In psychology and behavioral economics, the endowment effect, also known as divestiture aversion, is the finding that people are more likely to retain an object they own than acquire that same object when they do not own it. The endowment theory can be defined as "an application of prospect theory positing that loss aversion associated with ownership explains observed exchange asymmetries."
This is typically illustrated in two ways. In a valuation paradigm, people's maximum willingness to pay (WTP) to acquire an object is typically lower than the least amount they are willing to accept (WTA) to give up that same object when they own it—even when there is no cause for attachment, or even if the item was only obtained minutes ago. In an exchange paradigm, people given a good are reluctant to trade it for another good of similar value. For example, participants first given a pen of equal expected value to that of a coffee mug were generally unwilling to trade, whilst participants first given the coffee mug were also unwilling to trade it for the pen.
A more controversial third paradigm used to elicit the endowment effect is the mere ownership paradigm, primarily used in experiments in psychology, marketing, and organizational behavior. In this paradigm, people who are randomly assigned to receive a good ("owners") evaluate it more positively than people who are not randomly assigned to receive the good ("controls"). The distinction between this paradigm and the first two is that it is not incentive-compatible. In other words, participants are not explicitly incentivized to reveal the extent to which they truly like or value the good.
The endowment effect can be equated to the behavioural model willingness to accept or pay (WTAP), a formula sometimes used to find out how much a consumer or person is willing to put up with or lose for different outcomes. However, this model has come under recent criticism as potentially inaccurate.
Examples One of the most famous examples of the endowment effect in the literature is from a study by Daniel Kahneman, Jack Knetsch & Richard Thaler, in which Cornell University undergraduates were given a mug and then offered the chance to sell it or trade it for an equally valued alternative (pens). They found that the amount participants required as compensation for the mug once their ownership of the mug had been established ("willingness to accept") was approximately twice as high as the amount they were willing to pay to acquire the mug ("willingness to pay").
Other examples of the endowment effect include work by Ziv Carmon and Dan Ariely, who found that participants' hypothetical selling price (willingness to accept or WTA) for NCAA final four tournament tickets were 14 times higher than their hypothetical buying price (willingness to pay or WTP). Also, work by Hossain and List (Working Paper) discussed in the Economist in 2010, showed that workers worked harder to maintain ownership of a provisionally awarded bonus than they did for a bonus framed as a potential yet-to-be-awarded gain. In addition to these examples, the endowment effect has been observed using different goods in a wide range of different populations, including children, great apes, and new world monkeys.
Background The endowment effect has been observed from ancient times:
Psychologists first noted the difference between consumers' WTP and WTA as early as the 1960s. The term endowment effect however was first explicitly coined in 1980 by the economist Richard Thaler in reference to the under-weighting of opportunity costs as well as the inertia introduced into a consumer's choice processes when goods included in their endowment become more highly valued than goods that are not.
At the time Thaler's conceptualisation of the endowment effect was in direct contrast to that of accepted economic theory, which assumed humans were completely rational when making decisions. Through his contrasting viewpoint, Thaler was able to offer a clearer understanding of how humans make economic decisions. In the years that followed, extensive investigations into the endowment effect have been conducted producing a wealth of interesting empirical and theoretical findings.
Theoretical explanations
Loss aversion The leading explanation for the aforementioned WTP-WTA gap is that of loss aversion. It was first linked by Kahneman and his colleagues that selling an endowment means the loss of the object, and as humans are aligned to be more loss-averse, less utility is obtained from acquirement of the same endowment. They go on to suggest that the endowment effect, when considered as a facet of loss-aversion, would thus violate the Coase theorem, and was described as inconsistent with standard economic theory which asserts that a person's willingness to pay (WTP) for a good should be equal to their willingness to accept (WTA) compensation to be deprived of the good, a hypothesis which underlies consumer theory and indifference curves. Another aspect of loss aversion exhibited within the endowment effect is that opportunity costs are often undervalued. The overcharging of the selling item stems from the fixation of losing the item rather than the unattained gain if the sale falls through.
The correlation between the two theories is so high that the endowment effect is often seen as the presentation of loss aversion in a riskless setting. However, these claims have been disputed and other researchers claim that psychological inertia, differences in reference prices relied on by buyers and sellers, and ownership (attribution of the item to self) and not loss aversion are the key to this phenomenon.
