Endowment Effect

endowment effect by margaret hagan

In behavioral economics, the endowment effect (also known as divestiture aversion) is the hypothesis that a person’s willingness to accept (WTA) compensation for a good is greater than their willingness to pay (WTP) for it once their property right to it has been established. People will pay more to retain something they own than to obtain something owned by someone else—even when there is no cause for attachment, or even if the item was only obtained minutes ago. This is due to the fact that once you own the item, foregoing it feels like a loss, and humans are loss-averse.

The endowment effect contradicts the Coase theorem (a theory of economic efficiency), 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.

One of the most famous examples of the endowment effect in the literature is from a study by Kahneman, Knetsch & Thaler (1990) where human participants were given a mug and then offered the chance to sell it or trade it for an equally priced alternative good (pens). Kahneman et al. (1990) found that participants WTA compensation for the mug (once their ownership of the mug had been established) was approximately twice as high as their WTP for it.

Other examples of the endowment effect include work by Carmon and Ariely (2000) who found that participants’ hypothetical selling price (WTA) for NCAA final four tournament tickets were 14 times higher than their hypothetical buying price (WTP). Alsom 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 in a wide range of different populations using different goods including children and apes.

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 (1980) in reference to the underweighting 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.

Connection-based theories propose that subjective feelings are responsible for an individual’s reluctance to trade (i.e. the endowment effect). For example, receiving a mug may induce a minimal attachment to that item which an individual may be averse to breaking, resulting in an increase in the perceived value of that object. A real world example of this would be an individual refusing to part with an old painting for any price due to it having ‘sentimental value.’

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.

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. Others have argued that the use of hypothetical questions and experiments involving small amounts of money tells us little about actual behavior.

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 rendering the neoclassical tools of welfare analysis useless, concluding that courts should instead use WTA as a measure of value. Fischler (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 his property to the bank in exchange for an annuity).

See also

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