Econ 440: Lecture 7 on The Endowment Effect - Texas A&M University PDF

Econ 440: Lecture 7 Prof. Ragan Petrie Texas A&M University September 17, 2024 The Endowment Effect The Endowment Effect  The Endowment Effect Motivating Example ▶ Professor A likes to collect wine ▶ He will not pay more than $35 for a bottle ▶ Once he gets a...

Econ 440: Lecture 7 Prof. Ragan Petrie Texas A&M University September 17, 2024 The Endowment Effect The Endowment Effect  The Endowment Effect Motivating Example ▶ Professor A likes to collect wine ▶ He will not pay more than $35 for a bottle ▶ Once he gets a bottle, he will not sell it for less than $100 ▶ So, for a price between $35 and $100, will neither sell nor buy ▶ What is going on? ▶ Once he obtains the bottle, its value goes up ▶ This phenomenon is the endowment effect: owning an item changes its apparent value to the owner ▶ Explanation: prospect theory ▶ Before owning the bottle, reference point is not having it ▶ Once he owns the bottle, having it becomes the reference point ▶ Because of loss aversion, losing a bottle hurts more than gaining one feels good  The Endowment Effect The Classic Experiment ▶ Undergraduates participate sequentially in 11 markets for goods like pens and mugs ▶ Half of subjects randomly endowed with item ▶ Value of item for buyer and sellers gathered through price lists ▶ Buyers express willingness to pay (WTP) for items ▶ Sellers express willingness to accept (WTA) to give up items ▶ Items transacted at market prices Source: Kahneman, Knetsch, and Thaler (1991)  The Endowment Effect Results ▶ What relationship should we expect between WTP and WTA? > items were distributed randomly i.e. independent of student's actual value of item > so average value among sellers should be same as average value among buyers in expectation > that is, we expect WTP = WTA ▶ Results ▶ Median WTA (seller stated price) 2-3 times higher than median WTP (buyer stated price) ▶ Interpretation: Sellers’ stated price is higher because they are endowed with the items, and this increases their value ▶ We call this the willingness to pay vs willingness to accept gap Source: Kahneman, Knetsch, and Thaler (1991)  The Endowment Effect Loss aversion ▶ Loss aversion is one of the most well-supported theories from the field ▶ We already saw how it could explain behavior of cab drivers ▶ We will see two more famous examples today ▶ One additional real-world example, this time of professional golfers ▶ A laboratory experiment where reference points come from expectations  The Endowment Effect Is Tiger Woods Loss Averse? Is Tiger Woods Loss Averse?  The Endowment Effect Is Tiger Woods Loss Averse? Why Golf? ▶ Pope and Schweitzer (2011) examine observational data from professional golfers playing on the PGA tour ▶ Golf suggests a natural reference point for score on each hole: par ▶ Par is the number of strokes a professional golfer typically takes to complete the hole ▶ Because object of game is to minimize number of strokes, going below par is the gain domain and above par is the loss domain ▶ Terminology for going above or below par: ▶ Eagle: two shots below par ▶ Birdie: one shot below par ▶ Bogey: one shot above par ▶ Double bogey: two shots above par ▶ Stakes are very high: typical tournament pays out $5 million in prizes to the top finishers  The Endowment Effect Is Tiger Woods Loss Averse? Connection to Prospect Theory ▶ Let ∆x indicate the score relative to par ▶ Prospect theory value function (with no diminishing sensitivity): ( ∆x ∆x ≥ 0 v (∆x) = λ∆x ∆x < 0 ▶ Focus on putting (usually last 1-2 shots of the hole) ▶ Miss the putt for score ∆x − 1, or ▶ Make the putt for score ∆x ▶ Prediction: Putts attempted for par, bogey, and double-bogey will be more accurate than putts attempted for birdie and eagle putts in loss domain are more accurate than those in the gain domain due to loss aversion (desire to not putt too hard and end up far from hole; prefer to setup shot for par rather than putt too hard)  The Endowment Effect Is Tiger Woods Loss Averse? Value Function Applied to Golf  The Endowment Effect Is Tiger Woods Loss Averse? Results > on average, golfers 2-4 percentage points more likely to make putts for par from same distance as putt for birdie  The Endowment Effect Reference Points and Effort Provision Reference Points and Effort Provision  The Endowment Effect Reference Points and Effort Provision Expectations as Reference Point ▶ So far, we have mostly thought of a reference point as a fixed number, independent of the choice at hand ▶ However, it is possible that a reference point is based on the expected outcome ▶ For example, equal chances of getting $10, $40, or $50 ▶ Here, reference point of $0 makes little sense ▶ Getting $10 feels like a loss, while getting $40 or $50 feels like a gain ▶ So a more reasonable reference point might be the expected value: $10 + $40 + $50 = $33.33 3  The Endowment Effect Reference Points and Effort Provision Setup: Effort Task ▶ Abeler et al (AER, 2011) perform lab experiment where they manipulate expected payment for a task ▶ Task: count the number of zeros in an array of 150 randomly ordered ones and zeros ▶ This is really annoying Example ▶ Subjects performed as many of these tasks as they wanted, for up to 60 minutes ▶ One of two possible payment schemes ▶ With 50% probability, paid 10 cents per correct answer (piece rate) ▶ With 50% probability, paid a fixed amount: either 3 Euros (LOW treatment) or 7 Euros (HIGH treatment) ▶ Do not know which payment scheme will be used until after they have decided to stop working  The Endowment Effect Reference Points and Effort Provision Expected Results ▶ Assume that reference point for earnings is average of what subject will earn if paid piece rate and what subject will earn if paid fixed amount ▶ Which treatment would have higher effort? > This reference point should be higher for subjects in the HIGH treatment > Earning less than the reference point feels like a loss, so subjects work harder to get to reference point > Thus, subjects in the HIGH treatment are expected to work harder  The Endowment Effect Reference Points and Effort Provision Results