The Endowment Effect

Have you ever had an item of yours appraised – perhaps a laptop you were hoping to trade in for store credit – and been disappointed by the estimated value of your item? This cognitive bias is known as the endowment effect: the human tendency to attach more value to items we own simply because they belong to us.⁵  In other words, once we own something, we value it more.

Loss aversion: Loss aversion was first termed by Amos Tversky and Daniel Kahneman in 1979. It is a cognitive bias describing that the pain of losing is psychologically more powerful than the pleasure of gaining.⁸ Loss aversion is a foundational concept of prospect theory.

Prospect theory: First outlined by Amos Tversky and Daniel Kahneman in 1979, prospect theory is one which describes decision-making under uncertain circumstances such as insurance and gambling. A key assumption of this theory is loss aversion.⁹

Psychological ownership: A proposed trigger of the endowment effect. Ownership creates an association between the self and the item. This possession-to-self link increases the perceived value of the item.³

The term “endowment effect” was coined by Richard Thaler, a distinguished theorist of behavioral economics, in 1980.⁵ He identified this cognitive bias as an explanation for loss aversion, a theory outlined by Kahneman and Tversky in 1979. Specifically, Thaler used the endowment effect as a means to explain the loss of value associated with selling or giving up an item, which is greater than the financial or emotional gain associated with obtaining that item.

Thaler collaborated with Daniel Kahneman and Jack Knetsch in the early 1990s to provide empirical evidence for the endowment effect. In their paper, the researchers recruited undergraduate students, and randomly assigned half of them to either buyer or seller groups. The seller group received mugs with a university logo and were told that they could either keep their mugs or sell them to the buyer group. The buyer group was then instructed to attempt to buy the mugs. The authors also asked students what at price they would be willing to sell or buy the mugs. Their results indicated that students in possession of a mug priced theirs at double the cost of those who were not in possession of a mug. This experiment has successfully been replicated many times and exemplified how individuals often perceive an item that is theirs to be of greater value than something that is not.⁷

Thaler’s conceptualization of the endowment effect was in direct contrast to economic theory at the time, which assumed that humans consistently make rational decisions. By challenging the existing economic theories, Thaler provided us with a clearer understanding of how humans make economic decisions.¹³

There are many consequences associated with experiencing the endowment effect, both at individual and corporate levels. It can create market inefficiencies, as well as irregularities in value between buyers and sellers.⁹ Further, by employing marketing strategies that make use of the endowment effect and consumer mentality, businesses and corporations can reap the benefits of this effect.

At the individual level, the endowment effect can negatively impact us both as buyers and sellers. Consider a couple looking to sell their family home because they are looking to upgrade. This couple has presumably invested a lot of time, money and energy into maintaining this home and making it their own. Therefore, their asking price may be more than what the buyer is willing to pay. Ultimately, they overvalue the house because it is theirs, and because of this, they may experience additional difficulty selling their home. Further, by choosing to keep the house if no buyer is willing to pay their asking price, this couple may experience more inconveniences and unhappiness than if they sold the house at market price and moved elsewhere.

The endowment effect can also have ramifications at the business and corporation level. For instance, the creation of free trials or test runs for services such as streaming services and car dealerships take advantage of consumers and the endowment effect. When initially considering purchasing a subscription to a streaming service, the consumer may find it difficult to imagine the benefits of having that service. It may also seem expensive, or an unnecessary addition to their everyday lives. However, when companies provide a free trial for a set period of time, consumers are able to “own” that service without having to pay for it quite yet. This psychological ownership increases the perceived value of the service, and thus increases the probability that the consumer will purchase the subscription when the trial ends.⁴

[A free trial, in this case, is also an example of a nudge. Read more here: Nudges.]

Different theories have been proposed to explain the endowment effect, including loss aversion, psychological ownership, and even evolutionary arguments.

Loss Aversion

In a 1991 study, Daniel Kahneman and colleagues proposed that the endowment effect occurs, in part, due to loss aversion. They suggest that reference dependence, our tendency to evaluate something relative to a previous experience or purchase, leads buyers to frame an item as a gain, while sellers frame an item as a loss.⁹ Humans have been found to be loss averse: typically, the psychological impact of a loss is significantly greater than the equivalent impact of a gain. In other words, an item has a greater value when you are selling it than when you are buying it. Therefore, those in support of loss aversion as an explanation argue that the endowment effect is a result of the seller being averse to losing possession of an item, and therefore increasing their valuation of that item to avoid loss. However, findings from more recent research challenge this traditional view.

