Loss aversion is a psychological and economic concept[1] which refers to how outcomes are interpreted as gains and losses where losses are subject to more sensitivity in people's responses compared to equivalent gains acquired.[2] Kahneman and Tversky (1992) have suggested that losses can be twice as powerful, psychologically, as gains.[3] When defined in terms of the utility function shape as in the Cumulative Prospect Theory (CPT), losses have a steeper utility than gains, thus being more "painful" than the satisfaction from a comparable gain [4] as shown in Figure 1. Loss aversion was first proposed by Amos Tversky and Daniel Kahneman[5] as an important framework for Prospect Theory - an analysis of decision under risk.
In 1979, Daniel Kahneman and his associate Amos Tversky originally coined the term loss aversion in their paper criticising the expected utility theory and proposing prospect theory as an alternative descriptive model of decision making under risk.[5] “The response to losses is stronger than the response to corresponding gains” is Kahneman’s definition of loss aversion. “Losses loom larger than gains” implies that people by nature are aversive to losses and tend to avoid them. For example, given a choice between Option A: 50% chance of winning 1,000 Israeli pounds and 50% chance of winning nothing and Option B: winning 450 Israeli pounds for sure, the studied respondents were more likely to choose option B despite the higher expected value of option A (500 pounds). Loss aversion gets stronger as the stakes of a gamble or choice grow larger. Prospect theory and utility theory follow to make the person regret and feel anticipated disappointment for that said gamble.[3]
After the first 1979 proposal in the prospect theory framework paper, Tversky and Kahneman also used loss aversion for a paper in 1991 about a consumer choice theory that incorporates reference dependence, loss aversion, and diminishing sensitivity.[7] Compared to the original paper above that discusses loss aversion in risky choices, Tversky and Kahneman (1991) discuss loss aversion in riskless choices, for instance, not willing to trade or even sell something that is already in our possession. Here, "losses loom larger than gains" correspondingly reflects how outcomes below the reference level (e.g., what we do not own) loom larger than those above the reference level (e.g., what we own), showing people's tendency to value losses more than gains relative to a reference point. Also, the paper supported loss aversion with the endowment effect theory and status quo bias theory.
Loss aversion was popular in explaining many phenomena in traditional choice theory. In 1980, loss aversion was used in Thaler (1980) regarding endowment effect.[8] Loss aversion was also used to support the status quo bias in 1988 [9] and the equity premium puzzle in 1995.[10] In the 2000s, behavioural finance was an area with frequent application of this theory.[11][12][13][14]
In marketing, the use of trial periods and rebates tries to take advantage of the buyer's tendency to value the good more after the buyer incorporates it in the status quo. In past behavioral economics studies, users participate up until the threat of loss equals any incurred gains. Recent methods established by Botond Kőszegi and Matthew Rabin[15] in experimental economics illustrates the role of expectation, wherein an individual's belief about an outcome can create an instance of loss aversion, whether or not a tangible change of state has occurred.