Article Review

Would you give up your favorite shoes to get your money back?

Prospect Theory highlights the fundamental role of the Endowment Effect in trading goods: the value people give to certain goods is highly influenced by their initial endowment (reference point).

In an experiment carried out in 1989 by Jack L. Knetsch, a Canadian economist, students were divided into three classes each faced with the possibility of obtaining a prize (coffee mugs or Swiss chocolate) as compensation for completing a questionnaire. At the beginning of the experiment, participants in the first class were given the opportunity to win a coffee mug, those in another class a bar of Swiss chocolate, and students in the third class were free to choose between the mug and the chocolate bar.

After completing the questionnaire, the students in the first two classes were asked if they wanted to exchange their prizes (those who were given the mug could exchange it with the chocolate bar and vice versa). 89% of those initially endowed with the mug decided to keep their prize, and only 10% of those endowed with the chocolate bar decided to exchange it for the mug. In the third class (where students were free to choose between the mug and the chocolate bar), 56% chose the mug.

What is clear from this experiment, and from many others similar to this one, is that people tend to increase the value they give to an object as soon as they’re endowed with it. In the previous experiment, most of those initially endowed with the mug were not willing to trade it for the chocolate bar, and the same was true for those endowed with the chocolate bar. However, this pattern cannot be explained only by differences in preferences: the choice made by the third class confirmed that mugs and chocolate bars were initially valued very similarly by the students (56% vs 44%).

From an economic point of view, the results found in the experiment show that the willingness to buy or sell a good depends on the reference point. In particular, these results highlight the importance of loss aversion in the decision of exchanging one good with another (or, as we’ll see, with money). The pain of giving up a certain good that we already own is higher than the pleasure of getting the same (or similarly valuable) good.

It is important to specify that loss aversion does not appear when we are talking about commercial exchanges (a shoes manufacturer doesn’t feel bad in exchanging the shoes he sells for 60 bucks because both his shoes and your money are intended to be traded). It is instead relevant when goods are held for use, to be consumed, or enjoyed. 

The Endowment Effect, based on the principle of loss aversion, is a fundamental pillar of Prospect Theory, developed by Daniel Kahneman and Amos Tversky in 1979, described in Kahneman’s book “Thinking, fast and slow” (you can find our review here).

In another experiment carried out by Knetsch, Richard Thaler, and Daniel Kahneman, author of the book previously mentioned and winner of the Nobel Prize in Economics in 2002 for his work on Prospect Theory, participants were divided into three groups:

  • Sellers: each of them was given a coffee mug worth around $6. They were then asked if they were willing to trade it at a series of prices ranging from $0.25 to $9.25.
  • Buyers: they were asked if they were willing to buy a mug at the same range of prices.
  • Choosers: they were asked to choose, for each of the prices mentioned, between receiving a mug or the corresponding amount of money.

The median reservation prices were $7.12 for Sellers, $3.12 for Choosers, and $2.87 for Buyers. From this experiment, we can notice two remarkable findings.

  1. There is a considerable difference between the average buying price and selling price (which is more than double the buying price).
  2. There is a considerable difference between Choosers’ average price and Sellers’ average price.

Because of loss aversion, Sellers are willing to sell their mugs at a price that is higher than the actual value of the mug and which is more than double the amount Buyers are willing to spend for it.

Furthermore, Choosers and Sellers face the same choice. They can either go home with a certain amount of money or with a new mug. Nevertheless, the price at which Sellers are willing to sell their mugs is almost double the price that Choosers set for taking it!

The findings shown by these and many other experiments underline a wrong rule in Standard Economic Theory, for which two indifference curves never intersect. That is due to the assumption that indifference curves are reversible, for which an individual indifferent between two goods X and Y will always be willing to trade one good for the other because his Utility remains constant. However, considering loss aversion, this is not true anymore: the reference point, in our examples the initial endowment, has an impact on the trading with (initially) equally valuable goods!

Cover picture: Unsplash


Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s