Implications of Prospect Theory on Road Pricing

ETHOS Issue 02, Apr 2007

PROSPECT THEORY AND BEHAVIOUR

Prospect Theory¹ observes that individuals tend to be "loss averse": in other words, they are more sensitive to losses than to gains. Indeed, empirical studies suggest that losses are valued at twice that of gains. Furthermore, Prospect Theory demonstrates a Certainty Effect: gains and losses are accorded more psychological value when they are certain than when they are less probable. Certainty increases the pain of losses while increasing the appeal of gains. In the event of loss, this Certainty Effect can lead to more risk-taking behaviour, rather than the risk-averse behaviour predicted by standard economic theory under the same circumstances.

Road Pricing Then and Now

As of 2005, Singapore has 3,234 kilometres of road and 754,992 motor vehicles, of which automobiles make up about 50%. Road pricing, first introduced with the Area Licensing Scheme in June 1975, has since been extended to major expressways with the Road Pricing Scheme. In 1998, Electronic Road Pricing (ERP) came into effect, with 48 gantries in operation as of 2005. ERP rates are revised every three months to ensure traffic speeds remain within the desired speed limits of 45 to 65 kilometres per hour (kph) for expressways and 20 to 30 kph for arterial roads.

Endowment Effect

One implication of Prospect Theory is that people often demand much more to give up an object compared to the amount they are willing to pay to acquire it — this is known as the endowment effect. The existence of this effect contradicts standard economic theory, which assumes that for a given good, the minimum price people are willing to accept is identical to the maximum price people are willing to pay.

This phenomenon (also known as status quo bias) is one reason for the inelastic response of drivers to road pricing. Drivers are willing to pay much more in order to maintain their preferred arrival times (PAT) when travelling, than to adjust their schedule [for instance, to reschedule trip departure times in order to incur lower Electronic Road Pricing (ERP) charges]. This is further supported by Dube, ² whose findings show that people are averse to the risk of losing time.

This suggests that in order for road pricing to be effective, travel times relative to road pricing need to be consistent and stable, in order to minimise uncertainty —this is more likely to alter driver behaviour.

Mental Accounting

Drivers may also simply treat road pricing costs differently when evaluating their overall financial activities. Individuals tend to assign their expenditures into different "brackets" or categories (e.g., travel, food or entertainment) for evaluation on a regular basis, be it daily, weekly or monthly. Evaluations made frequently have implications on perceived consumption. Thaler ³ suggests that individuals frame their decisions in three different ways, known as "accounts": a minimal account, a topical account and a comprehensive account. In the minimal account, only the differences between two possible options are examined, disregarding all other common features. In a topical account, possible options are evaluated using a reference point that is determined by the context of the situation. Only in the comprehensive account are options evaluated by incorporating all other factors such as wealth, possible states and externalities. The outcome of this "mental accounting effect" is that the value of money is context-dependent. In terms of the driver's mental accounting, a dollar saved by avoiding priced road use does not have the same utility as a dollar saved in another category of spending.

In other words, drivers may not evaluate the increase in their travel costs relative to their total wealth or alternative financial activities; instead, they may value the additional cost of road pricing less than the potential loss of travel time in avoiding peak hour road use.

Sunk Cost

Finally, even if driving were no longer economically optimal, sunk costs may deter the driver from switching away from private transport. Thus, the driver will continue to drive, resulting in an inelastic demand when faced with road pricing.

Drivers may value the additional cost of road pricing less than the potential loss of travel time in avoiding peak hour road use.

This sunk cost effect is manifested in a greater tendency to continue an endeavour once an investment in money, effort or time has been made. ⁴ Economic theory postulates that sunk costs ought to be irrelevant in the calculation of utility, since the costs cannot be recovered. Instead, only incremental costs ought to be included. Empirical evidence demonstrates, however, that people do base their decisions on sunk costs. The reluctance of drivers to switch from driving to alternative modes of transport is made worse by the sunk cost effect of "lost" investment in the automobile.

This situation can also be explained in terms of Prospect Theory. Having already made a once-off investment during the purchase of the vehicle, Arkes⁵ suggests that additional losses owing to investment will do little to depress the driver's utility, while any potential gain will improve the driver's utility considerably. Furthermore, endowment effects mean that although investments in automobiles may have depreciated on paper, people are unwilling to translate paper losses into real losses. While a consumer would be better off selling his automobile, the effect dictates that the price at which he would be willing to sell his car will be far higher than any buyer's valuation and willingness to pay. In such a context, drivers have an incentive to continue driving despite the negative economic utility, instead of selling their vehicles. This situation may be compounded by a series of rebates on the cost of automobile ownership in response to the government's focus on regulating road usage. While the reduction in taxes and costs were aimed at offsetting the automobile owner's perception of losses with the imposition of road pricing, it inadvertently led to an increase in the demand for automobiles. Prospect Theory would suggest that purchase decisions for automobiles are based on upfront costs while tending to ignore the running costs, since upfront costs are considered as being more salient at the time of automobile purchase while daily usage costs are discounted. The daily costs of road pricing, which tend to be narrowly "bracketed" in daily accounting, seem small in comparison with the huge cost of purchasing the vehicle; this difference discourages drivers from giving up their cars. Drivers are thus more likely to continue driving

Prospect Theory would suggest that purchase decisions for automobiles are based on upfront costs while ignoring the running costs, since upfront costs are considered as being more salient at the time of automobile purchse while daily usage costs are discounted.

CONCLUSION

In response to road pricing, drivers have been shown to be unwilling to switch from their status quo, whether it be a change in departure times or a change in mode of transport. They are also averse to risking a loss of time, given the uncertainty of alternative schedules, other modes of transport, or traffic congestion conditions. They are thus more likely to continue driving at peak hours on the same roads. Sunk cost and mental accounting effects also skew drivers' evaluation of the true costs of car ownership, resulting in the tendency for car owners to continue driving. All of these behaviours have an impact on the effectiveness of road pricing.

Prospect Theory suggests that for road pricing to be more effective, charges will have to be set according not only to inelastic demand but to the high value drivers place on the loss of travel time. It must be noted, however, that such an effort must be accompanied by a holistic approach that promotes a comprehensive public transport network, high parking charges within the Central Business District, and an increasing awareness on the social costs of traffic congestion on the environment.

ABOUT THE AUTHOR

Anthony T. H. Chin is Deputy Head and Associate Professor in the Department of Economics at the National University of Singapore, where he teaches urban economics, transport economics and microeconomics. Within the University, A/Prof Chin is Director of the Economics Executive Programme and Principal Researcher in the Centre for Transportation Research. He also serves on the Singapore Public Transport Council, Government Parliamentary Committee on Transport and is Chief Editor of the European Journal of Logistics and Sustainable Transport.

This article was adapted from a longer study based on a series of experiments replicating various conditions under road pricing. The three experiments tested for the effects of sunk cost, Prospect Theory, and the endowment effect on drivers.

NOTES

Kahneman, D. and A. Tversky, "Prospect Theory: An Analysis of Decision under Risk," Econometrica 47 (1979): 263-92.
Dube, L., LeClerc, F., and B. Schmitt, "Waiting Time and Decision Making: Is Time like Money?," Journal of Consumer Research 22 (1995): 110-19.
Thaler, R. H, "Mental Accounting Matters," Journal of Behavioral Decision Making, 12 (1999): 183-206.
H. and C. Blumer, "The Psychology of Sunk Costs," Organizational Behaviour and Human Decision Processes 35 (1985): 124-40.
H. and C. Blumer, "The Psychology of Sunk Costs," Organizational Behaviour and Human Decision Processes 35 (1985): 124-40.