lemon car

Know Your Nuggets: The Endowment Effect

bob_sullivan
Bob Sullivan
Writer

Editor’s Note: I’ve been waiting to release this episode in our Know Your Nuggets series until I knew you’d read a few and become hooked. You’re hooked! I love the endowment effect, because it enables my fantasy of becoming something between an after-school-special drug dealer (“Psst, kid, first one’s free!”) and the mustachioed guy on the Pringles can (“Once you pop, you can’t stop.”) Thank you for joining my delusion. Enjoy the read.

 

I once owned a red Ford Mustang convertible. Not a nice one, mind you, like a 1967 Mustang. It was a 1983 model, manufactured during the lost early ’80s years of Mustangs. But, it was mine. I loved it. My golden retriever and I had such good times riding around during Seattle summers, at least when the sun was out. The thought of those days still makes me feel warm and fuzzy. It was almost priceless to me!

In truth, the top barely worked, it burned oil almost as fast as gasoline and threatened to overheat constantly, and I never trusted it for rides longer than 20 miles or so.  So when it came time to sell my beloved car, I learned a hard lesson. After a brief attempt a get few hundred dollars for it, I just donated the car to charity. Priceless, alright.

I had an emotional attachment to the car, so I perceived its value one way. Others, dispassionate about my dog's flowing locks, had a very different perception. This phenomenon is actually pretty common: behaviorists called it the "endowment effect." People tend to become attached to things they already own and "endow" them with extra value.

 

People tend to become attached to things they already own and "endow" them with extra value.

Not just things: Ever listen to baseball fans discuss potential trades? "What if we send our backup catcher and get your best starter in return?" Fans overvalue their favorite team's players all the time when discussing player swaps.

Back to my Mustang. As I watched it being towed away, I had to admit: I wouldn’t have paid much for it either. Or, to put it in dry economics terms, WTP < WPA: a buyer’s "willingness to pay" for something is often less than the owner’s "willingness to accept" an amount to sell it.

Sometimes, when markets get gummed up, this gap between WTP and WPA is partly to blame. When you've lived in a house for 20 years and you've lovingly tended to the gardens, you might be upset to find a potential buyer cares only about the price per square foot. The housing market collapse lasted as long as it did, in part, because sellers just couldn’t believe the lowball prices they were receiving for their beloved homes.

The Endowment Effect was first named by Richard Thaler in a 1980 paper titled “Toward a positive theory on consumer choice.” Later, Thaler and Daniel Kahneman published a paper on their classic and oft-repeated endowment effect experiment: Give mugs to half a room full of subjects, then ask the recipients how much they'd want to sell the mug, and ask the empty-handed subjects how much they'd pay for the mugs. On average, mug-holders wanted $7, while mug buyers would only pay $3.

If that roughly two-to-one ratio sounds familiar, it should. The endowment effect seems to be related to loss aversion, which we covered elsewhere on PeopleScience.com. Generally, losses loom larger than gains ... roughly twice as large.

 

The endowment effect seems to be related to loss aversion, which we covered elsewhere...

One theory about the endowment effect is that people become attached to things very quickly and are averse to the suffering that losing these things would cause. The mug-holders quickly became attached to their free gift. On the other hand, the mugless crowd could pretty much take or leave the thing.

Kahneman continued to experiment with endowment and found situations where the ratio was much higher. Duke University students go to legendary efforts to obtain tickets to their school’s basketball games, often camping out for days or weeks before big games. When Kahneman called students after tickets were handed out by lottery – that is, they did not expend extraordinary effort in this case – he found the winners wanted $2,400 to sell their prized tickets, while losers would only pay $175 to get them.

The endowment effect can be ever stronger in the investing world. A group of researchers led by Santosh Anagol examined the Indian IPO market and found that about half of investors who win the “lottery” and get shares at IPO price tend hold on to them for at least six months. Meanwhile, only around 1% of IPO “losers” even buy the shares at all. In other words, once they own a stock, investors see a big value in holding onto it, while those who don’t come up with a very different analysis.

 

Once they own a stock, investors see a big value in holding onto it, while those who don’t come up with a very different analysis.

Is this just emotional attachment gone awry, or is something else at play? A 2012 paper by Ray Weaver and Shane Frederick argues that loss aversion isn’t the only cause for what appear to be irrational decisions. Sometimes, people are just worried about being ripped off.

Setting fair prices is very hard – corporations put billions of dollars of research into finding precise willingness to pay levels. People engaged in everyday transactions like mug sales or even house sales are often in the dark. Weaver and Frederick conducted experiments showing that the use of reference prices – like a set of good comps in a housing market – shrunk or even eliminated the endowment effect.

“These results suggest that the endowment effect is often best construed as an aversion to bad deals rather than an aversion to losing possessions,” they wrote.

The endowment effect has plenty of applications in the workplace. One study showed that employees work harder to avoid losing a bonus that’s already been granted than they work to achieve a future bonus. (Editor’s note: A recent study conducted by Maritz’ Field Research Collaborative tried this in a very different setting – auto dealerships – and found that it did not have the intended effect. We’ll write about that pilot soon, but this is just a reminder that these principles are very context dependent and experimentation is a must.)

Consumers often don’t like giving up things once they physically possess them – that’s one reason car dealers are so keen to get you in for a test drive. (Editor’s note: I guess car dealers don’t get the whole “what’s good for the goose is good for the gander” thing, do they? Need more ganders.) Apple famously lets shoppers play with their gadgets endlessly in stores; after a day of that, consumers dislike walking out empty-handed. A new crop of Internet-based retailers like Stitch Fix sends items home “for free” to shoppers, understanding many will just keep what’s sent.

As is often the case, the consequences of falling prey to the endowment effect range from charming (“When will you get rid of that jalopy, Bob?”) to disastrous (“I was sure my retirement account couldn’t fall any farther”). One way to avoid this is to flip the script. Would you buy the thing you have right now? If you really believe in that stock, you should be willing to buy more. If not, it’s probably time to sell … the stock, the Mustang and whatever else is cluttering up the garage in your beloved homes.

(Editor’s final note: Wait! That’s it? I want to know more. How does this relate to sunk costs? Is there way to combat endowment effect? Is loss aversion real? Ahhhhh! You’ve got me hooked!)

 

bob_sullivan
Bob Sullivan
Writer

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