We recently mentioned in our Rational Roundup the Nobel Prize won by Prof. Richard Thaler. One of Richard Thaler’s key contributions to behavioral economics – and a reason for an increasing awareness of the latter as a field of research from the early 1980s onwards – is his work on what he labeled the endowment effect, well-illustrated through the so-called “coffee mug” experiment:
In this behavioral study Thaler and his two co-authors observed students valuing coffee mugs that had been randomly handed out to them. More specifically, half of the participants (the sellers) were given a coffee mug for free, followed by the question of how much they would be willing to sell the mug for. The remaining participants (the buyers) were asked to name an amount they would want to spend on the mug. Surprisingly, there was a significant difference between these two amounts: The sellers asked for approximately 7$, whereas the buyers were willing to pay only about 3$, less than half of what the other group expected to get. This tendency to demand more to give up an object compared to what one would be willing to pay to get it – just because you own it – links with and relates to other effects and behavioral asymmetries such as Kahneman/Tversky’s loss aversion idea in their prospect theory (trying to avoid losses more than seeking gains) and Samuelson/Zeckhauser’s status quo bias (preferring the current state or sticking with a former decision).[1]
Endowment theory quickly spread across many other research fields, law amongst others, as the findings linked to it contradicted the standard model assumption of preferences being independent from endowments. It hence much influenced the legal literature since the 1990s, in particular regarding the allocation and valuation of property rights. In this context, it went against the ‘Coase theorem’ which states that, in the absence of transaction costs, final property rights will be efficiently allocated, independently of who actually holds the initial property rights, as the affected parties would bargain in order to maximize the total surplus. This approach considers laws as granting entitlements which can – in theory – be traded. Marzilli-Ericson/Fuster illustrate this with an example: “For instance, consider a homeowner who is protected by law against the fumes coming from a nearby factory. If his value of clean air is below the factory manager’s value of being able to pollute, the manager can offer the homeowner a transfer for the right to pollute; the homeowner accepts, and the result is efficient. Most importantly, if the homeowner had not originally been entitled to clean air, the outcome would have been the same apart from the transfer (and any income effect).” [2] However, recent laboratory experiments under changed procedures and altered rules as well as outside-the-lab experiments have now shown that the empirical evidence for the endowment effect is rather mixed. Klass/Zeiler have much criticized endowment theory based on this new evidence, concluding that loss aversion coupled with ownership does not constitute the best explanation for such asymmetries in behavior.[3] Further studies have looked at whether the endowment effect is part of our evolutionary DNA, but again with mixed results: One study analyzes child behavior when exchanging toys, indicating that we might be “hard-wired” for the endowment effect; other studies, on the other hand, indicate a cultural influence on trade behavior. [4]
This has overall led to the question whether the effect really results mainly from loss aversion – or from pure misconceptions, other sources or a mixture of all of these – and whether mere ownership as a single reference point alone is hence enough to influence one’s willingness to trade. The literature and research in this field continue to grow and will have to be considered, challenged and debated by economic and legal scholars together with researchers from other fields (psychology, social sciences etc.) – taking into account the potential implications for ownership theory in legal policy-making in a balanced, evidence-based manner.
Not surprisingly, the choice of Richard Thaler as this year’s Nobel laureate has been much discussed and might indeed be a controversial one for those who promote the standard neo-classical theory and question the relevance of psychological factors or behavioral ‘anomalies’ such as the endowment effect when modelling human and real market behavior. But why not simply use them as any other new source of data if they contribute to a better understanding of behavior and improved economic and legal analysis? Thaler himself actually puts his own field in perspective by saying that
“[…] it is time to stop thinking about behavioral economics as some kind of revolution. Rather, behavioral economics should be considered simply a return to the kind of open-minded, intuitively motivated discipline that was invented by Adam Smith and augmented by increasingly powerful statistical tools and datasets. […] Indeed, my sense is that we are at the beginning of a new wave of theoretical developments made possible simply by turning our attention to the study of Humans rather than Econs.”[5]
KATHRIN MEIER
[1] cf. Kahneman, D., Knetsch, J., Thaler, R. (1991): “Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias.” Journal of Economic Perspectives, 5(1), pp. 193-206. The financial markets, for example, are a good illustration of the existence and importance of “less-than-fully rational agents” and their economic choices in this respect. It can be observed in situations where investors hold on to falling stocks too long in the hope that these will go up again at some point, allowing them to sell in the future without a loss.
[2] cf. Marzilli Ericson, K.M., Fuster, A. (2014): „The Endowment Effect“, Annual Review of Economics, Annual Reviews, vol. 6(1), pp. 555-579
[3] cf. Klass, G., Zeiler, K. (2013): “Against Endowment Theory: Experimental Economics and Legal Scholarship” UCLA Law Review, Vol. 61, pp. 2-64. Available at http://dx.doi.org/10.2139/ssrn.2224105
[4] cf. Harbaugh, W.T., Krause, K. Vesterlund, L. (2001): “Are adults better behaved than children? Age, experience, and the endowment effect.” Economics letters, 70(2), pp. 175-181
[5] cf. Thaler, R. (2016): “Behavioral Economics: Past, Present and Future”. Based on Thaler’s presidential address given at the American Economic Association annual meeting in January 2016. Available at SSRN: https://ssrn.com/abstract=2790606
