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Linda Caparyan, Dara Grabowska, & Ying Xiong February 7,
2003
Preference Reversals(Summary)
Citation:Tversky A. and R.H. Thaler (1990) Preference Reversals,
Journal of EconomicPerspectives, Vol. 4, No. 1, pp. 193-205.
Introduction:Much of what differentiates economics from the
other social sciences is the underlyingassumption of well-defined
and rational preferences. However, in several empiricalstudies,
results show agents making decisions that, on the surface, appear
to beirrational according to theoretical economic predictions.
Preference reversals are oneexample of such anomalies, as Tversky
and Thaler explain.
Preference Reversal (ex.):Consider the following case, as
outlined in this article: You are asked to pick betweentwo separate
gambles with practically, if not exactly, the same expected value.
Onelottery (A) has a high chance of winning a small prize (i.e.
9/10 chance to win $5.00, 1/10chance to win $0), whereas the other
gamble (B) has a lower chance of winning a largerprize (i.e. 1/10
chance to win $45, 9/10 chance to win $0). When asked to
choosebetween the two gambles, you select the A bet. However, when
asked to price each ofthe two lotteries (i.e. set the price at
which you would be willing tosell each game if youowned it), you
set a higher price for gamble B, indirectly revealing a preference
for Bover A. Clearly, there is a logical contradiction in
preference between the choosingscenario and the pricing scenario,
indicating the possibility of context-dependent, rather
than purely concrete preferences. The article discusses three
main explanations for theaforementioned anomaly, elaborating on the
likelihood of each based on experimentaldata.
Possible Explanations:The authors suggest that many have
explained preference reversals as the result of aviolation of one
of the following economic theories.
A) transitivity: This requires that the preference operator is
transitive in the sense that ifyou prefer to play gamble B over
receiving cash amount X, but prefer X to A, preferringA to B would
indicateintransitive preferences.
B) procedure invariance: This requirement, though often not
explicitly defined, assertsthat different measurements of
preferences should give rise to the same preferentialordering, such
that preferring A over B is equivalent to setting a higher
reservation pricefor A as opposed to B. In the case described
above, there could exist two separateviolations of procedure
invariance:
i) overpricing of B: when the subject prefers their reservation
price over the betitself when given the direct choice on a separate
occasion
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ii) underpricing of A: when the subject prefers the bet itself
over its price whengiven the direct choice on a separate
occasion
C) independence axiom of expected utility theory: This third
explanation deals withthe payoff scheme used to reveal cash
equivalence (minimum selling prices). A violation
of this axiom would lead to a participant stating a price that
does not, in reality,correspond to the cash equivalent of that
gamble.
Results:A series of separate, though related, studies were
carried through in an attempt to isolatethe effects of each of the
potential explanations above. Details of each study/process
havebeen left out for simplicity. Results indicate that
intransitivity accounts for a very smallportion of preference
reversal, as does a failure of the expected utility scheme
(i.e.specification of the payoff scheme). Therefore, the main cause
of preference reversal wasfound to be procedure invariance, in
particular, the overpricing of gambles with a lowprobability of
winning a large amount.
Conclusion:Findings suggest that the overpricing of a bet such
as B (i.e. low-probability, high payoff)is a result of the general
concept of stimulus-response compatibility. In other words,
sincethe cash equivalence (minimum selling price) as well as the
payoff of a bet are bothexpressed in dollars, payoffs will be
weighted more heavily in pricing bets than inchoosing between them,
leading to the overpricing of B. This theory is supported
byevidence showing that preference reversals are significantly
reduced when nonmonetaryoutcomes are used in assessing
preferences.
Furthermore, the compatibility hypothesis is not dependent on
risk and applies to casesoutside the betting arena, such as the
preferential ordering of short-term vs. long-termpayments, showing
the generality of preference reversal.
In conclusion, Tversky and Thaler assert that contrary to
classic economic theories ofchoice, preferential orderings can be
procedure dependent, and in particular, driven bythe compatibility
of scales/units embedded within the procedure. Moreover, the
authorsclaim that the principal of procedure invariance will hold
if people either havepreestablished preferences, or if they have
algorithms to aid judgment, independent ofcontext or procedure.
However, in the above example, as in the case of many
preferencereversal studies, subjects have neither preestablished
preferences for every possiblescenario, nor do they have a solid
algorithm with which to make objective choices. Theresult is often
the so-called anomaly of preference reversal, demonstrating the
context-dependency of preferences.
