Encyclopedia of Law & Economics - 0720 The Endowment Effect

0720

The Endowment Effect

Christopher Curran

Associate Professor, Emory University

© Copyright 1997 Christopher Curran



Contents

Abstract  
1. Introduction  
2. The Endowment Effect  
3. Format of the Experiments  
4. Preference for the Status Quo  
5. Prospect Theory  
6. Prospect Theory and the Endowment Effect  
7. A Neoclassical Explanation for the Endowment Effect  
8. Reception of the Endowment Effect in Law and EconomicsScholarship  
9. The Hovenkamp Critique  
10. On Using WTP or WTA Measures of Value  
11. The Superiority of the WTA Measure of Value  
12. The WTA Measure of Value and the Distribution of Income  
13. Overcoming Practical Problems  
14. A Logical Problem  
15. A Constitutional Solution to the WTP/WTA Disparity  
16. The Policy Makers' Problem  
17. Reflections from Public Choice Research  
18. Conclusion  
Bibliography on Endowment Effect (0720)  
Other References  




Abstract  

This essay reviews the literature on the endowment effect that challenges thevalidity of using neoclassical economic theory to evaluate legal issues. Whilea consensus does not yet exist, much of the research suggests that theendowment effect phenomena does not offer as much of a challenge toneoclassical economic theory as was once thought.

JEL classification: D0, D6

Keywords: Endowment Effect, Experimental Economics



1. Introduction  

This essay discusses the issue of whether the results of recent experimentalresearch on consumer behavior undermines the conclusions of neoclassicaleconomics enough to render arguments based on that theory incorrect. Thisentry is not a thorough review of the rich experimental economics literature (see Kahneman, Knetsch, and Thaler (1991) for summary of much of this research and Conlisk (1996) for a statement of the case for using the notion of boundedrationality in economics). Instead, we focus on the possibility that thephenomena known as the "endowment effect" may provide evidence thatquestions the applicability of some of the basic assumptions made byeconomists about consumer rationality. After describing the endowment effectand some of the theories used to take account of this effect, we recount howsome law and economics scholars use the endowment effect in their analyses.



2. The Endowment Effect  

The endowment effect arises when consumer's willingness to accept (WTA) fora good is greater than their willingness to pay (WTP) for it. While economistshave long recognized that an income effect may make cause the WTA to begreater than the WTP, they accepted the conclusion by Willig (1976) that thesedifferences should be small. While psychologists had noted a differencebetween the WTP and WTA as early as the 1960s (see Coombs, Bezembinder,and Goode (1967) and Slovic and Lichtenstein (1968) ), economists only beganto focus on the issue after observing this difference when using surveys tomeasure the value of environmental projects. When the economists askedconsumers about both their WTP and their WTA in these surveys, they foundthat the reported WTA is much larger than the reported WTP - much larger thanWillig's predictions suggest. Using students as subjects and goods such ascoffee mugs, candy bars, and trees as the commodities, experimental economistshave been able to find evidence that their subjects often have a WTA that issubstantially greater than their WTP. (see, for example, Bishop, Heberlein, andKealy (1983) , Knetsch (1984) , Knetsch and Borcherding (1979) , Knetsch andSinden (1984) , Brookshire and Coursey (1987) , Samuelson and Zeckhauser(1988) , Quattrone and Tversky (1988) , Donohue (1989) , Harless (1989) , Knetsch(1989) , Kahneman, Knetsch, and Thaler (1990) , Ortona and Scacciati (1992) , Boyce, Brown, McClellend, Peterson, and Schulze (1992) , Shogren, Shin, Hayes,and Kleibenstein (1994) , Loewenstein and Adler (1995) , Sileo (1995) , Pratt andZeckhauser (1996) for evidence about, explanations of, and implications of theendowment effect; Hoffman and Spitzer (1993) offer an excellent summary of theresults of both the empirical and theoretical research.)



3. Format of the Experiments  

The formats used these experiments follow a regular pattern. The experimentalresearchers randomly split the subjects into two groups. They give each of themembers of one group some object - say a coffee mug or a candy bar - and thenoffer to buy the object back from them using some truth-revealing mechanism.The researchers then give the members of the other group money and then allowthe subjects to purchase the object offered to the first group, again using atruth-revealing mechanism. (There are a large number of variations on thestructure of the various experiments; see these studies or Hoffman and Spitzer(1993) for more details of the different experiments.) The researchers reportpotentially conflicting evidence indicating (1) that the endowment effect ispersistent and substantive, (2) that the endowment effect, while evident initially,tends to disappear over time, and (3) that there is no difference in the WTP andthe WTA.



