Endowment effect

In psychology and behavioral economics, the endowment effect (also known as divestiture aversion and related to the mere ownership effect in social psychology) is the hypothesis that people ascribe more value to things merely because they own them. This is typically illustrated in two ways. In a valuation paradigm, people will tend to pay more to retain something they own than to obtain something they do not own—even when there is no cause for attachment, or even if the item was only obtained minutes ago. In an exchange paradigm, people given a good are reluctant to trade it for another good of similar value. For example, participants first given a Swiss chocolate bar were generally unwilling to trade it for a coffee mug, whereas participants first given the coffee mug were generally unwilling to trade it for the chocolate bar.

The endowment effect can be equated to the behavioural model Willingness to Accept or Pay (WTAP), a formula sometimes used to find out how much a consumer or person is willing to put up with or lose for different outcomes.

Examples

One of the most famous examples of the endowment effect in the literature is from a study by Daniel Kahneman, Jack Knetsch & Richard Thaler, in which participants were given a mug and then offered the chance to sell it or trade it for an equally valued alternative (pens). They found that the amount participants required as compensation for the mug once their ownership of the mug had been established ("willingness to accept") was approximately twice as high as the amount they were willing to pay to acquire the mug ("willingness to pay").

Other examples of the endowment effect include work by Ziv Carmon and Dan Ariely, who found that participants' hypothetical selling price (willingness to accept or WTA) for NCAA final four tournament tickets were 14 times higher than their hypothetical buying price (willingness to pay or WTP). Also, work by Hossain and List (Working Paper) discussed in the Economist in 2010, showed that workers worked harder to maintain ownership of a provisional awarded bonus than they did for a bonus framed as a potential yet-to-be-awarded gain. In addition to these examples, the endowment effect has been observed using different goods in a wide range of different populations, including children, great apes, and new world monkeys.

Background

Psychologists first noted the difference between consumers' WTP and WTA as early as the 1960s. The term endowment effect however was first explicitly coined by the economist Richard Thaler in reference to the under-weighting of opportunity costs as well as the inertia introduced into a consumer's choice processes when goods included in their endowment become more highly valued than goods that are not. In the years that followed, extensive investigations into the endowment effect have been conducted producing a wealth of interesting empirical and theoretical findings.

Theoretical explanations

Loss aversion

It was proposed by Kahneman and his colleagues that the endowment effect is, in part, due to the fact that once a person owns an item, forgoing it feels like a loss, and humans are loss-averse. They go on to suggest that the endowment effect, when considered as a facet of loss-aversion, would thus violate the Coase theorem, and was described as inconsistent with standard economic theory which asserts that a person's willingness to pay (WTP) for a good should be equal to their willingness to accept (WTA) compensation to be deprived of the good, a hypothesis which underlies consumer theory and indifference curves. However, these claims have been disputed and other researchers claim that ownership (attribution of the item to self) and not loss aversion is the key to this phenomenon.

Reference-dependent accounts

According to reference-dependent theories, consumers first evaluate the potential change in question as either being a gain or a loss. In line with prospect theory (Tversky and Kahneman, 1979), changes that are framed as losses are weighed more heavily than are the changes framed as gains. Thus an individual owning "A" amount of a good, asked how much he/she would be willing to pay to acquire "B', would be willing to pay a value (B-A) that is lower than the value that he/she would be willing to accept to sell (C-A) units; the value function for perceived gains is not as steep as the value function for perceived losses.

Figure 1 presents this explanation in graphical form. An individual at point A, asked how much he/she would be willing to accept (WTA) as compensation to sell X units and move to point C, would demand greater compensation for that loss than he/she would be willing to pay for an equivalent gain of X units to move him/her to point B. Thus the difference between (B-A) and (C-A) would account for the endowment effect. In other words, he/she expects more money while selling; but wants to pay less while buying the same amount of goods.

File:ValunFunProspectTheory2.png

Figure 1 : Prospect Theory and the Endowment Effect

Neoclassical explanations

Hanemann (1991), develops a neoclassical explanation for the endowment effect, accounting for the effect without invoking prospect theory.

Figure 2 presents this explanation in graphical form. In the figure, two indifference curves for a particular good X and wealth are given. An individual asked how much he/she would be willing to pay to move from A where he/she has X₀ of good X to point B, where he/she has the same wealth and X₁ of good X, has his/her WTP represented by the vertical distance between C and B since the individual is indifferent about being at A or C. On the other hand, an individual asked to indicate how much he/she would be willing to accept to move from B to A has his/her WTA represented by the vertical distance between A and D as he/she is indifferent about either being at point B or D. Shogren et al. (1994) has reported findings that lend support to Hanemann's hypothesis.

