Endowment Effect

A principle in behavioral psychology that describes the tendency of people to value an object that they own higher than they would value the same object if they didn’t own it

What is the Endowment Effect?

The endowment effect is a principle in behavioral psychology that describes the tendency of people to value an object that they own higher than they would value if they didn’t own it. Their valuation of an owned object will often be higher than its true fair market value. The endowment effect is also sometimes referred to as the “ownership effect.”

 

Endowment Effect

 

The endowment effect means that the highest price that people are willing to pay for an object that they don’t own is typically less than the lowest price they would be willing to sell the object for if they owned it.

In the classic experiment done to confirm the endowment effect, participants were given a mug and then asked if they were willing to trade it for some Swiss candy that actually had a higher retail value. Despite such a fact, 80% of the participants were unwilling to make the trade.

The cause of the endowment effect is frequently assumed to be related to loss-aversion psychology – a theory that states that people ascribe a higher value to losing something than they do to obtaining something. For example, one study found that employees worked harder to ensure that they maintained their qualification for a bonus that had already been provisionally awarded to them than they did for a higher bonus that they could earn in the future.

 

Summary

  • The endowment effect is a principle in behavioral psychology that describes the tendency of people to value an object that they own higher than they would value if they didn’t own it.
  • Various theories – including loss aversion, psychological inertia, and attachment – have been put forward to explain the endowment effect.
  • In business and finance, the endowment effect has implications both for marketing and for investing.

 

Explaining the Endowment Effect

In addition to loss aversion, a number of other psychological theories have been proposed to explain the endowment effect.

The psychological inertia theory states that people tend to opt for a state of “no change” – including retaining ownership of items they already have – unless they are presented with a substantial inducement to change the status quo in their lives.

Connection-based or attachment theories posit that people form an emotional attachment to things that they own that extends beyond an item’s material value, that once a person owns an item, it becomes a part of their self-identity. Thus, losing the item through selling it is emotionally perceived as a threat to who the person sees themselves as being.

 

The Endowment Effect in Investing

The endowment effect has been demonstrated many times in the area of investing. Time and again, investors have been shown to be reluctant to part with a poorly performing stock that they already own and less inclined to exchange it for ownership of a similar but better-performing stock. This type of behavior would seem to support the attachment theories put forward to explain the endowment effect.

 

Implications for Marketing

Awareness of the endowment effect has significant implications for the marketing of products, and businesses have tried in several different ways to incorporate it into their sales tactics.

A classic example of attempting to use the endowment effect to increase sales of a product is the free trial. Car dealerships often let a prospective buyer take home a car they are considering purchasing and drive it around for two or three days at no cost. It is an obvious attempt to engender a sense of ownership and attachment that will make someone more likely to go ahead and purchase the car.

Other items are offered to consumers on a 30-day free trial basis. It is, again, a tactic designed to create a psychological perception by the consumer that they already own the item, thus making them reluctant to part with it at the end of the trial period.

Other companies have employed sales tactics that fall short of actual physical possession of a product, but that nonetheless aim to create some sense of ownership attachment within a potential buyer. For example, Converse enables potential buyers to select the color or design for a pair of shoes with computer imaging. This act of personalizing their purchase has been shown to be effective in making consumers more likely to buy.

Apple stores, in hopes of engendering a feeling of attachment, allow browsing customers to freely handle products as much as they like. A more subtle attempt to leverage the endowment effect occurs when companies use the second-person form of address in describing their products – e.g., “Your (product “x”) will make your morning routine easier and more enjoyable.”

 

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