Merit Pay - Loss Aversion and Merit Pay

Loss Aversion and Merit Pay

Loss aversion was first proposed by Daniel Kahneman and Amos Tversky in 1979 Econometrica They proposed the notion that individuals assign value to gains and losses rather than to final assets. In other words individuals have a tendency to prefer avoiding losses rather than accruing gains.

This notion of people hating to lose, more than they like gaining something, even if the potential amount that could be lost is the same as the amount to be gained, has been tested in many arenas.

An experiment conducted by Kahneman et al. 1990 Journal of Political Economy describes testing loss aversion through the concepts of the Endowment effect and the Coase Theorem The endowment effect reveals the notion that people place a higher value on objects they own relative to objects they do not. The Coase theorem focuses on transaction costs and the importance of who owns a particular commodity.

They found that randomly assigned owners of a mug required significantly more money to part with their possession (around $7) than randomly assigned buyers were willing to pay to acquire it (around $3). Kahneman attributed this result to loss aversion: owners' were effected more by the loss of the mug compared to the effect of a buyer purchasing the mug as a gain.

Another experiment conducted by Terrance Odean at Berkeley College examined the account of 10,000 investors at a large discount brokerage house. The tendency of investors revealed they held on to losing investments too long and sold winning investments too soon. Their behavior did not appear to be motivated by rational rebalancing of portfolios or to avoid higher trading costs. According to Odean, these investors held on to these losing stocks in order to prolong the feeling of loss from selling them, even though there was no evidence that by holding onto them, they would rise in value. "Winning investments that investors chose to sell continued in subsequent months to outperform the losing stocks investors kept"

Loss aversion experimentation has most recently been applied within an educational setting in an effort to improve achievement within the U.S. Recent results from Programme for International Student Assessment (PISA) 2009 ranked the US ranks # 31 in Math and #17 in Reading.

In this latest experiment, Fryer et al. posits framing merit pay in terms of a loss in order to be most effective. This study was performed in the city of Chicago Heights within nine K-8 urban schools, which included 3,200 students. 150 out of 160 eligible teachers participated and were assigned to one of four treatment groups or a control group. Teachers in the incentive groups received rewards based on their students' end of the year performance on the ThinkLink Predictive Assessment and K-2 students took the Iowa Test of Basic Skills (ITBS) in March). The control group followed the traditional merit pay process of receiving "bonus pay" at the end of the year based on student performance on standardized exams. However, the experimental groups received a lump sum given at beginning of the year, that wpuld have to be paid back. The bonus was equivalent to approximately 8% of the average teacher salary in Chicago Heights, approximately $8,000.

Methodology - Gain" and "Loss" teachers received identical net payments for a given level of performance. The only difference is the timing and framing of the rewards. An advance on the payment and the reframing of the incentive as avoidance of a loss, the researchers observed treatment effects in excess of 0.20 and some as high as 0.398 Standard Deviations. According to the authors, 'this suggests that there may be significant potential for exploiting loss aversion in the pursuit of both optimal public policy and the pursuit of profits'.

Utilizing loss aversion, specifically within the realm of education has gotten much notoriety in blogs and mainstream media:

The Washington Post discussed merit pay in a recent article and specifically the study conducted by Fryer et al. The article discusses the positive results of the experiment and estimates the testing gains of those of the "loss" group are associated with an increase in lifetime earnings of between $37,180 and $77,740. They also comment on the fact that it didn't matter much whether the pay was tied to the performance of a given teacher or to the team to which that teacher was assigned. They state that "a merit pay regime need not pit teachers in a given school against each other to get results." “Washington Post”

Science Daily specifically covers the Fryer study stating that the study showed that "students gained as much as a 10 percentile increase in their scores compared to students with similar backgrounds -- if their teacher received a bonus at the beginning of the year, with conditions attached." It also explains how there was no gain for students when teachers were offered the bonus at the end of the school year. Thomas Amadio, superintendent of Chicago Heights Elementary School District 170, where the experiment was conducted, is quoted in this article stating "the study shows the value of merit pay as an encouragement for better teacher performance." “Science Daily”

Education weekly also weighs in and discusses utilizing loss aversion within education, specifically merit pay. The article states there are "few noteworthy limitations to the study, particularly relative to scope and sample size; further, the outcome measure was a "low-stakes" diagnostic assessment, not the state test—it's unclear if findings would look the same if the test was used for accountability purposes. Still Fryer et al. have added an interesting tumbling element to the merit-pay routine."“Education weekly”

The Sun Times interviewed John List, Chairman of the University of Chicago's department of economics. He stated 'It's a deeply ingrained behavioral trait. .. that all human beings have — this underlying phenomenon that 'I really, really dislike losses, and I will do all I can to avoid losing something'. The article also speaks to only one other study to enhance performance in a work environment. The only prior field study of a "loss aversion" payment plan, they said, "occurred in Nanjing, China, where it improved productivity among factory workers who made and inspected DVD players and other consumer electronics." The article also covers reaction by Barnett Berry, president of the Center for Teaching Quality, who stated "the study seems to suggest that districts pay "teachers working with children and adolescents in the same way "Chinese factory workers" were paid for "producing widgets. "I think this suggests a dire lack of understanding of the complexities of teaching.“Suntimes”

There has also been other criticism of the notion of loss aversion as an explanation of greater effects.

Larry Ferlazzo in his blog questioned what kind of positive classroom culture a "loss aversion" strategy would create with students, and what kind of affect a similar plan with teachers would have on school culture. He states that 'the usual kind of teacher merit pay is bad enough, but a threatened "take-away" strategy might even be more offensive'.

Researchers Nathan Novemsky and Daniel Kahneman also state there are limits to loss aversion. Their article focuses on individual intentions and how such intentions can produce or inhibit loss aversion. They further state that 'the coding of outcomes as gains and losses depends on the agent's intentions and not only on the objective state of affairs at the moment of decision'. They provide an example of two individuals with different intentions performing a transaction. One, a consumer who has a pair of shoes and would consider giving them up a loss, because their intention would be to keep them. The other individual however, if he were a shoe salesman with different intentions, would not be effected by loss aversion, if he were to give up the shoes from his store.

Bill Ferriter also posted an article in the Teacher's Leaders Network exclaiming that no matter when external incentives are awarded, they are not effective in education because teachers are already working as hard as they can.