A Brief Introduction to the Endowment Effect Kam Leung Yeung Feb 19, 2013

Introduction $$$$$$ Endowment effect (EE): what is given to a person is valued more by that person than by someone who does not receive the same item

An example (Kahneman, Knetsch, and Thaler, 1990) Introduction SellersBuyersChoosers Given a mug Shown a mug - Indicate selling price Indicate buying price Choose between a mug and cash Pick a price ranging from $0 - $9.25

Only 3 trades took place (out of 77 students) Introduction

First identified in 1980 by Richard Thaler Have generated research interest for over 30 years The effect was replicated extensively across many types of goods, including mugs, candy bars, binoculars, pens, wine, and intangible goods such as hunting permits, clean air, and time One of the most robust psychological effects Let’s look at factors that affect the price disparity Introduction

Transaction demand Definition: The motivation to complete a transaction (Mandel, 2002) Prediction: as transaction demand increases, what happen to buy/sell price?  Owners will sell at lower price  Buyer will buy at higher price

Transaction demand High transaction demand of the merchant  A. A decade ago, you purchased a case of good wine for £5 per bottle. A wine merchant is now interested in buying the case. How much would you be willing to sell it for per bottle?  B. A decade ago, a wine merchant purchased a case of good wine for £5 per bottle. He is now interested in selling the case. How much would you be willing to buy it for per bottle? High transaction demand of the participant  C. A decade ago, you purchased a case of good wine for £5 per bottle. You are now interested in selling the case to a wine merchant. How much would you be willing to sell it for per bottle?  D. A decade ago, a wine merchant purchased a case of good wine for £5 per bottle. You are now interested in buying the case. How much would you be willing to buy it for per bottle?

Transaction demand Results  EE is observed when merchants are in high transaction demand  EE is eliminated when participants are in high transaction demand

Market Value Heuristic What do you prefer?

Market Value Heuristic $2k ~ $20k / kg

Market Value Heuristic How much would you sell for each?

Market Value Heuristic People predominantly prefer the hedonic goods BUT at the same time sell the less attractive good at higher price

Market Value Heuristic Normatively speaking, one’s monetary valuation of an object should follow one’s preference But market value heuristic significantly distort sellers’ price Boothe, Schwartz and Chapman, 2007

Virtual Goods & Trading Experience EE is not limited to goods with physical entity Reluctance to trade is demonstrated on low-experience online gamers (De Sousa and Munro, 2012)

Virtual Goods & Trading Experience

What about Physical Possession? Would the fact that being able to hold and examine an object affect valuation? (Reb and Connolly, 2007) 2 (Ownership vs. no ownership) x 2 (Possession vs. no possession Object: chocolate bar (Exp 1) and mug with university logo (Exp 2)

What about Physical Possession? Results

What about Physical Possession? And that is not the end of the story … The price disparity is completely mediated by feeling of ownership, measured by “How much do you feel like you own X (even though you don’t legally own it)?”

While other factors are interesting, loss aversion from the Prospect Theory remains the primary explanation of the EE (Kahneman & Tversky, 1979) Loss Aversion + -

Loss aversion  e.g. Prospect Theory (Kahneman & Tversky, 1979) Loss Aversion + - Owner Non-owner

Loss Aversion Can be loss averse Cannot be loss averse $$$$$$

Psychological Ownership Owners Non-owners $$$$$$

Preference follows ownership  Preference for letters of one’s own name (Heider, 1958)  Owning a coupon increases preference for the corresponding product (Sen and Johnson, 1997) Psychological Ownership

Various behavioral evidence support augmented valuation follows psych ownership  Psych ownership, not factual ownership, explains price difference (Reb and Connolly, 2007)  Psych ownership, driven by positive valence of touch, explains price difference (Peck and Shu, 2009) Psychological Ownership

Usually loss aversion and ownership are confounded: Morewedge et al. (2009) Lose the object from owning Own the object Gain the object from owning nothing Do not own the object

Loss aversion: Sellers > Buyers Ownership: Owners > Non-owners Morewedge et al. (2009) Owner seller Non-owner buyerOwner buyer

Loss aversion: Sellers > Buyers Ownership: Owners > Non-owners Morewedge et al. (2009) Owner seller Non-owner buyerOwner buyer

No effect of factual ownership Selling price > Buying price Yeung & Weber (2010) Sell price for self Buy price for other Sell price for other Buy price for self Buy price for other Sell price for other No transaction took place

Q & A Thank you! Any questions ?