Behavioural Economics II

This article is part 2 in a four-part series on behavioural economics. Next article: Loss aversion. Previous article- The role of honesty.

In microeconomics, we say preferences are reversible. If you would pay £2 for a bar of chocolate, then you would be happy to sell a bar of chocolate for £2, especially if I gave it to you for free. Sounds reasonable? Well, in fact, this is not the case. Once again, consumers, just like you and me, are irrational, and thanks to what’s known as the endowment effect, classical economics falls flat once again.

The endowment effect

In an experiment conducted by Knetsch, participants were randomly allocated into three different categories. The first were given a coffee mug, the second were given some candy, and the third were given nothing. We say that the first two groups were endowed; they were given an item for free at no cost to them.

Then the participants in the first two groups were given the option to either swap their item for either the mug or the candy or keep the item they were endowed with. The third group, treated as a control, was given the option to choose between the two and keep which they preferred the most.

In the control group, we saw that about half of the participants chose the mug and half chose the candy. But in the endowed groups, an overwhelming majority decided to keep the item they were given rather than swapping!

Therefore, as we can clearly see, when someone is endowed with an item, their perception of its utility (or benefit) seems to increase, so when given the opportunity to switch items, they often decline.

Clearly, from an economic perspective, when endowed with an item, your utility curve for that item differs from when given the opportunity to choose. But why might that be the case?

When you are endowed with an item, you own that item and, in a sense, hold responsibility over it. You become possessive, and this sense of ownership seems to have its own psychological value; therefore, the act of giving it up for something of equal worth is no longer treated as a fair trade-off. Whereas when not endowed, you have no sentiment value attached to the items, and for the most part, people are indifferent between them!

A good example of this could be an old, run-down car. Buyers of this car see it for what it is—something that is barely functional. But owners of the car who have driven it for 20 years see it as more than that. There is an emotional attachment to the car that makes it more valuable in their eyes.

Is the endowment effect always true?

List conducted a similar experiment. A survey was undertaken by both unexperienced and experienced 'traders', and then after the survey, they were given trading cards as a reward. They were then given the opportunity to trade their cards if they wanted to.

Non-experienced traders were subject to the endowment effect, so they kept the cards they worked hard for, but experienced traders knew that some cards may be more valuable, even if only slightly, which meant that they were able to overcome this effect.

Additionally, what was found was that when participants were aware and went into the experiment knowing that there would be a trade, they had the intention to trade, which also managed to remove the endowment effect.

In essence, the endowment effect serves as a reminder of the complexities inherent in human psychology and decision-making. There are many limitations in traditional economic models, which emphasises the need for behavioural economics and the inclusion of multidisciplinary thinking.

To discover more about behavioural economics and in particular how honesty plays a big role in restructuring economic thinking, click here to read my prior article, and be sure to look out for more articles to come in the future!

Written by George Chant

Related article: Explaining altruism

References:

Knetsch, Jack L. “The Endowment Effect and Evidence of Nonreversible Indifference Curves.” The American Economic Review 79, no. 5 (1989): 1277–84.

John A. List, Does Market Experience Eliminate Market Anomalies?, The Quarterly Journal of Economics, Volume 118, Issue 1, February 2003, Pages 41–71,33