Endowment Effect

Charlie Plott says that endowment effect has been thoroughly refuted. Need to follow up on this.

Some of the facts you reference have not been held up on close examination. The procedures used for both the "endowment effect",which has been rather solidly rejected, and the beauty contest suggest that the stories used to explain those results are not reliable (If you want I can send some references) and that the "effects" themselves are related to experimental procedures.

NOTES on “Mental Accounting” Lecture in Advanced Microeconomics,

by Dr. Asad Zaman

PURPOSE: Main purpose of the lecture was to show how consumers behave in ways that does not correspond to standard utility maximization theory. Secondary purpose to describe “Prospect Theory,” which does give a better model of how consumers behave.

ENDOWMENT EFFECT: The current ownership status of materials and money makes a big difference to how consumers behave. This is contrary to what economic theory assumes.

Example 1: I took Rs. 20 as entry fees, and later refunded it before the dollar auction. According to Economic Theory, this should make ZERO difference. However, in fact, it does make a difference. People think that this is “free” money, and they can do with it as they like. Remember the example from the notes of the couple who got $300 because their fish were lost by the airline. They had an expensive dinner with it that they would not ordinarily have had. In mental accounting people keep separate accounts for different headings – education budget, food budget, gifts budget, etc. Once the 20 Rs. is lost, it goes out of the normal budget. When received back as a gift, it becomes part of a separate account which can be spent more freely.

Example 2: We did an experiment in class, which had same results as usual all over the world: People are risk averse to gains, preferring to have $500 in cash rather than a equal chance gamble between $1000 and $0. People are risk loving for losses, preferring a gamble between losing $1000 and 0, to a certain loss of $500.

What is the Problem? How do these examples show that utility theory is wrong? After all, both risk loving and risk averse behavior can result from utility maximization?

The problem is that the endowment point changes – that is, losses and gains are judged from “Current Position” which keeps changing. The utility function is supposed to remain fixed. Studies of human happiness, satisfaction, well-being, etc. show that people get used to what they consume. If they acquire new goods, for a short time they are happy about the acquisition, but later on they consider it their right or normal level. The new goods do not give them the additional satisfaction, but if somehow they lose them, then they become very unhappy. For example, if people used to a very poor standard of life get an increase they are happy (temporarily, until they get used to it). But they become very unhappy if somehow they have to go back to the previous low life style – they are no longer used to it. This means that increasing consumption/wealth is not a very effective way of increasing happiness or satisfaction. Perhaps this is what is meant by the Quran when it says that:

(Q57:20) Know ye (all), that the life of this world is but play and amusement, pomp and mutual boasting and multiplying, (in rivalry) among yourselves, riches and children. (…). And what is the life of this world, but goods and chattels of deception?

Example 3: Risk of death – people who have already been exposed to a disease (this now becomes part of endowment) which may cause death will pay for a cure, but they will pay much less than what they will ask for if they are asked to expose themselves to a small chance of death. According to theory, these two numbers should be about the same – that is, if I pay $1000 for a cure for an existing condition, I should be willing to take $1000 to be exposed to a small chance of acquiring this condition. Again there is a very strong asymmetry between gains and losses judged from the current position.