Endowment effect
Encyclopedia
In behavioral economics, 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.
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 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.
Willingness to pay
In economics, the willingness to pay is the maximum amount a person would be willing to pay, sacrifice or exchange in order to receive a good or to avoid something undesired, such as pollution...
(WTP) for a good should be equal to their willingness to accept
Willingness to accept
Willingness to accept is the amount that а person is willing to accept to abandon a good or to put up with something negative, such as pollution. It is the minimum monetary amount required for sale of a good or acquisition of something undesirable to be accepted by an individual...
(WTA) compensation to be deprived of the good. This hypothesis underlies consumer theory
Consumer theory
Consumer choice is a theory of microeconomics that relates preferences for consumption goods and services to consumption expenditures and ultimately to consumer demand curves. The link between personal preferences, consumption, and the demand curve is one of the most closely studied relations in...
and indifference curves.
The effect was first theorized by Richard Thaler
Richard Thaler
Richard H. Thaler is an American economist and the Ralph and Dorothy Keller Distinguished Service Professor of Behavioral Science and Economics at the University of Chicago Booth School of Business...
. It is a specific form, linked to ownership, of status quo bias
Status quo bias
The status quo bias is a cognitive bias for the status quo; in other words, people tend not to change an established behavior unless the incentive to change is compelling...
. Although it differs from loss aversion
Loss aversion
In economics and decision theory, loss aversion refers to people's tendency to strongly prefer avoiding losses to acquiring gains. Some studies suggest that losses are twice as powerful, psychologically, as gains....
, a prospect theory
Prospect theory
Prospect theory is a theory that describes decisions between alternatives that involve risk i.e. where the probabilities of outcomes are known. The model is descriptive: it tries to model real-life choices, rather than optimal decisions.-Model:...
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.
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
Natural environment
The natural environment encompasses all living and non-living things occurring naturally on Earth or some region thereof. It is an environment that encompasses the interaction of all living species....
resources and personal health
Health
Health is the level of functional or metabolic efficiency of a living being. In humans, it is the general condition of a person's mind, body and spirit, usually meaning to be free from illness, injury or pain...
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.
See also
- Behavioral economics
- List of cognitive biases
- Sunk costs
- Transaction costTransaction costIn economics and related disciplines, a transaction cost is a cost incurred in making an economic exchange . For example, most people, when buying or selling a stock, must pay a commission to their broker; that commission is a transaction cost of doing the stock deal...
External links
- "The WTP-WTA Gap, the 'Endowment Effect,' Subject Misconceptions, and Experimental Procedures", Charles Plott et al., American Economic Review 2005
- The Endowment Effect's Disappearing Act, Larry E. Ribstein, December 4, 2005
- "Exchange Asymmetries Incorrectly Interpreted as Evidence of Endowment Effect Theory and Prospect Theory?", Charles Plott et al., American Economic Review 2007