Thursday, March 2, 2017

The Endowment Effect

Some time not too long ago, maybe 30 years or so, psychologists discovered that people value things they already have over things they don't have.  One big experiment took place in a classroom where students were given coffee mugs and asked how much they would be willing to sell them for.  Let's say the average was $5 (though I don't remember exactly).  They then asked students how much they would buy the identical mug for, and the average was $2.  So here was a mug that students valued at $5 when they owned it, but only $2 when they didn't own it, which is contrary to economic theory that identical things should have identical value.  They called "the Endowment Effect."

The Endowment Effect seems like an amazingly good thing for society.  It makes everyone happier with what he has than what he doesn't have.  In other words, the net happiness of everyone is higher when they all own things because they will value their things beyond their utility.  If you think people are envious now, imagine how much worse it would be if people didn't value their own things more.  It is theoretically possible that they would even value their own things less than other people's, which sometimes seems to be the way people think.  It's "the grass is greener on the other side" applied to ownership of goods:  you want what someone else has until you acquire it, and then it seems less valuable to you.  Trading in these circumstances would presumably be intense:  everyone wants what everyone else has, and that continues even after they have made the trade.  They both want to trade back.

I don't think the Endowment Effect is as counterintuitive as some people claim, however.  There is at least one thing that it doesn't account for, and that is transaction costs.  Now, if you are a student in class and someone is offering to buy or sell a mug for cash, there is obviously little transaction cost.  In other cases, however, there is.  I know this because there is a minimum value that I'm willing to part with things on eBay.  Even though it isn't really all that much trouble to sell things there, I just don't want to invest the effort for less than $10.  In other words, I'd rather forego $10 than go to the trouble of selling something.  That would appear, in economic terms, like a sort of endowment effect.

But the transaction cost in strict terms is not the major thing driving the Endowment Effect.  I think there are two other features, one of which I will address now, and another I will reserve for my next blog entry.

The first thing that makes you value your own things over others is that you know your own things.  Arguably this is a sort of transaction cost that involves getting familiar with the goods that you acquire.  When you buy a new car, you have a lot of things to get used to:  the steering, the acceleration, the location of the controls, the kind of tires it needs, and so forth.  You may not be willing to trade an old car for a newer one because you don't want to take the trouble of figuring out the ins and outs of the new vehicle.  Obviously, this would only be worth so much money:  you're not going to turn down a new Corvette for a 20-year-old Escort under almost any circumstances.  But it is a real cost.  I don't think it's a transaction cost so much as a matter of the monetary value of knowledge.  The only way to get familiar with something is to use it, and you can't use it (normally) until you own it.  You will also, then, have a propensity for the same model with which you are familiar, and the same brand more generally, which is something that corporations know well:  that's one reason they offer you good deals to switch to their brand.  Even if they lose money in the short run, they stand to benefit by shifting your comfort to their brand instead of the competitors.

Even if you are trading for an identical model, information discrepancies exist.  Imagine, for example, that you buy a new car today.  Tomorrow at work, you find that one of your co-workers bought the exact same model from the same dealer on the same day.  The only difference is that his is red and yours is blue.  Now, if he approaches you and says, "I thought I wanted the red car, but I really would rather have the blue one.  I know red is your favourite colour, how about we just swap cars?"  Would you do it?

On one hand, the cars are ostensibly identical, and suppose you are indifferent to colour.  There would seem to be no reason for you not to trade cars with him.  On the other hand, you might be suspicious that there is something about his car that he doesn't like besides the colour.  With warranties, this is probably moot, but let's assume there could be some problem with the car not covered by the warranty.  Did he really just change his mind about the colour, or is he trying to get out of some other issue?  If you know the person well and trust him, you might assume it was just the colour; but that would be another means of addressing the information asymmetry, not a way of making it go away.  On top of that, there is a hassle in trading cars.  You probably have a loan that you would have to deal with; you would have to sign over the title and get the title to his car, hopefully without any issue; you would have to address the warranty's changing hands.

Just to carry this a bit further, suppose the cars were the same colour and he wanted to trade.  That would make you really suspicious, because there would seem to be no reason to trade identical vehicles, especially not with the paperwork hassle.

These issues do not apply to a coffee mug worth a few dollars, of course, but I think they are relevant to our psychology.  In general, there are good reasons why we might prefer what we have to what we don't have, even if they appear to be the same.  In my next post, I will address another possible reason for the Endowment Effect.

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