The Endowment Effect
By Diya Singhal
BA (H) Economics, Hansraj College
No financial constraints, no shifting to another continent and no downsizing can ever convince us to give away that old dress, the first copy of a classic novel and that vinyl record that has been in the family for half a century. We are attached to these objects. These objects are ours. We are endowed with them.
This feeling of ownership towards material products is called the Endowment Effect and it has long been researched and tested by psychologists and marketers.
It has been found that the Endowment Effect is so potent that it is in work even if the object does not have an emotional value attached to itself. The Endowment Effect comes into effect instantly, as soon as we start owning an object. Once we own the object, we start attributing the object with more value and meaning. People are less likely to trade something that they already own to obtain something owned by someone else. This happens even when the object was obtained just moments ago and they have no cause for attachment to the object.
Research has identified two main psychological reasons as to what causes the endowment effect: ownership and loss aversion. A classic experiment was done by Profs. Kahneman, Knetsch & Thaler to see how the endowment effect influences our decision making. The scientists randomly divided the participants into two groups as buyers and sellers. They gave the sellers coffee mugs as a gift. They then asked the sellers for how much they would sell the mug and asked the buyers for how much they would buy it.
The value placed by the sellers was significantly higher than what the buyers put for the mugs. They were willing to sell a mug for $7.12 while buyers were willing to pay $2.87 (median reservation prices). People tend to raise the value of the things that they already own more than those which they might own. The sellers were then, each given a choice to swap their mug, for an equally-priced alternative which was a pen in this case. Interestingly, the sellers wanted to be paid twice the price for their mug as they were themselves willing to pay for the pen. It is merely the fear of losing the mug (loss aversion) for the sellers. Once you own an item, forgoing it feels like a terrible loss. Imagine your mobile phone. We personalize and protect our phone with apps, skins and covers and we are unlikely to exchange it for an equally priced item. Do you remember the last time you lost your phone?
The endowment effect is primarily a problem for sellers as we have seen little reluctance to buy but much reluctance to sell. Moreover, not all sellers are afflicted with an endowment effect. An owner will not be reluctant to sell an item at a given price if a perfect substitute is readily available at a lower price. This means that endowment effects will occur when owners are faced with an opportunity to sell an item purchased for use that is not easily replaceable.
Economic theory suggests that people’s preferences are independent of their entitlements. But the evidence of the experiment conducted by the Professors indicates that people's preferences depend on their reference positions. Good A may be preferred to B when A is part of an original endowment, but the reverse may be true when the initial endowment is changed.
The results of the experimental demonstrations of the endowment effect have direct implications for economic theory and economic predictions.
We can see the endowment effect in use when we visit an Apple store. The company lets the visitors touch and use all the products in the showroom without any time-limit. The staff is particularly ordered not to pressure anyone to leave. This leads the visitors to have a sense of belonging. They can now imagine themselves owning the product which leads them to not leave the store without purchasing it.
Beauty brands let you apply their products kept on the shelf and sometimes have service persons to apply the products on your skin as per your skin type and requirements. This is also an application of the endowment effect as it ensures the customer’s belongingness with the company.
Most online clothing stores are using the endowment effect by letting the customer pay only after delivery. IKEA’s Place App lets one see how a product fits within their personal space. This lets the potential customer perceive the product as it is already theirs. ‘X Days Money-Back Guarantee’ and ‘Start a Free Trial’ are two frequently used market implementations of this effect. These are simply telling the customers to try their product and if they don’t like it, they can just return it and not pay for it.
These companies are giving the potential customers time to fall in love with their product without any monetary risk involved. Once the potential customers start liking the product, they almost instantaneously get prepared to pay for the price. By the time the free period ends, their aversion to loss makes it hard for them to not purchase the product.
When initial public offerings (IPOs) of companies in the share market are oversubscribed, issuers conduct a lottery to allocate the shares. It has been found that one month after the trading started, 62.4% of lottery winners were still holding the shares, while only 1% of losers had bought them. Even two years later, 36% of the winners were still hanging to their shares, while only 1.7% of losers had bought them.
In theory, the two groups of investors should have had equal desire to own the shares as they both participated in the IPO. No significant relationship between the endowment effect and the stock price movements has been found, so there is no rational explanation for this behavior.
This research proves that investor behavior is not rational at all times. The IPO winners were more willing to hold on to their shares, regardless of their profit or loss, while the losers preferred not to buy the shares in the market, although they initially wanted to get the shares at the IPO.
We can clearly see that human beings do not always make rational decisions. The endowment effect is a behavioral bias that is exploited by corporates to attract customers to their products. It makes human beings choose irrationally without taking into account the effects of their decision.
Kahneman, D., Knetsch, J., & Thaler, R. (2008). “The Endowment Effect: Evidence of Losses Valued More than Gains,” Handbook of Experimental Economics Results.
Experimental Tests of the Endowment Effect and the Coase Theorem,” Journal of Political Economy
(IPO) Anagol, S, V Balasubramaniam, and T Ramadorai (2015), “The Effects of Experience on Investor Behavior: Evidence from India’s IPO Lotteries“.