4. Preference for the Status Quo  

Studies that find evidence of the endowment effect suggest that consumers mayhave a greater preference for the status quo than what the assumption ofrationality implies. Several criticisms have been leveled at the studies that findevidence of an endowment effect. For instance, some authors reject the use ofhypothetical questions and experiments involving small amount of money asrevealing little about a subject's actual behavior in the market place (see Hoffmanand Spitzer (1993, n. 23 on p. 69) ). Other authors question whether the subjectsreally understand what they are being asked and whether the effect will remainafter repeated experiments. Unfortunately, the evidence on these points is mixed;while some studies find evidence that the WTP is equal to the WTA inexperiments involving simple securities (see Kahneman, Knetsch, and Thaler(1990, pp. 1329-30) and Harless (1989) ), other studies reach the oppositeconclusion for simple securities (see, for instance, Knez, Smith, and Williams(1985) ) and for more complicated securities involving risk (see, for instance, McClelland and Schulze (1991) ).



5. Prospect Theory  

The experimental evidence has generated several attempts to provide atheoretical explanation of the endowment effect. We briefly review two ofcontrasting explanations here, referring the reader to Hoffman and Spitzer (1993,pp. 85-96) , Radin (1982) , Heiner (1983) , and Thaler (1980) for examples of and afuller discussion of the theoretical literature generated by the endowment effect.The first of these explanations - usually identified as a version of "prospecttheory" - assumes that individuals have a preference for the status quo.Originally, Kahneman and Tversky (1979) suggested this model to describehuman behavior in risky circumstances. (Also, see Tversky and Kahneman(1991) and Tversky and Wakker (1995) .) Later, Thaler (1980) and Kahneman,Knetsch, and Thaler (1990) use elements from prospect theory to explain theendowment effect. Kahneman and Tversky (1979) assume that consumers havea value function that is positively sloped, concave for gains, and convex forlosses, implying that individuals are risk-averse with respect to gains andrisk-loving with respect to losses. Figure 1 illustrates the value functionsuggested by Kahneman and Tversky (1979) .

   

 

6. Prospect Theory and the Endowment Effect  

Figure 2 illustrates how prospect theory might explain the endowment effect. Westart with an individual owning quantity A of some good and ask how much hewould be willing to pay to acquire the larger quantity B. Thus, the verticaldistance between points D and C represents the WTP of this individual toacquire (B - A) units of the good. Now we compare this situation with the casewhere the individual already owns B units of the goods and is offered theopportunity to sell (B - A) units of the good. Since the individual actually ownsB units of the good, we begin at point E (shown in this case to be valued higherthan when the individual did not actually own the good, though it is notnecessarily of higher value) and move to point F. Thus, the vertical distancebetween E and F is the individual's WTA, which in this case is greater than hisWTP. The key point is that potential losses have a greater impact on theindividual's value than do potential gains.

   

 

7. A Neoclassical Explanation for the Endowment Effect  

The second explanation of the endowment effect, developed by Hanemann(1991) , implies that we do not need to scrap neoclassical economic theory togenerate large gaps between an individual's WTP and his WTA. Figure 3 , whichillustrates Hanemann's contribution, shows two indifference curves for somegood X and wealth. Consider an individual's WTP to move from point A wherehe has X 0 of good X to point B where he has the same wealth and X 1 of good X.Since the individual is indifferent between being at point A and point C, thevertical distance between points B and C measures how much this individual iswilling to pay to move to point B. Now consider how much this individual iswilling to accept to move from point B to point A. Since the individual isindifferent between being at points B and D, the vertical distance between A andD measures his willingness to accept the move from point B to A. Figure 3 shows the case where the individual's WTA is greater than his WTP. As Hanemann (1991) proves, the size of this difference depends on the elasticity ofsubstitution of the indifference curves - the more inelastic the indifferencecurves are, the larger is the spread between the WTA and the WTP. Put anotherway, the less substitutable a good is with money, the larger will be theendowment effect. More importantly, if Hanemann's hypothesis is correct, theendowment effect observed by experimental economists does not imply that theneoclassical analysis of welfare economics is fatally flawed. Shogren, Shin,Hayes, and Kleibenstein (1994) report the results of experiments that lendsupport to Hanemann's hypothesis.

   

 

8. Reception of the Endowment Effect in Law and Economics Scholarship  

Scholars in law and economics have given the endowment effect a mixedreception. Some authors such as Knetsch and Borcherding (1979) , Hovenkamp(1991) , Hoffman and Spitzer (1993) , and Fischel (1995) accept the endowmenteffect as a real phenomena with serious implications for the study of legal issueswhile others such as Curran and Rubin (1995) , while analyzing the implicationsof the endowment effect, seem to doubt its existence. A majority of legalscholars ignore the existence of an endowment effect.



