Endowment effect: what is it and how does it affect decision making?

The endowment effect has a very significant impact on our buying and selling decision making.

Typical situation in every household with babies and children. The child is playing with all but one of his toys. We pick up the toy and he starts pouting. He feels he is losing something, something that gives him great value for one simple reason: it is his.

This phenomenon can be extrapolated to the adult world and especially in the buying and selling of products. It's called the endowment effect, and there's a lot of psychology and scientific research involved.. Let's discover it below.

What is the endowment effect?

The endowment effect is a psychological phenomenon that occurs when people attribute more value to things solely by virtue of possessing them.. In other words, it is about overvaluing what we already have and fearing, more or less rationally, losing it.

Although things have an objective value, the subjective value that we can attribute to them is very variable depending on whether we already possess them or, on the contrary, we want to acquire them. This is very easily understandable having in mind situations in which economic transactions take place. The seller will place a higher value on the object he wants to sell compared to the buyer, who will want to acquire it at a lower price.who will want to acquire it at a low price. For this reason, in places without fixed prices such as flea markets it is so common to see haggling.

Based on this, it can be understood that the endowment effect, insofar as it is a bias, makes it impossible to make an objective analysis of the value of a given good. That is why in many economic situations the intervention of a professional, such as an appraiser or manager, is necessary to give the price that the product you are trying to sell and buy deserves.

Research on this effect

The endowment effect was originally described by economist Richard Thaler who, together with Nobel Prize-winning economist Daniel Kahneman and his colleague Jack Knetsch saw how this particular effect developed, as well as addressing it experimentally.. The first thing that got them thinking about it was the particular case described below.

A person had bought a case of wine in the 1950s. Each bottle had been purchased at a price of about $5. Years later, the person who had sold the bottles showed up and offered to buy the bottles back from the new owner at a price much higher than the original price: $100 per bottle, i.e., 20 times the original value. Despite the succulent offer, which implied earning $95 more for each bottle, the new owner of the bottles refused to resell them..

Faced with this curious case, Thaler's group set out to experimentally address this effect, this time in laboratory conditions and with cheaper objects: cups and chocolate bars.

In one of the first experiments, the participants, who were students, were divided into three groups. A group of buyers, a group of sellers and a group that had the option of buying or receiving money for a given product.

In the sellers' group, participants had to sell their cups at prices ranging from $1 to $9.25. In the group of buyers, the buyers had to purchase the mugs by offering bids of no more than $9.25 either. The third group had to choose between the mug and the amount of money offered as a bid.

Differences were seen in the value of the mug depending on the role of the participant.. On average, the sellers sold their mugs at prices close to $7, while the buyers wanted to purchase them at prices no higher than $3. Those who had the option of acquiring the mug or a cash offer accepted around $3.

In another experiment, instead of putting money in the middle, participants were given one of two things: either a mug or a bar of Swiss chocolate. After giving each participant one of these two objects at random, they were told that they could keep what they had been given and exchange it with other people in case they would have preferred to have the other object. The majority of participants, both those with the mug and the Swiss chocolate, chose to keep what they had been given..

What causes this phenomenon?

It is possible that a certain sentimental attachment to that object has been generated, which makes it difficult to part with it, since it is seen as losing a part of oneself. This is very easy to see when we shared a toy in childhood with a sibling or a friend. We were afraid that it would get lost or broken, and we preferred to keep it by our side.

Another way to understand it, from a more adult point of view, is the valuation we make of the value of our home compared to that of others. It is possible that, in terms of quality and quantity of square meters, all these houses are equal, but as a general rule we attribute a higher price to our own house than to others.

This sentimental value can be generated very quicklyIt does not need to be very deep for the endowment effect to occur. In fact, this is demonstrated by research conducted by the Georgia Institute of Technology and the University of Pittsburgh by Sara Loughran Sommer and Vanitha Swaminathan.

In this experiment, subjects acted as both sellers and buyers. Sellers were given a pen that they could sell for values between $0.25 and $10, with the option of buying it from them as well. Buyers could either buy the pen for a price in that range or keep the money.

Before the study, half of the participants were asked to think of a past love relationship that did not go well and write about it with the pen the researchers gave them. The other half were asked to write about something everyday, without much sentimental value.

The salespeople who wrote about the love relationship tended to put a higher price on the pen, from which it can be concluded that the pen had a higher value.From this we can conclude that it is harder for us to get rid of an object once a bond is created with that object.

What does this have to do with loss aversion bias?

Part of not wanting to get rid of something has to do with another cognitive bias, in this case that of loss aversion. This bias is of great importance in day-to-day life, since it is one of the psychological is one of the psychological phenomena that most strongly affects all of our daily decision making.

Getting rid of something, even if it is done voluntarily, can be interpreted as a loss, and no one wants to lose. The human being is an animal that wants to retain as long as possible any property he has in his hands. It is for this reason that, although completely consciously, when we have to decide to eliminate something from our lives, we try to avoid it, giving it a higher value than it really has, sabotaging a sale or preventing us from sharing it with others.

According to Thaler, the buyer sees acquiring a new object as something pleasurable, a need that, although not real, must be satisfied. On the other hand, the seller sees the parting with the object as a loss, something that, in spite of being repaid with money, he is not willing to feel..

What implications can this have in the commercial world?

Although we have explained the endowment effect in terms of buyers and sellers, the latter being less likely to give a low value to their product, it is true that it can be used as a beneficial commercial tactic for those who, at first, seemed to be harmed by this psychological phenomenon.

Many stores have been able to use this psychological effect. In order to get customers to buy a particular product once they have focused their attention on it, store managers often allow customers to touch and handle the objects they are interested in.. In this way, by holding it in your hands, you may unconsciously be developing a certain emotional bond, which will make it harder for you to refuse to buy it.

However, one of the situations in which this phenomenon is most detrimental is in finance and the stock market. Many people who are involved in the world of stock trading sometimes unwittingly hold on to certain possessions, which causes them to make financial mistakes.

Investing in the stock market implies having to make very conscientious decisions. If among these decisions is that of being too cautious, avoiding selling when the market signals that the time is right, you will start to make losses which, ironically, is what you avoid having when the endowment effect occurs.

Bibliographical references:

• Carmon, Z.; Ariely, D. (2000). "Focusing on the Forgone: How Value Can Appear So Different to Buyers and Sellers". Journal of Consumer Research. 27 (3): 360-370. doi:10.1086/317590. doi:10.1086/317590.
• Dommer, S. and Swaminathan, V. (2013). Explaining the Endowment Effect through Ownership: The Role of Identity, Gender, and Self-Threat. Journal of Consumer Research. 39. 1034-1050. 10.1086/666737.
• Kahneman, D.; Knetsch, J. L.; Thaler, Richard H. (1991). "Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias". The Journal of Economic Perspectives. 5 (1): 193–206. doi:10.1257/jep.5.1.193.