Working Paper

How Much Relevance Does Reality Imply? (Re)Considering the Endowment Effect

Jul 15, 2016 | Timothy J. Brennan

Summary

The endowment effect principle, that people’s preferences are relative to an anchor, is consistent with standard economics. But in and of itself, it does not explain differences between “willingness to pay” and “willingness to accept”.

Key Findings

  • Unlike claims that consumers make biased choices that do not reflect their underlying welfare, the endowment effect is consistent with neoclassical economics, which lacks theories of preference origin or form.
  • Examples where endowment effects may matter—in advertising or Buddhism, for example—suggest they are not easily malleable.
  • “Loss aversion” interpretations, as they concern decisions under uncertainty, do not help explain differences between willingness to pay and willingness to accept.
  • A fruitful interpretation of the endowment effect may be normative: Willingness to accept could be relevant to policy evaluations where consumers should have something they currently do not.

Abstract

A leading approach to understanding significant discrepancies between observed willingness to pay (WTP) and willingness to accept (WTA) in policy evaluation is the “endowment effect”—that preferences are based on a reference point or anchor that leads WTA to exceed WTP. Unlike assertions that consumers make biased choices not reflecting their underlying welfare, the endowment effect possibility is consistent with neoclassical economics. Examples where endowments matter suggest they are not malleable. WTA can exceed WTP if endowments differ across contexts. “Loss aversion” interpretations do not apply, as those concern the utility of money, not willingness to give up one good for another. Kinked indifference curves can increase WTA over WTP, but calling the quantity at the kink an “endowment” adds nothing to the concept. A likely interpretation of the endowment effect is normative: WTA should be relevant to policy evaluations where consumers should have something they currently do not.