By Apurva Narayan
Economics models generally presume that rational economic agents evaluate goods independently of their ownership (known as ‘basic independence ownership’). However, these rational economic agents tend to behave irrationally oftentimes. One such anomaly is the endowment effect, a cognitive bias which manifests itself in economic decision-making. Coined by the Nobel prize-winning economist Richard Thaler (1980), the term states the tendency of people to value objects that they own more than objects not owned by them. Its economic consequences are significant, leading to market inefficiencies, discrepancies in valuations by buyers and sellers, reluctance to trade, etc.
How and why this bias occurs?
1. You don’t like losing what’s yours.
Just imagine, you bought a concert ticket for ₹500. It’s not your favourite artist but you are excited about attending the concert with your friends. Unfortunately, you are forced to take a rain check on the day of the concert, so you decide to resell the ticket. Now, you price the ticket at ₹800 even though you bought it for a smaller sum. Because it is your ticket. Selling it at market value would feel like a loss. So you cover for it by attributing more value to the ticket. On the flip side, if you had to buy the same ticket you certainly wouldn’t be willing to pay ₹800 for it. Economists and psychologists call this phenomenon ‘loss aversion’ – another powerful cognitive bias. Basically, we hate experiencing losses by roughly 2.5 times of experiencing gains of similar size.
2. Your childhood bicycle is a part of you.
Your old bicycle has been lying unused in your garage for days, it was a gift from your uncle. Let’s say your neighbour wants to buy that bicycle from you. They’re willing to pay ₹1500. Seems like a fair price for an old, dusty and slightly ragged bicycle. But you couldn’t just sell it like that! You think about all the memories and happy times attached to the bike and reject the offer. This is because owned items are perceived as part of the “extended self,” carrying high subjective value. This is backed by research demonstrating stronger endowment effects for long-owned items and items closely associated with the self. Moreover, people boost their self-image by attributing increased value to their beliefs, possessions, and identities.
Therefore, loss aversion and ownership can be attributed as the driving factors or triggers of the endowment effect.
The infamous mug experiment
In the pivotal study conducted by Daniel Kahneman, a Nobel Prize-winning economist, alongside esteemed economists Jack Knetsch and Richard Thaler in 1990, the “Experimental Tests of the Endowment Effect and the Coase Theorem” brought the Endowment Effect to life.
Their research involved a series of experiments, featuring participants offered the opportunity to purchase a mug. The participants were required to assign a monetary value they’d be willing to pay for the mug. Following this, they were handed the mug, without any payment needed.
Subsequently, the participants were presented with a choice – whether to trade their mug for items of equivalent value, in this case, pens. Tasked with determining the number of pens they’d accept in exchange for their mug, the outcome was striking. On average, participants indicated a desire for twice as many pens for their mug. In essence, they valued the mug at twice the price when it was in their possession, as opposed to when it was not under their ownership.
Conflict with Coase theorem
Coase theorem, given by economist Ronald Coase in 1960, suggests that where there is perfect competition, the presence of complete information, no transaction costs and the absence of income and wealth effect, individuals will privately bargain to reach an optimal and efficient outcome, regardless of initial allocation (I.e, endowment) of property. Enter, endowment effect. In scenarios where individuals are arbitrarily designated as buyers and sellers, experiments reveal that they struggle to agree on a fair trading price – measures of willingness to accept (WTA) greatly exceed measures of willingness to pay (WTP). Thus, violating the Coase theorem as individuals fail to reach mutually agreeable trade terms.
Does market experience affect this cognitive bias?
Behavioural biases like the endowment effect can appear even without much market exposure. The widespread and early occurrence of these biases suggests that they may be fundamental to human thinking, more so than commonly believed. Notably, these biases are evident in children without market experience, indicating that cultural learning and market exposure might not heavily shape their development. This early emergence implies that these biases could be linked to basic cognitive processes, possibly originating from an older cognitive framework than previously thought.
How businesses make you prey to this effect?
If you’ve ever test-driven a car, you must know how amazing it feels to sit in a brand new car, with great specs, and the exact colour you want. You drive it and it feels…just right. It’s one of the oldest sales tactics in the books. You imagine how owning the car would add to your life and you want it all the more. This is the endowment effect at play, not limited to test-driving cars. Clothing brands have trial rooms not just to help you pick the right size and Lenskart does not come to your doorstep with 5 pairs of glasses just to help you pick the right colour. They are leveraging the endowment effect by giving you a sense of ownership. So beware customer!
How to avoid it
- Weigh Opportunity Costs:
When deciding on sale prices, resist the urge to set them significantly above market value. While sentimentality might tempt you, an excessively high price can scare off potential buyers. Opt for a price that mirrors the item’s actual worth to prevent missing out on a sale altogether.
2. Analyse Costs and Benefits:
Apply a cost-benefit analysis to your choices. Weigh the advantages and disadvantages of holding onto an item versus its actual value. This pragmatic approach guides decisions based on practical considerations.
3. Stay Alert to Psychological Ownership:
Keep a watchful eye on psychological ownership triggers. Whether it’s a test drive or persuasive sales tactics, these can emotionally tie you to a product. Remember, brief interactions don’t automatically inflate value. Stay on guard against attempts to create emotional bonds during your buying journey.
4. Compare and Contrast:
Make use of comparative analysis to gain clarity on value. By evaluating owned and non-owned items side by side, you can ascertain if your attachment is influencing your assessment.
5. Anchor Prices to Market Standards:
Research by Weaver and Frederick suggests that when both buyers and sellers perceive the value as market-based, the endowment effect weakens. Aim for a price closer to the middle of the customary range to narrow the gap between your valuation and potential buyers.
References
- What is Endowment Effect?
- Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias
- The Endowment Effect – Everything You Need to Know | InsideBE
- Endowment Effect – an overview | ScienceDirect Topics
- Endowment Effect – The Decision Lab
- https://www-jstor-org.ezaccess.libraries.psu.edu/stable/pdf/1831454.pdf?refreqid=excelsior:a7def43e3c79b377efdbae0eafad84d7&ab_segments=&origin=&initiator=&acceptTC=1
- https://www-jstor-org.ezaccess.libraries.psu.edu/stable/1831454#
- Is the Endowment Effect Due to Loss Aversion or Mere Ownership? Lisa L. Shu Harvard University
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