In behavioral economics, the endowment effect (also known as divestiture aversion) is the hypothesis that people ascribe more value to things merely because they own them. This is illustrated by the observation that people will tend to pay more to retain something they own than to obtain something owned by someone else—even when there is no cause for attachment, or even if the item was only obtained minutes ago.
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.
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 participants 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 provisional 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.
Psychologists first noted the difference between consumers' WTP and WTA as early as the 1960s. The term endowment effect however was first explicitly coined 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. In the years that followed, extensive investigations into the endowment effect have been conducted producing a wealth of interesting empirical and theoretical findings.
It was proposed by Kahneman and his colleagues that the endowment effect is, in part, due to the fact that once a person owns an item, forgoing it feels like a loss, and humans are loss-averse. 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. However, these claims have been disputed and other researchers claim that ownership (attribution of the item to self) and not loss aversion is the key to this phenomenon.
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 that is lower than the value that he/she would be willing to accept to sell (B-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 2 presents this explanation in graphical form. In the figure, two indifference curves for a particular good X and wealth are given. An individual asked how much he/she would be willing to pay to move from A where he/she has X0 of good X to point B, where he/she has the same wealth and X1 of good X, has his/her WTP represented by the vertical distance between C and B since the individual is indifferent about being at A or C. On the other hand, an individual asked to indicate how much he/she would be willing to accept to move from B to A has his/her WTA represented by the vertical distance between A and D as he/she is indifferent about either being at point B or D. Shogren et al. (1994) has reported findings that lend support to Hanemann's hypothesis.
Connection-based theories propose that subjective feelings are responsible for an individual's reluctance to trade (i.e. the endowment effect). For example, receiving a mug may induce a minimal attachment to that item which an individual may be averse to breaking, resulting in an increase in the perceived value of that object. A real world example of this would be an individual refusing to part with an old painting for any price due to it having "sentimental value". Work by Morewedge, Shu, Gilbert and Wilson (2009) provides some support for these theories, as does work by Maddux et al. (2010). 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).
Huck, Kirchsteiger & Oechssler (2005) have raised the hypothesis that natural selection may favor individuals whose preferences embody an endowment effect given that it may improve one's bargaining position in bilateral trades. Thus in a small tribal society with a few alternative sellers (i.e. where the buyer may not have the option of moving to an alternative seller), having a predisposition towards embodying the endowment effect may be evolutionarily beneficial. This may be linked with findings (Shogren, et al., 1994) that suggest the endowment effect is less strong when the relatively artificial sense of scarcity induced in experimental settings is lessened.
Some economists have questioned the effect's existence. Hanemann (1991) noted that economic theory only suggests that WTP and WTA should be equal for goods which are close substitutes, so observed differences in these measures for goods such as environmental resources and personal health can be explained without reference to an endowment effect. Shogren, et al. (1994) noted that the experimental technique used by Kahneman, Knetsch and Thaler (1990) to demonstrate the endowment effect created a situation of artificial scarcity. They performed a more robust experiment with the same goods used by Kahneman, Knetsch and Thaler (chocolate bars and mugs) and found little evidence of the endowment effect. Others have argued that the use of hypothetical questions and experiments involving small amounts of money tells us little about actual behavior (e.g. Hoffman and Spitzer, 1993, p. 69, n. 23 ) with some research supporting these points (e.g. Kahneman, Knetsch and Thaler, 1990, Harless, 1989) and others not (e.g. Knez, Smith and Williams, 1985)
Herbert Hovenkamp (1991) has argued that the presence of an endowment effect has significant implications for law and economics, particularly in regard to welfare economics. He argues that the presence of an endowment effect indicates that a person has no indifference curve (see however Hanemann, 1991) rendering the neoclassical tools of welfare analysis useless, concluding that courts should instead use WTA as a measure of value. Fischel (1995) however, raises the counterpoint that using WTA as a measure of value would deter the development of a nation's infrastructure and economic growth.
The endowment effect has also been raised as a possible explanation for the lack of demand for reverse mortgage opportunities in the United States (contracts in which a home owner sells back her/his property to the bank in exchange for an annuity) (Huck, Kirchsteiger & Oechssler, 2005).
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