails are in United States Senate (1975).

46R. Thaler, Toward a positive theory of consumer choiceOther marketing strategies can be u n d e r s t o o d with the use of thee n d o w m e n t effect. Consider the case of a t w o w e e k trial period with a m o n e yback guarantee. At the first decision point the consumer thinks he can loseat most the transactions costs of taking the good home and back. If thetransactions costs are less than the value of the utilization of the good fortwo weeks, then the maximizing consumer pays for the good and takes ithome. The second decision point comes two weeks later. If the consumer hasfully adapted to the purchase, he views the cost of keeping the good as anopportunity cost. Once this happens the sale is more likely. O f course, it isentirely possible that were the good to be stolen and the price of the goodrefunded by his insurance c o m p a n y he would fail to repurchase the good. 7A final application of the e n d o w m e n t effect comes from the field of sportseconomics. Harold Demsetz (1972) argues that the reserve clause (which tiesa player to a team for life) does not affect the distribution of players amongteams. His argument is as follows. Resources go to their highest valued use.Teams are free to sell or trade players to other teams. Thus if a player iso w n e d by one team b u t valued more highly by another, a transaction willtake place. Since the transaction costs appear to be low, the argument seemscorrect, but the facts clearly contradict the conclusion!Consider first the free agent draft in football. Teams take turns selectingplayers who have finished their collegiate eligibility. The teams pick in aspecified order. Demsetz (and economic theory) would suggest that teamsshould draft at their turn the player with the highest market value and thentrade or sell him to the team that values him most. Thus we should expect tosee a flurry of trades right after the draft. Instead, while drafting rights (i.e.,turns to pick) are frequently traded, players drafted are virtually never tradedduring the period between the draft and the start of the season. W h y ? Beforeoffering an answer, consider another empirical observation. In baseball overthe last few years the reserve clause has been weakened and many players(starting with 'Catfish' Hunter) have become free agents, able to sign withany team. If players are already on the teams where their value is highestthese free agents should all re-sign with their former teams (at new highersalaries that give the rents to the player rather than the owner). Yet this hasnot happened. Instead, virtually all of the players who have become freeagents have signed with new teams.7Suppose your neighbors are going to have a garage sale. They offer to sell any of yourhousehold goods for you at one half of the original purchase price. You must only tell themwhich goods to sell and they will take care of everything else, including returning any unsolditems. Try to imagine which goods you would decide to sell and which goods you would decideto keep. Now imagine that some of the goods you decided to keep are stolen, and that yourinsurance will pay you half the or

models of behavior and actual behavior occur because of what Herbert Simson (1957, p. 198) called 'bounded rationality': 'The capacity of the human mind for formulating and solving complex problems is very small compared with the size of the problems whose

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