The Endowment Effect

Business Insider recently posted on why people have a tendency to value things higher when they own the property. Known as the Endowment Effect, it is an interesting and studied area of human behavior and economic theory.

As appraisers in today's marketplace we deal with this situation almost daily, having to tell people the value of their property is worth less than they expect, and in many circumstances, such as brown furniture, far less than expected. So when dealing with clients with depreciating objects, we get a double shot of telling bad news, one from the general marketplace and two, from the endowment effect.

Business Insider reports

Behavioral economists have pointed out dozens of ways in which human behavior deviates from standard economic theory.

As it turns out, our decisions and behavior aren't always rational, but are instead heavily influenced by emotions and cognitive blind spots.

One of the most well-known examples is the endowment effect, which describes our tendency to value things more highly when we already own them. If I'm trying to sell you my car, I might think it's worth $10,000, while you might think it's only worth $7,000.

The endowment effect was first identified by economist Richard Thaler in the 1970s. Thaler gave the example of a man who bought a case of wine in the late 1950s for about $5 a bottle. A few years later his wine merchant offers to buy the wine back for $100 a bottle and the man refuses, even though he's never paid more than $35 for a bottle of wine.

In 1990, Thaler, along with Daniel Kahneman and Jack Knetsch published experimental research that illustrated the power of the endowment effect.

For the study, college students were randomly assigned to one of three conditions: seller, buyer, or chooser. Sellers were given a university mug and asked if they would sell it for between $0 and $9.25. Buyers were asked if they would purchase the mug for a price in that range. Choosers were given the option at each price to choose between a mug and the same amount of cash.

Results showed that sellers (who already owned the mugs) placed a significantly higher value on the mugs than the other two groups did. Specifically, they required a median sum of $7.12 to give up the mug, while choosers said the mug was worth a median of $3.12 and buyers were willing to pay a median of $2.87.

The question is: What exactly causes the endowment effect?

Behavioral economists initially proposed that the effect occurred because humans are naturally loss-averse. We place more significance on losses (like giving away the car we've had for a decade) than we place on gains (like buying that used car).

More recent research suggests that ownership of an item creates a link between that item and our identity.

In 2012, Sara Loughran Dommer and Vanitha Swaminathan had undergrads role-play a transaction around a ballpoint pen. Specifically, "sellers" were given pens and asked whether they would prefer to keep the pen or exchange it for a cash amount between $0.25 and $10.00. "Buyers" saw the pen and decided whether to take the pen or a cash sum in that range.

Before the role play, experimenters asked some students to imagine a past relationship in which they felt unloved and write about their thoughts and feelings. Others wrote about an average day.

Results indicated that sellers who'd thought about rejection placed a higher value on the pen than students who'd written about an average day. But self-threat did not have the same effect on buying prices.

The researchers write: "After a social self-threat, individuals likely have strong possession-self links because possessions can enhance the self and help individuals cope with the threat." In other words, we may have a hard time separating from things once we feel like they're part of us.

Whether you're involved in a transaction for a mug, a pen, or a car, it helps to be aware of the endowment effect and its influence on our behavior. If you can take a step back and realize why an item is so meaningful to you or to someone else, you may have an easier time negotiating a favorable outcome.

Source: Business Insider