9. The Hovenkamp Critique  

Hovenkamp (1991) claims that the endowment effect has very significantimplications for the study of law and economics because it potentiallyundermines the validity of traditional results from welfare economics. AsHovenkamp argues, the equality of WTP and WTA is central to the constructionof demand curves, the estimation of consumers' surplus, the use of cost-benefitsanalyses, and the use of indifference curves. He carries the argument furtherwhen he suggests that, when the endowment effect exists, "the person has noindifference curve." Hovenkamp (1991 p. 226) Thus, he concludes that anendowment effect that is "substantial and ubiquitous could make" the tools ofwelfare economics "virtually useless." Hovenkamp (1991, p. 227)  



10. On Using WTP or WTA Measures of Value  

Having rejected the traditional tools of neoclassical welfare analysis as virtuallyuseless, Hovenkamp tackles the problem of whether courts should continue usethe market price, which is equal to the WTP, as a measure of the value ofproperty in cases involving eminent domain, environmental regulation, and torts.While Hovenkamp's reasoning differs from that used in earlier studies by Knetsch and Sinden (1984) and Kennedy (1981) , he reaches the similarconclusion that courts should use WTA as a measure of value. Moreover,Hovenkamp argues that in the presence of a large endowment effect, "thewealth-maximizing state may find it appropriate to intervene on behalf of the poormore often than under traditional efficiency models." Hovenkamp (1991, p. 228)  



11. The Superiority of the WTA Measure of Value  

It is useful to review Hovenkamp's reasoning. Consider an entitlement in a worldwith significant differences in individual's WTP and WTA. There is anindividual who has the largest WTA if he owns the entitlement - say individualA. Additionally, there is an individual - say individual P - who has the largestWTP for this entitlement. In a competitive world with transacting being costless,ownership of the entitlement will end up with individual P unless it originallybelongs to some individual with a WTA that is higher than the WTP ofindividual P. Hovenkamp argues that, while this outcome is Pareto optimal, thereexist other arrangements where the total wealth of society is higher. In particular,social wealth is maximized if entitlements begin in the hands of those who havethe largest WTA - person A in our example. Thus, Hovenkamp concludes thatentitlements should be assigned to those with the highest WTA.



12. The WTA Measure of Value and the Distribution of Income  

Hovenkamp connects his analysis to income redistribution by arguing that,while there are no systematic differences in individual's WTA associated withincome differences, there is good reason to believe that an individual's WTP isa positive function of income. Moreover, Hovenkamp argues that theWTA-to-WTP ratio is much higher for the poor than it is for the rich, a point that Curran and Rubin (1995) implicitly do not accept in their criticism of Hovenkamp.By Hovenkamp's logic, transferring endowments to the poor from the rich willincrease the total amount of social value.



13. Overcoming Practical Problems  

One of the practical difficulties of using WTA as a measure of value when theWTA and WTP measures differ is the fact that no one ever observes WTA.Clearly, market prices are an accurate measure of the WTP of the purchaser andthe WTA of the seller; they provide little information about the buyer's WTAonce he is the owner. This measurement problem is especially important in thinmarkets where there are few substitutes for the good or where a good cannot bebought and sold. A piece of land that has sentimental value for the currentowner is an example of a good with few substitutes while environmental goodslike clear air and water are examples of goods that have no recognizable markets.Hovenkamp Hovenkamp (1991, pp. 238-243) recognizes this difficulty with usingWTA as a measure of value. He suggest, however, the fact that economic theoryoffers policy makers little aid in measuring WTA does not mean that they cannotuse the concept. He suggests that policy makers should turn to psychologistsand sociologists for aid in measuring WTA. Researchers in these fields,Hovenkamp contends, have many tools - surveys, questionnaires, interviews,and tests - that would help in the measurement of WTA. Gathering thisinformation is costly. When costs become prohibitive, Hovenkamp suggeststhat policy makers resort to generalizations. As an example of such ageneralization, Hovenkamp (1991, p. 243) suggests the fact that biologicalorganisms have "a common set of survival needs and perhaps a common set ofminimal needs for social productivity" implies that policy makers can assumethat goods such as these have a WTA that is systematically greater than theirWTP. Economists aware of the problems of rent-seeking common togovernments -- and well-documented in the public choice literature -- probablywill not share Hovenkamp's faith in the ability of policy makers to correctlyidentify what goods belong to the "common set of survival needs."



