The endowment effect: It’s mine, I tell you

Mankind’s inner chimpanzee refuses to let go. This matters to everything from economics to law

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“I AM the most offensively possessive man on earth. I do something to things. Let me pick up an ashtray from a dime-store counter, pay for it and put it in my pocket—and it becomes a special kind of ashtray, unlike any on earth, because it’s mine.” What was true of Wynand, one of the main characters in Ayn Rand’s novel “The Fountainhead”, may be true of everyone. From basketball tickets to waterfowl-hunting rights to classic albums, once someone owns something, he places a higher value on it than he did when he acquired it—an observation first called “the endowment effect” about 28 years ago by Richard Thaler, who these days works at the University of Chicago.

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The endowment effect was controversial for years. The idea that a squishy, irrational bit of human behaviour could affect the cold, clean and rational world of markets was a challenge to neoclassical economists. Their assumption had always been that individuals act to maximise their welfare (the defining characteristic of economic man, or Homo economicus). The value someone puts on something should not, therefore, depend on whether he actually owns it. But the endowment effect has been seen in hundreds of experiments, the most famous of which found that students were surprisingly reluctant to trade a coffee mug they had been given for a bar of chocolate, even though they did not prefer coffee mugs to chocolate when given a straight choice between the two.

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Moreover, it is now possible to see the effect in the brain. In the June 12th edition of Neurone, Brian Knutson of Stanford University describes a brain-scanning study he carried out recently. The pattern and location of the activity he observed suggests the endowment effect works by enhancing the salience of possible loss. But that still does not explain why this sense of loss should be felt. The question is whether such behaviour is truly irrational, or just “differently” rational. That might be the case if, for instance, it was a hangover from the evolutionary past that worked then, but is no longer appropriate now.

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Mug’s game
The endowment effect has nothing to do with wealth (it is not as if chocolate bars and coffee mugs matter) or transaction costs (in most experiments these are zero). Not even emotional attachment, whatever that means, can really be called in as an explanation, since the effect is both instantaneous and sometimes felt even by those who buy and sell for a living. According to Pete Lunn, an economist at the Economic and Social Research Institute in Dublin, professional market traders are often reluctant to sell investments they already hold, even though they could trade them for assets they would prefer to invest in if starting from scratch.

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Keep on trucking
Because the endowment effect touches on so many areas, Dr Jones thinks it may be helpful for legislators to understand its evolutionary origins. That goods and rights such as pollution permits, radio spectrum and mobile-telephone licences do not inexorably flow towards the most efficient distribution worries the legal scholars charged with designing fair allocations. The effect also complicates the negotiation of contracts, as people demand more to give up standard provisions than they would have been willing to pay had they bargained anew.

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Nor is the endowment effect alone in suggesting that Homo economicus is a rarer species than neoclassical taxonomists would like to believe. Other “irrational” phenomena include confirmation bias (searching for or interpreting information in a way that confirms one’s preconceptions), the bandwagon effect (doing things because others do them) and framing problems (when the conclusion reached depends on the way the data are presented). All in all, the rational conclusion is that humans are irrational animals.

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Related books:
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Nudge: Improving Decisions About Health, Wealth, and Happiness
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Predictably Irrational: The Hidden Forces That Shape Our Decisions (Also available in an AUDIO BOOK)