Ownership Account

A newer explanation of the endowment effect is an ownership account. In a 2012 study, Dommer and colleagues examined whether ownership of an item creates an association between an item and the self, thus increasing its value. If ownership were to account for the endowment effect, varying potential moderators of the possession-self link (social self-threat, social identity, and gender) should have an impact on the strength of the endowment effect. Note that a social self-threat refers to something that directly impacts our sense of self, such as interpersonal rejection, or receiving negative criticism from a superior.

Participants were asked to reflect on a relationship that they had where they felt uncomfortable being alone and worried that the other person did not value them as much as they valued them. They then completed a buyer or seller task similar to the original study by Kahneman and colleagues (1990). The authors found that participants who experienced a self-threat sold their items for more than they were worth (i.e. the endowment effect), but it did not impact buying price. Thus, the value of goods tends to increase if you own them, as they become integrated into the self-concept, suggesting that when people experience a social self-threat, even a generic item can become linked to the self.³ These findings align with previous findings by Morewedge and colleagues (2009), Maddux and colleagues (2010) and Gawronski and colleagues (2007), and provide strong evidence for an ownership account of the endowment effect.

Evolutionary Argument

An evolutionary hypothesis was first proposed by Huck and colleagues (2005). They believed that natural selection may favor those who exhibit an endowment effect, as the effect may have been beneficial when trading goods in ancestral times. This theory is more recently supported by Jaeger and colleagues (2020), who derived six factors that accounted for 52% of the variation in endowment effect magnitude among humans. Specifically, their findings suggest that items that we overvalue now have features that may have aided our ability to survive thousands of years ago.⁶

Haptic Imagery and Marketing

There is extensive evidence to suggest that touching an object can increase our perceived ownership of that object and thus can induce the endowment effect.^1,12 Businesses that employ this strategy by replacing traditional paper menus with iPads or other tablets have been found to increase sales because customers are required to physically tap an item on the screen to order it.¹⁴ However, an equally powerful effect has been observed when participants simply visualize touching an object.¹²

In a study published in The Journal of Consumer Psychology, Peck and colleagues (2013) instructed participants to either visualize an item or physically feel an item. They found that participants who imagined touching an item reported a degree of perceived ownership that was comparable to participants who actually held the object. This finding has many direct implications in marketing and is widely applied to online shopping. Many company websites describe how a product will feel on the consumer’s skin, the texture of the item, and provide ample photos to aid in visualizing of the product. These tactics all contribute to haptic imagery and thus increase a consumer’s perceived sense of ownership, which triggers the endowment effect. Similarly to free trials, this method increases the perceived value of the product, thereby increasing the chance that the potential buyer will make a purchase.

The IKEA Effect 

IKEA is largely known for its affordable and easy to assemble furniture. The company began selling flat-pack furniture in the 1950s, whereby the responsibility of assembly lay with the consumer. Although this strategy has many cost benefits for the company, it also strongly influences consumers’ evaluations of the products.

The IKEA effect is closely linked to the endowment effect. It was first coined in a 2011 study published in The Journal of Consumer Psychology, by Michael Norton and colleagues. The authors randomly assigned participants into builder or non-builder groups. The builder group was responsible for assembling a plain IKEA storage box, while the non-builder group was given a fully assembled box. Norton and colleagues then asked participants their willingness to pay for the product and also rated how much they liked the box on a 7-point scale.¹⁰ The authors found that participants who built their boxes liked them more, and also were willing to pay more for them than the non-builders. Couple these findings with how our sense of ownership of an object is increased by touching it¹², and IKEA’s strategy really does seem  ingenious.

Therefore, although it may not seem enjoyable at the time, by requiring you to build the IKEA table or bed frame, and invest time into doing so, you will actually value the product more than if you had just bought it in one piece. Further, you will be more likely to purchase an item from IKEA again because of how satisfied you were with the product.

Richard Thaler

If you would like additional information on Richard Thaler and his impact on behavioral economics and nudging, this article outlines several of his innovative ideas, including the endowment effect.

Why Do We Buy Insurance?

If you are interested in loss aversion and how it can contribute to the endowment effect, this article outlines its neural underpinnings and describes how the two phenomena connect.

Does Emotion Affect Our Ability to Make Rational Decisions?

If you are interested in the different levels of decision making, and how this can contribute to the endowment effect, this article outlines how emotions can interfere with the decision-making process.

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