Bestiary of Behavioral Economics/Preference Reversal

Preference Reversal is the situation in which preferences for bundles are shifted after the options are juxtaposed. When bundles are valued separately the decision made on the bundle is different than when they are valued jointly. This is due to the relativity of choices. "Relativity is easy to understand, but there's one aspect of relativity that consistently trips us up. It's this: we not only tend to compare things with one another, but also tend to focus on comparing things that are easily comparable- and avoid comparing things that cannot be easily compared." This is the reason that people tend to change preferences when comparing things separately and jointly. Comparisons become easier once juxtaposed, and more important attributes can be easily compared. Preference Reversal is a theory opposite of the theory of riskless choice. Riskless choice is a theory created by Jeremy Bentham and James Mill that states that decision makers reach utility maximizing choices through consistent and stable choices. Preference Reversal theory however, states that optimal choices might not exist even with the most simple of choices when preferences are contingent on circumstance and whims. When uncertainty is introduced into the decision making process, the theory of consistent and stable preferences is contradicted. Preference reversals have been noted in a number of settings, but have largely been ignored by economists as many believe that preference reversals are wiped out in marketplace settings. A study by John A. List has proven the opposite however, as he has taken to the marketplace to prove the existence of preference reversals. Preference Reversals violate the theory of the weak axiom of revealed preference. WARP states that if bundle A is strictly preferred to bundle B, and the two bundles are not the same, then it cannot be true that bundle B is directly revealed preferred to bundle A. When presented relative to other goods however, we can see a preference reversal due to relativity.

Marketplace Application

John List has conducted a study using the marketplace for sports trading cards to prove the existence of the “more is less” phenomenon, a name used to describe preference reversals. Professor List attended a trading card showcase to observe market behavior of experienced and non-experienced card enthusiasts. He offered four bundles of cards for sale. The first was ten excellent condition trading cards worth a total of $15, which he auctioned off. The second bundle was the exact same ten cards, plus three “poor” condition cards worth $18, which he auctioned off as well. In the third bundle, he auctioned off the exact same two sets of cards side by side. In the fourth bundle, he had customers pay him $5 to choose which set of cards they wanted. What List finds is that when bid on separately, consumers bid higher on the ten card bundle rather than the 13 card bundle, even though the 13 card bundle is worth $3 more than the ten card bundle. When the two bundles are juxtaposed, consumers bid higher on the 13 card bundle, showing a reversal of preference. This phenomenon can be see using non-dealers, who are in-experienced, and also holds true for the dealers, who are considered extremely experienced in this field. List goes on to conclude that when individuals bid on one item in isolation, easy to evaluate characteristics, not necessarily the most important ones are used to determine value. When bid on jointly in a juxtaposition, bundles are judged compared to the other bundle, and reference characteristics are better defined allowing consumers to make utility maximizing choices.

Joint vs. Separate Evaluation

There are two types of evaluations seen in the Preference Reversal theory. These evaluations are Joint Evaluation and Separate Evaluation, in which drastically different choices are made depending on the type of evaluation being done. Joint Evaluation is the situation in which multiple options are presented at the same time and the consumer can make decisions based upon comparison to the other options. This type of evaluation usually leads to better decisions and less consumer error. Separate Evaluation is the situation in which consumers are presented one option at a time and evaluated in isolation from other options. This type of evaluation draws on consumers references and is affected by uncertainty, leading to consumer error.

Evaluating Attributes

Some attributes, most notably measurable attributes such as GPA, IQ, or other scores, are easy to independently evaluate, and other attributes such as job experience or how many programs a candidate has written are more difficult to independently evaluate. In Separate Evaluation, the attributes that are difficult to evaluate have less impact on the overall choice or decision. In Separate Evaluation, easy to evaluate attributes hold more weight and are the primary determinants of the final decision. In Joint Evaluation however, options can be compared side by side and the difficult to evaluate attributes become easier to evaluate, exerting greater influence over the final decision. Easy to evaluate attributes do not play a large role in Joint Evaluation, as they can even be evaluated in the Separate Evaluation mode and are of no use when difficult to evaluate attributes can be used. This leads to preference reversal as the impact of the different attributes change when using Joint Evaluation as opposed to Separate Evaluation.