What Is Loss Aversion, Status Quo Bias, Endowment Effect?
0Endowment theory can be defined as "an application of prospect theory positing that loss aversion associated with ownership explains observed exchange asymmetries."
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Loss aversion
It was proposed by Kahneman and his colleagues that the endowment effect is, in part, due to the fact that once a person owns an item, forgoing it feels like a loss, and humans are loss-averse. They go on to suggest that the endowment effect, when considered as a facet of loss-aversion, would thus violate the Coase theorem, and was described as inconsistent with standard economic theory which asserts that a person's willingness to pay (WTP) for a good should be equal to their willingness to accept (WTA) compensation to be deprived of the good, a hypothesis which underlies consumer theory and indifference curves. However, these claims have been disputed and other researchers claim that psychological inertia
Psychological inertia
David Gal proposed a psychological inertia account of the endowment effect. For example, in the case of Kahneman et al.'s (1990) classic mug experiments (where sellers demanded about $7 to part with their mug whereas buyers were only willing to pay, on average, about $3 to acquire a mug) there was likely a range of prices for the mug ($4 to $6) that left the buyers and sellers without much incentive to either acquire or part with it. Buyers and sellers therefore maintained the status quo out of inertia. Conversely, a high price ($7 or more) yielded a meaningful incentive for an owner to part with the mug; likewise, a relatively low price ($3 or less) yielded a meaningful incentive for a buyer to acquire the mug.
Reference-dependent accounts
According to reference-dependent theories, consumers first evaluate the potential change in question as either being a gain or a loss. In line with prospect theory (Tversky and Kahneman, 1979), changes that are framed as losses are weighed more heavily than are the changes framed as gains. Thus an individual owning "A" amount of a good, asked how much he/she would be willing to pay to acquire "B", would be willing to pay a value (B-A) that is lower than the value that he/she would be willing to accept to sell (C-A) units; the value function for perceived gains is not as steep as the value function for perceived losses.
Others have argued that the short duration of ownership or highly prosaic items typically used in endowment effect type studies is not sufficient to produce such a connection, conducting research demonstrating support for those points (e.g. Liersch & Rottenstreich, Working Paper).
Greater sensitivity to market demands for sellers
Sellers may dictate a price based on the desires of multiple potential buyers, whereas buyers may consider their own taste. This can lead to differences between buying and selling prices because the market price is typically higher than one's idiosyncratic price estimate. According to this account, the endowment effect can be viewed as under-pricing for buyers compared to the market price; or over-pricing for sellers compared to their individual taste. Two recent lines of study support this argument. Weaver and Frederick (2012) A review of over 30 empirical studies showed that selling prices were closer to the lottery's expected value, which is the normative price of the lottery: hence the endowment effect was consistent with buyers’ tendency to under-price lotteries as compared to the normative price. One possible reason for this tendency of buyers to indicate lower prices is their risk aversion. By contrast, sellers may assume that the market is heterogeneous enough to include buyers with potential risk neutrality and therefore adjust their price closer to a risk neutral expected value.
Biased information processing theories
Several cognitive accounts of the endowment effect suggest that it is induced by the way endowment status changes the search for, attention to, recollection of, and weighting of information regarding the transaction. Frames evoked by acquisition of a good (e.g., buying, choosing it rather than another good) may increase the cognitive accessibility of information favoring the decision to keep one's money and not acquire the good. By contrast, frames evoked by disposition of the good (e.g., selling) may increase the cognitive accessibility of information favoring the decision to keep the good rather than trade or dispose of it for money (for a review, see Morewedge & Giblin, 2015).