Bestiary of Behavioral Economics/Endowment Effect

Definition

The endowment effect occurs when a good increases in value based on ownership of that good . The endowment effect is important in economics because it causes actual behavior to conflict with microeconomic theory, which says that an object’s value should be independent of ownership.

General Explanation of the Endowment Effect

Endowment of a good generally changes an individual’s economic behavior toward that good. Kahneman gives this general example for how endowment affects preference:

• A person may prefer Good 1 over Good 2 when they start out with ownership of Good 1. Otherwise, that person would prefer Good 2 over Good 1.

Ariely generalizes the idea for a non-economic audience by describing an exchange situation where the owner thinks his possession is of higher value than what the buyer is willing to pay. He uses the quote, “One man’s ceiling is another man’s floor” to describe the endowment effect. When you own an object you are at the ceiling and want to sell at a higher price than the desired price of the buyer, who is at the floor. The endowment effect, as Ariely puts it, is just a change of perspective. The endowment effect is easily understood in the long-term, where emotional attachment is likely to occur. But, the effect of ownership can be instant as well. Kahneman showed through several experimental tests that the value given to an object instantly increases when ownership of that object is gained, even if that object is as trivial as a pen . The endowment effect greatly affects economic theory. Instead of thinking that ownership and preferences are unrelated, experiments show that preferences are formed in reference to what a person owns. Thus, preferences are directly related to endowment effects.

Setting for the Endowment Effect

The endowment effect is a factor in the exchange of goods and it mostly affects the seller. But, not all sellers feel this effect. For example, there is no endowment effect when a good is being held only for the purpose of being a money token. On the other hand, if an item is purchased for use, the owner is very likely to be influenced by an endowment effect, especially if the item is rare or hard to replace. Endowment effects occur not only for individuals, but for organizations such as businesses, firms, and corporations as well .

Consequences of the Endowment Effect

The endowment effect causes indifference curves to have a kink at the initial endowment because this is the reference point for a person’s preferences. Also, trade will not be as profitable because sellers may be reluctant to trade and ask for increased prices (compared to a trade where there is no endowment effect).

Examples and Experiments

Many experiments have been conducted showing that the endowment effect has a large affect on economic decision making.

• Dan Ariely conducted an experiment with college students at Duke University. Basketball is a beloved sport at Duke and because the small arena is not even close to large enough to hold the entire student population, basketball tickets are in high demand amongst college students. So, a very intense process has been developed where only the most dedicated student fans will gain admittance. In the experiment, after the tickets had been distributed, those without tickets were willing to pay around $170 for a ticket. On the other hand, those who earned tickets were willing to sell for around $2,400 a ticket.
• Purohit performed an experiment involving used cars. At trade-in, the owner was shown to prefer a higher payment for the used car over a lower price for the new car, even if the overall price was the same in both cases.
• In an experiment by Franciosi (and others) where some people traded mugs from a university bookstore, endowment cause significant undertrading as opposed to when there was no initial endowment. There were many variations on the experiment in order to show how slight alterations in the exchange setting can change the impact of the endowment effect.
• A similar experiment by Kahneman used the trade of mugs and pens to observe the endowment effect. There were successive experiments so trades could be observed where trading experience was gained. Also, trials were run with and without trading rules, and with and without money incentives. Also, in order to create a realistic environment, buyers were not given money and had to supply money out of their own pocket in order to make exchanges. In this experiment, average selling prices were more than double the buying prices.