The Endowment Effect

The Endowment Effect

by Roman on June 26, 2008

According to the dominant economic theory all decisions made by humans are rational. Humans are looked as beings who make rational decisions in order to maximize their wealth. Scientists even have a name for it – Homo economicus.

The problem with Homo economicus is that it is the cornerstone in almost all modern theories that try to explain how markets and economies work. At the same time it is more and more evident that contrary to popular scientific belief humans are not always trying to maximize their wealth and can therefore make decisions that are money wise irrational.

The Endowment Effect

The Endowment Effect says that once someone owns something, he places a higher value on it than he did before acquiring it.

This seems like common sense for an ordinary person but this revelation has made quite a storm in the scientific world because this means that there are situations when the Homo economicus theory is wrong.

According to the endowment effect if you were to buy a bike for 100 dollars you would be unwilling to sell it immediately afterwards for the same $100. After feeling a sense of ownership the bike is not just an ordinary bike it used to be but YOUR BIKE. In a way it feels that your new bike is special just because it belongs to you.

The theory of rational markets says just the opposite – the value someone gives something does not depend on whether he actually owns it. According to the modern economic theory a bike that is worth  100 dollars is always worth a 100 dollars – no matter who owns it!

It seems that the dominant economic theories and the way people actually behave can be totally different.

Examples of The Endowment Effect

One of the fist experiments that showed the endowment effect in action found that students were surprisingly reluctant to trade a coffee mug they had been given for a bar of chocolate, even though they did not prefer coffee mugs to chocolate when given a choice between the two.

Since then, there have been hundreds of experiments and observations made in real life about the endowment effect

Investors

According to professor Pete Lunn working in the Economic and Social Research Institute in Dublin, professional investors are sometimes reluctant to sell investments they already hold even when they could trade these investments for something they would buy if starting from scratch.

I have also felt the same effect in my personal investment portfolio but never knew what it was before hearing of the endowment effect.

Monkeys

Keith Chen from Yale University showed in 2006 that capuchin monkeys could learn to trade and in doing so also developed the endowment effect. This suggests that the nature of this effect could be hidden in our evolution. Some scientists believe that in the past it was too risky to give up anything that you already owned and that is why we give a higher value to the things we own versus the things we don’t.  Giving up something you owned could mean certain death.

In the study done by Keith Chen the monkeys were given the option to choose between peanut butter and frozen juice bars. 60% of monkeys chose peanut butter and 40% juice bars.

However when a monkey was given peanut butter without being able to choose anything else in the beginning and afterwards presented with an option to trade it for a juice bar, 80% of monkeys decided to keep the peanut butter. Since actually only 60% of monkeys preferred peanut butter when presented with a choice, it seemed that the peanut butter had somehow gotten more valuable to them after owning it. This experiment proved that the endowment effect is also present with other primates not only humans.

Explanation of the Endowment Effect

As of now there are two competing explanations to the endowment effec.

  1. In modern societies with multiple markets a customers can go elsewhere when he doesn’t like the price of what he is buying but in small ancient communities there were no alternative sellers. In that case, those who were reluctant to sell might have gotten better prices because the buyers knew that if they truly wanted to buy something they had to pay the price they were asked to. The sellers had a lot of negotiating power while the buyer had almost none. We could simply value our things pricier than those not belonging to us because deep down our brains still think that we are the only people in possession of what we have and therefore the buyer will have to pay the price we are asking.
  2. As already mentioned in this post – In the past it could have been too risky to give up anything that you already owned. For example giving up food could have meant death even if you traded it for a lot of gold.

Conclusion

Whatever the real reasons behind the endowment effect there is one thing for sure – human beings are way more complex than economic theories assume. It should be possible to take into account the psychological aspects we know about humans and use them to make a small fortune.

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{ 1 comment }

Nick June 26, 2008 at 12:39 pm

Very interesting. I have never really thought of it before, but I do see that even in my own life and with many of my possessions. I have always just considered it sentimental value or emotional attachment or something along those lines.

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