Putting the endowment effect to the test

Feb 1, 2020 |3 min read
investment and debt struggle endowment effect

The endowment effect has been shown to apply to capuchin monkeys and great apes, as well as humans in many contexts, but does it apply to a room full of market researchers and marketers?

The endowment effect is a psychological bias that says once we own something, we tend to (irrationally) over-value it. So we find time and time again that there's a gap between what someone is willing to sell something for and what other parties are willing to pay - which can make negotiations and trade more difficult.

This effect has been seen in numerous experiments - in one famous example, basketball game ticket holders at a US university were willing to sell their tickets for an average 14 times the price non-holders were willing to pay for them ($2400 versus $175).

In another case, students were randomly divided into two groups -  potential sellers, who were gifted a mug; and potential buyers, who received nothing. The mug owners wanted $7.12 on average to give up their mug, while buyers were only willing to pay $2.87 on average to buy the mug.

Late last year I presented at a conference in Singapore and one of the topics covered was the endowment effect.  We thought we'd have some fun by running a similar experiment to the mug example in the room.  So when the audience took their seats, half of them had a business card holder in front of them and half didn't.  We then asked:

The theory states that the average of the two amounts should be a long way apart - a typical ratio is 2.5 times as high for the owners' willingness to sell figure, compared to the willingness to pay figure.

The result was clear and the endowment effect was clearly evident:

So owners were on average willing to sell for an amount 2.8 times as high as the willingness to pay - meaning not many deals in the room were done!

Why does it occur?

There is no absolute agreement in the academic world, but the simplest explanation is that it reflects another bias we tend to display - loss aversion, meaning we feel the pain of losses more than the pleasure of equivalent gains.  This comes into play once we have something in our hands, and we want to avoid possible feelings of loss that may occur once we no longer have it - hence we require a higher monetary reward for parting with it.  

This effect even occurs when we own something unexpectedly that we may not have initially wanted - as was the case with the mug experiment and our business card holder version.  In neither of these cases was the product something personally special to the people involved, but they still were reluctant to give them up once they owned them.

Why does it matter?

It is an important dynamic for any business person to understand - particularly anyone involved in negotiating or purchasing.  There are many examples where owners of businesses should have accepted generous offers for their company, but chose to reject and later found their company to be worth much less.  For example, in 2008 Yahoo! founder Jerry Yang rejected a $44.6 billion offer from Microsoft to buy the company, as he felt the company was being undervalued; the company was later sold to Verizon for $4.83 billion.   

It can also be leveraged in marketing - creating a sense of ownership can increase the level of attachment we have to products (and hence their brands).  IKEA is an often-cited example of this, where we feel a greater sense of ownership for its products because we are the ones assembling them.  Free trials are also an effective way to encourage purchase - once someone is using the product or service, feelings of ownership will kick in and they will find it hard to give it up once the free trial is over.

In any situation where a sense of ownership is present or can be created, we should assume the endowment effect is playing a role in people's behaviour - it is seemingly baked into our brains (as proven by the monkey and ape experiments), so clever people in business and brands can use it to their advantage.