The endowment effect
The endowment effect
August 1, 2020
I’m willing to bet that you have at least one possession that you would not part with for any (realistic) amount of money. Perhaps it is the leaning tower of Pisa shot glass you bought after having had one too many shots of Sambuca. It might be an old, comfortable t-shirt left over from your flag football days, with the blood stain still visible. Whatever it might be, your unwillingness to sell the possession at an objective market price is an example of the endowment effect.
There are several explanations for the endowment effect. You might value the shot glass and t-shirt for purely sentimental reasons, but the endowment effect can also be caused by loss aversion, the subject of July’s newsletter. It could also be related to something called the status quo bias (self-explanatory). Confirmation bias (the subject of the May 2020 newsletter) and the so-called bias toward inaction might also contribute to the endowment effect.
Whatever the cause, if you are “endowed” with a possession, you tend to put a higher value on it than what it would cost to buy it.(1) Conversely, you are not willing to sell it at its market price.
Perhaps the best-known experiment demonstrating the endowment effect was conducted by Kahneman, Knetsch, and Thaler.(2) Students were given a coffee mug and told its value (price). They were then offered the chance to sell it at that price. The researchers found that the selling price the students demanded, once the mug was theirs, to be approximately twice as high as the amount they were willing to pay to buy the mug.
So why might this be important? Let’s consider two examples. The first is from the realm of investments. Suppose you inherited some shares from your grandfather, shares of the Warwick Buggy Whip Company. In spite of management’s efforts to put a chip in the buggy whips to record the number and intensity of whips, the prospects of the company look bleak. A rational analysis suggests that it would be best to sell the shares and deploy your money elsewhere. But the endowment effect gets in the way of making a rational decision. It might be sentiment (but did you really like your grandfather?) or any of the other causes discussed above. But either way, being endowed with the shares makes you reluctant to sell them when it makes sense to do so.
The second example looks at a public policy called “eminent domain”. In many countries, the government has the right to take land from its citizens if there is a legitimate public benefit to doing so (such as building a straight highway, rather than one that zigs and zags). Although eminent domain laws vary by locality, in general, the person whose land has been taken is to be compensated at the “market value” or “fair value” of that land (and perhaps the building on the land).
I think you can see the role that the endowment effect plays here. The landowner probably values the land more that its market value (if she valued it less than the market value, she would have sold it already). So being compensated at market value feels unfair to the landowner. A Google search will turn up many cases in which landowners strongly resist the exercise of eminent domain. Of course, pretending to value the land highly could be a negotiating ploy. Nonetheless, the endowment effect suggests that resistance to eminent domain takings is at least in part sincere.
Finally, a heads up. It is not surprising that marketers understand the endowment effect (as well as many other behavioral biases). For example, the endowment effect can kick in almost immediately, that is, very soon after you acquire the possession. Or maybe even earlier?! One website(3) states, “We tend to infuse products with meaning as soon as we touch them. How can we recreate this in retail marketing?” Wow, we don’t even have to own something to be subject to the endowment effect! Caveat emptor.
Notes:
I’m not claiming that the endowment effect applies to all your possessions, but at least some.
For a very readable, in-depth discussion of the endowment effect, see Kahneman, Daniel; Knetsch, Jack L.; Thaler, Richard H. (1991). "Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias". The Journal of Economic Perspectives. 5 (1): 193–206.
https://blog.crobox.com/article/endowment-effect-marketing-examples