14. A Logical Problem  

The fact that Hovenkamp rejects neoclassical economic theory presents him witha logical problem - what, if any, parts of the economic model can he use in hisanalysis? Clearly, Hovenkamp offers a theory that purports to differentiateamong the various Pareto optimal points. However, Hovenkamp (1991, p. 230) does not explain what he means by "Pareto optimality" in a world whereindifference curves do not exist. Hovenkamp does not resolve this logicalproblem by constructing a completely new model of human behavior to replacethe neoclassical economic model. Instead, he assumes that consumers' WTA islarger than their WTP and then borrows concepts from the neoclassical modelwhen he needs them. While Curran and Rubin (1995) temper their analysis withexpressions of concern, they also mix the results of neoclassical welfareeconomics in their criticism of Hovenkamp (for which Fischel (1995, p. 200) criticizes them).



15. A Constitutional Solution to the WTP/WTA Disparity  

Fischel attempts to skirt this problem by substituting "constitutionalism" forwelfare economics. Fischel argues that the participants at the Federal and themany state constitutional conventions knew about the endowment effect whenthey specified that the market price (WTP) and not the WTA was to be themeasure of just compensation for eminent domain cases. Fischel argues that theparticipants of these constitutional conventions understood that using WTP asa measure of value would increase the ability of the government to exercise itseminent domain powers. Fischel suggests that one reason these individualsconsistently choose to use the WTP measure of value is that they understoodthat using WTA as a measure of value would deter the development of thenation's infrastructure that is so important for economic growth. Moreover, hesuggests that individuals may have an endowment effect when it comes to theirearnings. Fischel posits that in resolving how to measure "just" compensationin eminent domain constitution designers considered both (1) the public gain tosociety from the taking versus the private loss to the property owner and (2)impact of the endowment effect on the property owner (of his land) and on thetaxpayer (on his earnings). The resolution was to use WTP as a measure ofvalue. Thus, since this resolution of the issue was by the conscience choice themembers of constitutional conventions, Fischel concludes that "the offer/askdisparity may undermine welfare economics less than is usually supposed." Fischel (1995, p. 187)  



16. The Policy Makers' Problem  

Many may not find Fischel's assurances that the members of the variousconstitutional conventions considered and correctly solved the WTP/WTAdisparity issue satisfactorily. The dilemma facing society is that in decidingwhether to pursue a project policy makers need to determine if the project ispotentially Pareto improving. To make this determination, they have to estimatethe costs of the project where these costs include the losses in value sustainedby property owners affected by the project. Currently, in the United Statescourts use the market value of the property - that is, the WTP - plus someamount to cover any losses to the owner due to inconvenience. The advantageof using the WTP is that it is generally inexpensive to measure and avoids thestrategic problems inherent in convincing an individual to reveal his true WTA.As long as the property is a close substitute for wealth, using WTP has theadditional advantage of closely approximating WTA. However, in cases wherethe property involved has a great deal of sentimental value - for instance, whenone's ancestors are buried on the land that is to be flooded in order to build adam - the use of WTP may substantially underestimate WTA and may lead tothe completion of projects that are not Pareto improving.



17. Reflections from Public Choice Research  

Public choice research suggests further complications in restricting governmentproject to those that are Pareto improving. (For examples of public choiceresearch on income distribution see Hochman and Peterson (1974) , Gaertner andPattanaik (1986) , Lee and McKenzie (1990) , Olson (1987) , Rowley and Peacock(1975) , Stigler (1970) , Tullock (1971) , Tullock (1983) , and Tullock (1986) .) Interestgroups and politicians often have incentives to engage in rent-seeking activitiesthat would cause them to systematically ignore WTA measures in favor of thelower WTP measures. For instance, de Alessi (1960) recounts the manydistortions created by government officials in an effort to use cost-benefitanalysis to justify public projects. Thus, the fact that the members of the federaland various state constitutional conventions generally were politicians whoeither were members of various interest groups or may have been readilyinfluenced by representatives of these interest groups undermines Fischel'sconstitutional justification for measuring value with market prices. On the otherhand, it would be surprising if economic scholars find Hovenkamp's conclusionthat sociologists and psychologist have tools for accurately measuring WTAto be very convincing.



18. Conclusion  

The obituary for neoclassical economics surely is premature. As Hanemann(1991) , Shogren, Shin, Hayes, and Kleibenstein (1994) , and Calfee and Rubin(1992) demonstrate, neoclassical economic theory predicts that the ratio ofWTA-to-WTP can take on any value, depending of the elasticity of substitutionbetween a good and wealth: the lower the elasticity of substitution, the larger theratio of WTA-to-WTP will be. Moreover, as the leading proponent ofexperimental economics Smith (1991, p. 894) observes, for all its deficienciesstandard models of economic behavior based on individual rational choice areexcellent predictors of actual behavior observed "in the social context ofexchange institutions." It would seem rash to toss out all of neoclassicaleconomic theory based solely on the evidence offered by the endowment effect.



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© Copyright 1997 Christopher Curran