Psychological inertia David Gal proposed a psychological inertia account of the endowment effect. In this account, sellers require a higher price to part with an object than buyers are willing to pay because neither has a well-defined, precise valuation for the object and therefore there is a range of prices over which neither buyers nor sellers have much incentive to trade. For example, in the case of Kahneman et al.'s (1990) classic mug experiments (where sellers demanded about $7 to part with their mug whereas buyers were only willing to pay, on average, about $3 to acquire a mug) there was likely a range of prices for the mug ($4 to $6) that left the buyers and sellers without much incentive to either acquire or part with it. Buyers and sellers therefore maintained the status quo out of inertia. Conversely, a high price ($7 or more) yielded a meaningful incentive for an owner to part with the mug; likewise, a relatively low price ($3 or less) yielded a meaningful incentive for a buyer to acquire the mug.
Reference-dependent accounts According to reference-dependent theories, consumers first evaluate the potential change in question as either being a gain or a loss. In line with prospect theory (Tversky and Kahneman, 1979), changes that are framed as losses are weighed more heavily than are the changes framed as gains. Thus an individual owning "A" amount of a good, asked how much he/she would be willing to pay to acquire "B", would be willing to pay a value (B-A) that is lower than the value that he/she would be willing to accept to sell (C-A) units; the value function for perceived gains is not as steep as the value function for perceived losses.
Figure 1 presents this explanation in graphical form. An individual at point A, asked how much he/she would be willing to accept (WTA) as compensation to sell X units and move to point C, would demand greater compensation for that loss than he/she would be willing to pay for an equivalent gain of X units to move him/her to point B. Thus the difference between (B-A) and (C-A) would account for the endowment effect. In other words, he/she expects more money while selling; but wants to pay less while buying the same amount of goods.
Figure 1: Prospect Theory and the Endowment Effect
Neoclassical explanations Hanemann (1991), develops a neoclassical explanation for the endowment effect, accounting for the effect without invoking prospect theory.
Figure 2 presents this explanation in graphical form. In the figure, two indifference curves for a particular good X and wealth are given. Consider an individual who is given goods X such that they move from point A (where they have X0 of good X) to point B (where they have the same wealth and X1 of good X). Their WTP represented by the vertical distance from B to C, because (after giving up that amount of wealth) the individual is indifferent about being at A or C. Now consider an individual who gives up goods such that they move from B to A. Their WTA represented by the (larger) vertical distance from A to D because (after receiving that much wealth) they are indifferent about either being at point B or D. Shogren et al. (1994) has reported findings that lend support to Hanemann's hypothesis. However, Kahneman, Knetsch, and Thaler (1991) find that the endowment effect continues even when wealth effects are fully controlled for.
Figure 2: Hanemann's Endowment Effect Explanation
When goods are indivisible, a coalitional game can be set up so that a utility function can be defined on all subsets of the goods. Hu (2020) shows the endowment effect when the utility function is superadditive, i.e., the value of the whole is greater than the sum of its parts. Hu (2020) also introduces a few unbiased solutions which mitigate endowment bias.
Experiments in cognitive psychology have demonstrated that the endowment effect can be brought about by asymmetries in cognitive processing in judging owned and not-owned goods. A 2007 fMRI study by Knutson et al. demonstrated that the insula, an area of the brain associated with loss aversion, is stimulated when people ponder relinquishing goods they already possess. This is consistent with the hypothesis that the endowment effect entails not only ownership bias but also emotional attachment and loss anticipation neural processes. Further, the effect is also conditioned by cultural environment and personality difference in risk sensitivity. Knutson, B., Rick, S., Wimmer, G. E., Prelec, D., & Loewenstein, G. (2007). Neural predictors of purchases. Neuron, 53(1), 147–156. https://doi.org/10.1016/j.neuron.2006.11.010
Connection-based, or "psychological ownership" theories Connection-based theories propose that the attachment or association with the self-induced by owning a good is responsible for the endowment effect (for a review, see Morewedge & Giblin, 2015). Work by Morewedge, Shu, Gilbert and Wilson (2009) provides support for these theories, as does work by Maddux et al. (2010). For example, research participants who were given one mug and asked how much they would pay for a second mug ("owner-buyers") were WTP as much as "owners-sellers," another group of participants who were given a mug and asked how much they were WTA to sell it (both groups valued the mug in question more than buyers who were not given a mug). Others have argued that the short duration of ownership or highly prosaic items typically used in endowment effect type studies is not sufficient to produce such a connection, conducting research demonstrating support for those points (e.g. Liersch & Rottenstreich, Working Paper).