On the Endowment Effect

“There is a very real difference,” my friend told me, “between getting a car ‘new’ and getting it ‘second-hand’. When you’re getting it second-hand, you have no idea what the previous owner did with (or in) the car.”

He should know. We were sitting in his (second-hand) car, bought just a couple of months back, his sixth car in three years. Of these six, only his first two were new.

It reminded me of something I’d been thinking about lately: the endowment effect, of which definition I’ve happily copied and pasted below from good ol’ Wikipedia:

The endowment effect (also known as divestiture aversion) is the hypothesis that people ascribe more value to things merely because they own them. This is illustrated by the observation that people will tend to 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.

There have been a number of experiments done to demonstrate this effect, with the one that I’ve read about the most times being the following (also from Wikipedia):

One of the most famous examples of the endowment effect in the literature is from a study by Kahneman, Knetsch & Thaler (1990) where 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’ willingness to accept compensation for the mug (once their ownership of the mug had been established) was approximately twice as high as their willingness to pay for it.

But I’ve never actually read about an experiment that tried to explain it in terms of the bid/ask spread as it relates to investing (which compensates for risk) and information asymmetry. Or how it relates to how our default option is really not to trade, and that trading requires motivation and commands a premium.

For example, let’s say you are given the choice to buy the mug. There’s no reason to think that the amount quoted to you would be below the market price.

On the other hand, if you are given the mug, and then someone quotes you a price for it, there’s no reason to think that it would be above the market price, even if that price came in the form of a set of equally priced pens.

In fact, try playing the scenario in your head and see if you’d do any different:

  1. The experimenter (a stranger) comes up to you and says, “would you like a mug or a pen? By the way, both cost the same.”
  2. Randomly, you choose the mug. There is no reason, at this point in time, to think either the mug or the pen costs more than the other.
  3. The experimenter gives you the mug.
  4. After five minutes, the same experimenter comes up to you and offers you the choice to trade, saying, “are you sure you don’t want to have this set of pens instead of the mug? I’m willing to trade if you are…” (these are the same pens talked about in point #1)
  5. What would you think? Personally, I’d think there was a catch. You give me a mug, and five minutes later you’re trying to get it back. It’s got to be worth more than the pens if not why on earth would you want to trade?

Point #5 highlights risk and information asymmetry. There’s a risk I’m getting the shorter end of the stick because the experimenter seems to know more than me (i.e. the “true” value of the mug and pens). Why else would s/he offer to trade? (This, I think, is why new cars command such a premium over pre-owned ones. There’s a big risk pre-owned cars were subject to abuse you’d prefer not to know about. Why else would the car owner want to sell?)

Experiencing this risk would urge me to ask for more. If you give me $X more than you’re offering, I’m willing to take the risk that the mug really isn’t worth more than you say it is worth. If I decided on the trade, it’d mean that I trusted you completely on the fact that they were worth the same.

And let’s not forget the idea that people in general don’t really like to think; we don’t like to expend energy unnecessarily. If there’s a risk that we could be losing out, but we don’t really want to think about it, the default option would be to just say “no”, or quote a price such that it’s easy to say “yes”.

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Donn

My name is Donn, and you’ll find me working at the intersection of business and information technology, constantly looking for ways to apply IT to business and life to make things better. I’m a big fan of data analysis and its subsequent communication. It always gives me a thrill extracting meaning out of data through analysis, and figuring out the best way to present the findings for maximum impact!

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