Endowment effect

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The endowment effect (also known as divestiture aversion) is a hypothesis that people value a good or service more once their property right to it has been established. In other words, people place a higher value on objects they own than objects that they do not. In one experiment, people demanded a higher price for a coffee mug that had been given to them but put a lower price on one they did not yet own. The endowment effect 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. This hypothesis underlies consumer theory and indifference curves.

The effect was first theorized by Richard Thaler. It is a specific form, linked to ownership, of status quo bias. Although it differs from loss aversion, a prospect theory concept, those two biases reinforce each other in cases when the asset price has fallen compared to the owner's buying price. This bias has also a few similarities with commitment and attachment.

The existence of the effect has been questioned by some economists. 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 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 and Thaler (chocolate bars and mugs) and found no evidence of the endowment effect.

Whether or not the endowment effect is a relevant economic phenomenon is somewhat uncertain; it is possibly a reflection of conventional substitution effects.

In 1994, Dan Ariely and Ziv Carmon performed an experiment at Duke University which showed the endowment effect using a singular product, for which conventional substitution effects are not applicable. Duke University has a very small basketball stadium and the number of available tickets is much smaller than the number of people who want them, so the university has developed a complicated selection process for these tickets that is now a tradition. Roughly one week before a game, fans begin pitching tents in the grass in front of the stadium. At random intervals a university official sounds an air-horn which requires that the fans check in with the basketball authority. Anyone who doesn't check in within five minutes is cut from the waiting list. At certain more important games, even those who remain on the list until the bitter end aren't guaranteed a ticket, only an entry in a raffle in which they may or may not receive a ticket. After a final four game, Carmon and Ariely called all the students on the list who had been in the raffle. Posing as ticket scalpers, they probed those who had not won a ticket for the highest amount they would pay to buy one and received an average answer of $170. When they probed the students who had won a ticket for the lowest amount they would sell, they received an average of about $2,400. This showed that students who had won the tickets placed a value on the same tickets roughly fourteen times as high as those who had not won the tickets.

Also when asked about the reasons for their decisions they presented different justifications for the amount. Those in a position to purchase tickets for $170 cited various other purchases they could make such as beer, food, music and clothes. Those in a position to sell a ticket cited school pride and their expectations of memories they could pass on to their children and grandchildren. In a rational sense (and according to traditional economic theory), neither the time they spent camping out to receive the tickets nor the experience of the game itself are dependent upon the outcome of the raffle and therefore students should have viewed these tickets the same way. The endowment effect shown in this case may be an effect of cognitive dissonance. The time spent camping out, waiting for the chance to be in the raffle became worth about $24/day to the students who didn't win the raffle, but was alternatively worth about $340/day to the students who won the raffle.

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[edit] References

Thaler, R. (1980). Towards a positive theory of consumer choice. Journal of Economic Behavior and Organization, 1, 39-60.
Jason F. Shogren; Seung Y. Shin; Dermot J. Hayes; James B. Kliebenstein 'Resolving Differences in Willingness to Pay and Willingness to Accept' The American Economic Review, Vol. 84, No. 1. (Mar., 1994), pp. 255-270
W. Michael Hanemann 'Willingness to Pay and Willingness to Accept: How Much Can They Differ?' The American Economic Review, Vol. 81, No. 3. (Jun., 1991), pp. 635-647
Ziv Caromon and Dan Ariely (2000) 'Focusing on the Forgone: How Value Can Appear So Different to Buyers and Sellers' Journal of Consumer Research