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Is the endowment effect really irrational?

What's it worth?
There's nothing a psychologist likes better than to wind up an economist, and in the 70s psychology succeeded big time with the endowment effect. Economics expects us to give an object a value, and that value should determine how we would price it to buy it or sell it. But experiments have shown that we value something we own a lot more than the same object if we don't own it.

Economists, and us sciencey types who want people to be more rational, tend to highlight the endowment effect as one of the 'errors' people suffer from in making rational decisions. But I'd suggest, as is often the case in science, it's more complicated than that.

Here are two suggestions as to why the endowment effect can be just as rational as an other approach. I'm going to take a variant of the original experimental demonstration of the endowment effect to show this. In our experiment, some participants are given a mug, then later asked how much they'd accept to sell it back. Others are asked what they would pay to buy the same mug. Those who have been given the mug tend to value it around twice as highly as those who are asked to buy it. But is that really as irrational as some seem to think?

Firstly there's incomplete knowledge. Traditional economics assumes that we have complete knowledge to be able to make a rational decision. But the real world isn't like that. If I've got the mug, I have more knowledge than if I don't. I know, for instance, that it's a solid product that exists and that the other person can't cheat me in the sale. But in the other scenario, I could get ripped off in all sorts of dodgy trader fashions. It's reasonable to value a product you have more information on higher than one you know less about.

That's a well-known challenge to considering the endowment effect an error. But I think there's another one that is less frequently mentioned. Like many people, I've got plenty of mugs. I'll take one if you give it to me, but I'm not going to buy one, even for a small amount. I don't need any more mugs. So my 'what will you buy it for' value is very low. But if I have a mug and you say you'll pay me money for it, I obviously want to maximise my return. I'm not going to say 'It has no value to me, so you can have it for free.' I'll ask what I think I can get away with, based on the typical price of mugs in shops - inevitably a much higher value than my own.

So, next time you see one of those lists of ways humans don't act rationally and it includes the endowment effect, bear in mind that people aren't as simple as this kind of analysis suggests.


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