File:Simple-indifference-curves-2.png

Figure 2 : Hanemann's Endowment Effect Explanation

Connection-based, or "psychological ownership" theories

Connection-based theories propose that the attachment or association with the self-induced by owning a good is responsible for an individual's reluctance to trade (i.e. the endowment effect). Work by Morewedge, Shu, Gilbert and Wilson (2009) provides support for these theories, as does work by Maddux et al. (2010). For example, research participants who were given one mug and asked how much they would pay for a second mug ("owner-buyers") were WTP as much as "owners-sellers," another group of participants who were given a mug and asked how much they were WTA to sell it (both groups valued the mug in question more than buyers who were not given a mug). Others have argued that the short duration of ownership or highly prosaic items typically used in endowment effect type studies is not sufficient to produce such a connection, conducting research demonstrating support for those points (e.g. Liersch & Rottenstreich, Working Paper).

Two paths by which attachment or self-associations increase the value of a good have been proposed (Morewedge & Giblin, 2015). An attachment theory suggests that ownership creates a non-transferrable valenced association between the self and the good. The good is incorporated into the self-concept of the owner, becoming part of her identity and imbuing it with attributes related to her self-concept. Self-associations may take the form of an emotional attachment to the good. Once an attachment has formed, the potential loss of the good is perceived as a threat to the self. A real world example of this would be an individual refusing to part with a college T-shirt because it supports one's identity as an alumnus of that university. A second route by which ownership may increase value is through a self-referential memory effect (SRE) – the better encoding and recollection of stimuli associated with the self-concept. People have a better memory for goods they own than goods they do not own. The self-referential memory effect for owned goods may act thus as an endogenous framing effect. During a transaction, attributes of a good may be more accessible to its owners than are other attributes of the transaction. Because most goods have more positive than negative features, this accessibility bias should result in owners more positively evaluating their goods than do non-owners.

Biased information processing theories

Several cognitive accounts of the endowment effect suggest that it is induced by the way endowment status changes the search for, attention to, recollection of, and weighting of information regarding the transaction. Frames evoked by acquisition of a good (e.g., buying, choosing it rather than another good) may increase the cognitive accessibility of information favoring the decision to keep one's money and not acquire the good. By contrast, frames evoked by disposition of the good (e.g., selling) may increase the cognitive accessibility of information favoring the decision to keep the good rather than trade or dispose of it for money (for a review, see Morewedge & Giblin, 2015). For example, Johnson and colleagues (2007) found that prospective mug buyers tended to recall reasons to keep their money before recalling reasons to buy the mug, whereas sellers tended to recall reasons to keep their mug before reasons to sell it for money.

Evolutionary arguments

Huck, Kirchsteiger & Oechssler (2005) have raised the hypothesis that natural selection may favor individuals whose preferences embody an endowment effect given that it may improve one's bargaining position in bilateral trades. Thus in a small tribal society with a few alternative sellers (i.e. where the buyer may not have the option of moving to an alternative seller), having a predisposition towards embodying the endowment effect may be evolutionarily beneficial. This may be linked with findings (Shogren, et al., 1994) that suggest the endowment effect is less strong when the relatively artificial sense of scarcity induced in experimental settings is lessened. Countervailing evidence for an evolutionary account is provided by studies showing that the endowment effect is moderated by exposure to modern exchange markets (e.g., hunter gatherer tribes with market exposure are more likely to exhibit the endowment effect than tribes that do not), and that the endowment effect is moderated by culture (Maddux et al., 2010).

Criticisms

Some economists have questioned the effect's existence. Hanemann (1991) noted that economic theory only suggests that WTP and WTA should be equal for goods which are close substitutes, so observed differences in these measures for goods such as environmental resources and personal health can be explained without reference to an endowment effect. Shogren, et al. (1994) noted that the experimental technique used by Kahneman, Knetsch and Thaler (1990) to demonstrate the endowment effect created a situation of artificial scarcity. They performed a more robust experiment with the same goods used by Kahneman, Knetsch and Thaler (chocolate bars and mugs) and found little evidence of the endowment effect. Others have argued that the use of hypothetical questions and experiments involving small amounts of money tells us little about actual behavior (e.g. Hoffman and Spitzer, 1993, p. 69, n. 23 ) with some research supporting these points (e.g. Kahneman, Knetsch and Thaler, 1990, Harless, 1989) and others not (e.g. Knez, Smith and Williams, 1985)

Implications

Herbert Hovenkamp (1991) has argued that the presence of an endowment effect has significant implications for law and economics, particularly in regard to welfare economics. He argues that the presence of an endowment effect indicates that a person has no indifference curve (see however Hanemann, 1991) rendering the neoclassical tools of welfare analysis useless, concluding that courts should instead use WTA as a measure of value. Fischel (1995) however, raises the counterpoint that using WTA as a measure of value would deter the development of a nation's infrastructure and economic growth.

The endowment effect has also been raised as a possible explanation for the lack of demand for reverse mortgage opportunities in the United States (contracts in which a home owner sells back her/his property to the bank in exchange for an annuity) (Huck, Kirchsteiger & Oechssler, 2005).

See also

• Behavioral economics
• List of cognitive biases
• Sunk costs
• Transaction cost

External links

• Wright, Josh (2005). The Endowment Effect's Disappearing Act, and (2009) What's Wrong With the Endowment Effect?
• The "Mystery" of the Endowment Effect, Per Bylund, December 28, 2011