How Will the "Endowment Effect" Affect You?
New research shows experience in trading lessens this economic bias
Posted Aug 05, 2016
When was the last time you sold something? Is the price you listed it for really what you would be willing to pay to purchase it? Chances are, likely not. This is due to a phenomenon called the 'Endowment Effect', wherein we irrationally ascribe a higher price value to something just because we own it. Or, as the economist who coined the term, Richard Thaler, noted, "goods [that] are included in the individual’s endowment will be more highly valued than those not held in the endowment, ceteris paribus.”
Also known as "divestiture aversion", there are two psychological reasons why we might be willing to sell something for more than we'd be willing to pay for it: loss aversion and ownership. First, people are inherently loss averse: We can justify 'losing' something that is in our possession (through selling it) if someone is willing to pay a premium for it. Second, we also tend to activate the endowment effect when we feel a sense of ownership or possession over a certain item, which tends to be particularly true for Westerners. For instance, as past research found, if we own a specific coffee mug and are asked to sell an identical coffee mug, we will nonetheless sell the mug for more than we'd be willing to pay for it because we happen to own the same one.
While on the surface, this may sound like a bias which has the potential to yield positive results (after all, maybe someone will be willing to pay the price you set, even if that someone isn't necessarily you), but, as economists have found, the endowment effect, in fact, distorts market prices and reduces trade. As new research, published in the Proceedings of the National Academy of Sciences, has found, with a little experience in trading, our economic bias is lessened.
The research, titled "Trading experience modulates anterior insula to reduce the endowment effect", first began with scanning the brains of 18 experienced eBay traders versus 12 inexperienced traders who were shown four items for which they had to assign a selling price. The participants were then presented with each item separately and asked to accept or reject an offer to buy the product. The offers consisted of 15 prices below their suggested selling price, 15 items above, and 1 which equalled the selling price. Participants were asked to hold four wooden blocks in their hand and pretend they were the items presented, in order to encourage them to feel more strongly towards them. In comparison to inexperienced traders, the fMRI scans of those well-versed in the trading world showed decreased activity in the brain's right anterior insula, an area of the brain which may be responsible for anticipating and avoiding losses.
The second study asked 15 inexperienced traders to sell items on eBay for a period of two months, or, roughly, 20 trades, conducting brain scans before and after using the same study procedures as the first experiment to see if experience would make any marked changes. Indeed, they found that gaining trading experience resulted in decreased activity in the right anterior insula, thus reducing the endowment effect.
As the authors conclude, "When [the selling price] is generally greater than [the buying price], buyers and sellers are less likely to agree on a price, resulting in undertrading in real markets. Our results suggest that even a modest amount of trading experience may help eliminate such inefficiencies in part through reducing the influence of loss aversion."
Morewedge, C. K., Shu, L. L., Gilbert, D. T., & Wilson, T. D. (2009). Bad riddance or good rubbish? Ownership and not loss aversion causes the endowment effect. Journal of Experimental Social Psychology, 45(4), 947-951.
Thaler, Richard (1980). "Toward a positive theory of consumer choice". Journal of Economic Behavior & Organization. 1 (1): 39–60. doi:10.1016/0167-2681(80)90051-7.
Tong, L. C., Karen, J. Y., Asai, K., Ertac, S., List, J. A., Nusbaum, H. C., & Hortaçsu, A. (2016). Trading experience modulates anterior insula to reduce the endowment effect. Proceedings of the National Academy of Sciences, 201519853.