What Is The Endowment Effect And Why Should We Care?

The endowment effect is considered by some to be a cognitive bias, while others call it a behavioral hypothesis. It has been investigated by several experts, including Daniel Kahneman and Richard Thaler, the latter the Nobel Prize winner in economics.

In short, the endowment effect suggests that people attribute a higher value  to possessions just because they are. This contradicts the premise of standard economic theory, which states that material goods have the same value for everyone.

Thus, the endowment effect makes us appreciate and depreciate things in economic terms, by a subjective dictation : ownership over them. This, of course, affects financial decisions, especially those that have to do with purchases and sales.

The endowment effect

Why do you place more value on things you already have as opposed to things you don’t have? Shouldn’t the opposite happen, that is, that the desire to acquire something that one does not have makes it overvalued? In principle, it could be thought that this is due to the sentimental value that people place on objects.

In this way, a person gives greater value to their home because they have spent memorable moments there and it is full of memories. However, there is a study that says otherwise. It was carried out by the University of Pittsburgh and the Georgia Institute of Technology.

Such a study exposes an interesting experiment. A group of volunteers was divided into two subgroups: sellers and buyers. The former were given a pen that they could sell for between € 0.25 and € 10. If they preferred, they could also stay with him. The second group was given money and could buy the pen or keep the cash.

Before starting the buying and selling, everyone was asked to write on a piece of paper with a pen. They should talk about a love affair from the past that hadn’t turned out well. Those who did then asked for a higher price for the pen during the transaction. Why? On the surface,  there was reluctance to dispose of an object that had been bonded with.

Loss aversion

In the experiment described, the object in question had been in people’s hands for only a few minutes. Still, it was enough to make them feel like it was their own and not a commodity that they could earn money from. In their minds this drove the price of the pen up. This is how the endowment effect works.

Everything indicates that part of this resistance to detach ourselves from the objects we possess, even sacrificing a possible gain, is due to another bias: aversion to loss. This has a lot to do with decision making. It has to do with the fact that letting go of something that we consider our own is experienced as a loss.

Loss aversion then leads to property ownership being overvalued. A person will only be willing to part with them if he considers that what he receives in return has at least the same value. Therefore, it raises the price, sometimes to irrational levels. Let’s think that the value we give to objects is, ultimately, subjective.

The endowment effect and decisions

Of course, the endowment effect gives a special color to different economic transactions. It affects financial decisions far more than some are willing to accept. Mark both small actions and large determinations.

It should be noted that this kind of attachment to what one possesses not only encompasses objects as such, but also ideas or habits. For example, a person may be in a financial crisis, but even then he is reluctant to buy his clothes in a store that is not his favorite. You experience possible change as a loss, and therefore often prefer to refrain from buying or losing money rather than change.

Likewise, when it comes to selling properties, such as houses or cars, many people waste valuable time offering them at a price that no one is willing to pay. Often times, there is no technical evaluation, but a light survey that results in a high price. In this way, the endowment effect comes to hinder a person’s financial rationality.