Week 6 - The Endowment Effect

The endowment effect suggests that people may overprice their items that they are trying to sell. This contradicts the economic theory, which suggests that the value of an object is independant of initial ownership (Kahneman et al., 1990). The loss aversion proposed by the Prospect Theory's value function suggests that people should find it difficult to part with things that they own.

Kahneman et al (1990) conducted a study on students to research into this effect. The students were randomly allocated into three groups; in one group, labelled as the 'sellers', were given a coffee mug and were asked whether they were willing to sell the mug at a series of prices ranging between $0.25 and $9.25. In the second group, known as the 'buyers', were asked if they were willing to buy a coffee mug at the same set of prices. As a result, the sellers set a higher median price ($7.12) than the buyers ($2.87), this is consistent with the endowment effect predicted by loss aversion. The third group provided independent valuations of the coffee mugs to see whether the sellers were overpricing the mug. This group were called the choosers, as they were asked to choose, for each of the prices, whether they would rather have a coffee mug or the cash. As a result, the medium price of the choosers group was $3.12, of which was quite close to the buyers evaluation, therefore suggesting that the value of an object depends on ownership, even when that ownership is randomly assigned. However, authors have argued that the endowment effect is only present with naive participants and can be reduced with people who have experience in a market setting (Coursey et al, 1987).