Life can be troublesome. The reason it can be so troublesome is that we experience loss. Loss can come in many forms. For example: one of your loved ones has started the process of decay. This is not an article about grief (it’s not that deep). My phone is dying and I need to replace it. And holy spirit of Buddha, I don’t want to.
Sure, there is great new phones out there. The price is right, the specs are better. But first, I am experiencing the effects of choice overload: all these phones are the same if you ask me and there is truly too many of them out there. There is some potential regret theory in there too (thanks Graham!), what if I don’t pick the right one? What if it’s not the right one. It is truly nerve-wrecking. But I’m mainly experiencing the endowment effect: hundreds of phones out there, but none of them are mine… The object of my affection. My ride and die. Always there with me. Truly almost part of me. It has become a new limb. And just like Rose in Titanic, I really don’t want to let go. But I must. The pain of letting go, and the sentiment surrounding a simple object is very much what the endowment effect is based on.
So, what is the endowment effect? It’s quite simple. The title of this article says it all: I love it because it’s mine. And that is exactly how the endowment effects works. Once endowed with something, you love it more. This love can translate directly into monetary valuation. This explains (some of) the discrepancies between prices asked by sellers (willingness to accept) and prices offered by buyers (willingness to pay). The best example for this: the housing market.
Have you ever tried selling a house? I’m a millennial so I will never, ever, EVER, establish such a feat (I mean selling a house? That means I have to own one first – not going to f*cking happen is it…?!), but I have read and heard about it. It seems to me that if you have owned and as such experienced a house, you will have build memories. Those little moments in the garden BBQing, those evenings hosting your friends in the living room playing boardgames. Even that slightly off bathroom door that keeps hitting you in the shin. They are quirks and memories that have value. Issue is, they only have value to you.
When a new person, a potential owner, comes to your house, they do not see this. They have no experience. Their eye is much more objective, although coloured by their own previous experience. Instead of seeing a BBQ with friends in the garden, they are wondering whether it’s big enough, facing the right way, not too noisy etc. The bathroom door will definitely be replaced. That stain on the carpet where your friends have spilled red wine just once too often, that’s another turnoff. It’s another costs – that carpet will have to be replaced or chemically cleaned. Memories for you, costs for them. What you see as a home, is just a house to them. And that is a rude awakening when the negotiating about sales price starts.
It makes sense that this would work for things such as houses. They turn into homes. But the example paper for the endowment effect has nothing to do with an object so sentimental. No, the original studied mugs. Yeah, sounds fascinating already, but bear with.
In an experiment by Kahneman, Knetsch, and Thaler (1990) mugs were given to one half of the participants and, after extensive explanations and two hypothetical trials, they were asked their minimum selling price; with the other half asked their maximum buying price. The results showed that the minimum sum needed to compensate losers was about two and a half times the maximum amount that others were willing to pay for the same mugs. So, if I owned a mug already, I’d want 2.5 pounds for it if I were selling it. You, without having a mug, would only pay about 1 pound for obtaining it. There might be some market issues there. Supply and demand are not enough to fix that.
If mugs aren’t fascinating enough for you, let’s talk mugs AND chocolate. This exchange experiment (Knetsch, 1989) was conducted with three groups in which all participates could obtain one of two goods (a chocolate bar or a coffee mug, obviously…). The first group (N = 55) chose between the mug or the chocolate bar. The second group (N = 76) was just given the mug, and the third group (N = 87) was given the chocolate bar. Groups 2 and 3 were then given the chance to exchange their object for the other object (exchange the mug for the chocolate, or vice versa) without any cost!
So what happened then? Theory provides the strong prediction that the proportions of subjects indicating a preference for mugs over chocolate bars, and the proportions with the opposite preferences, should be roughly the same for each of the three groups. So in each group the mug should be preferred 20% (random number) of the time, without much fluctuation. But that is not what the results show at all…
In group 1, slightly more than half (56%) of subjects in the first group selected a mug over a chocolate bar. So did that remain constant over all groups? No. In group 2, 89% refused to exchange the mug for a chocolate bar. This is because this group would lose a mug to obtain chocolate, rather than just gain chocolate as group 1 would. In group 3, 90% of people did not want to exchange their chocolate for the mug. Again, people didn’t want to lose their initial product, even though initial preferences showed that 56% prefer mugs to chocolate. This is the endowment effect messing about. If we feel this intensely about mugs we have just obtained, can you now imagine how bad selling a house you call your home would be?
It took me multiple days to write this article, and in those days, I have ordered a new phone, to replace the beauty that is my old one. It is heartbreaking. But maybe I should be more like Marie Kondo. I should hold my phone close to my heart, thank it for its service, and then just let go. Endowment effect or not, it’s time to move on.
References Kahneman, Daniel, Knetsch, Jack L., Thaler, Richard H. (1990). “Experimental tests of the endowment effect and the coase theorem”. Journal of Political Economy 98, 1325–1348.
Knetsch, Jack L. (1989). “The endowment effect and evidence of nonreversible indifference curves”. The American Economic Review 79, 1277–1284.