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The endowment effect literature review and business implications

Hundreds of law articles have argued that the endowment effect (henceforth EE) requires the law to intervene in private ordering. In free markets people should ideally exchange goods until they are owned by those who value them the most absent transaction costs (Coase, 1960; Tontrup, 2017).

But transaction costs are not the only impediment of beneficial exchange, another are the owners themselves, when their decisions are biased. The size of the EE suggests that the bias is a severe behavioral threat of efficient trade: prices demanded in the state of possession typically exceed people’s` willingness to pay by a factor of 3 or 4.

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The effect is robust and replicates reliably when the standard experimental protocols are used. The implication for private ordering is far reaching: unlike in a Coasian world, the EE suggests that initial ownership matters. Owners will keep their entitlements, even when other market participants would value the property considerably more (see, for example, Thaler, 1980; Knetsch & Sinden, 1984; Knetsch 1989; Tversky & Kahneman, 1991; Kahneman, Knetsch & Thaler, 1991; Tontrup, 2017).

However, when owners are biased voluntary transactions cannot realize these gains from trade, because they exist only when both parties are in the same state of possession. Thus, unless owners themselves can overcome their EE, the bias seems to call for external intervention. In recent years though, the evidence on the EE and the policy recommendations based on it are viewed more skeptical. First, Plott and Zeiler criticized the results on methodological grounds.

They argue that the gap between WTA and WTP prices is often an artefact of the experimental methods used. For example in some studies experimenters endowed subjects with a good they personally assigned instead of allocating it randomly.

Plott and Zeiler show that subjects value the good more, if it was personally selected for them. However, the EE has since been reproduced attending to their critique: Isoni et al (2011), Heffitz and List (2013), Arlen and Tontrup (2015), and others.

Arlen and Tontrup (2015) by contrast do not question that ownership can bias valuation. They argue that the legal EE literature tends to derive policy recommendations from experiments that do not account for the institutions that people typically use or act within when they trade.

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Sellers anticipate experiencing regret should they find out after the sale that keeping their entitlement would have been the better decision. The expected costs of regret can prevent them from trading. In business contexts however, owners seldom trade alone. They employ institutions like an agent or a board of peers decides by vote.

The institutions allow decision makers to share responsibility and to mute the regret they expect to experience over a wrong decision. Entitlement holders even purposely involve costly institutions in order to self-debias and trade at lower regret costs (Tontrup, 2017) .

Strategic behavior and preference misrepresentation are characteristic for business and trading decisions. Competition is almost never perfect: A good`s attributes and price may not be fully transparent, for some goods no near substitutes may be available, strategic situations like hold ups may occur.

Owners and buyers can exploit these situations and exaggerate or downplay their true valuation for an entitlement. As strategic incentives are so omnipresent in real transactions our findings suggest that policy intervention may seldom be needed to protect private exchange against the influence of the EE.

The EE experiments in Psychology and Economics typically abstract from strategic behavior. The two most often used experimental paradigms are a random price mechanism and a random allocation design (for the details see the literature section); both instruct and incentivize subjects to focus on valuing their entitlement.

The experiments are designed to analyze the cognitive processes that underpin preference formation. To cleanly proof that valuation is state dependent and affected by loss aversion they radically reduce the decision making situation, such that ownership alone can affect the valuation of a good.

In these experiments participants` sole cognitive task is to value their entitlement; the only information they are provided with and that they have to process are the positive and negative attributes of the good.

Strategic behavior is ruled out as a confounding factor. The law`s interest by contrast is policy orientated and concerned with private exchange and this brings strategic behavior into focus: When people trade they typically set prices strategically to earn a profit. Their personal valuation for the good they want to trade, presents only a reservation price.

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Trading is a complex cognitive task. Instead of focusing on the value the good has for him, the decision maker shifts attention to the social and economic context of the transaction. He focuses on market prices, he will form beliefs about the behavior of potential partners he interacts with.

He may have expectations concerning the profit he has to realize for his business or for private matters, he may consider whether he can compensate the loss if expectations are not met. We argue that the complexity of this cognitive task divides the sellers` attention between many economic and social factors they have to process when they trade. Compared to the experimental designs Economic and Psychology use in their EE experiments they focus less attention on their entitlement and its valuable attributes. As a result we expect the EE to affect actual trading behavior less than typically reported in earlier experiments and in the legal literature.

We ground our study in cognitive process theories of attention. The original explanation for the EE is Prospect Theory`s loss aversion (Kahneman & Tversky, 1979) (Tontrup, 2017): The owner experiences selling the good as a loss while the buyer perceives adding the same good to his endowment as a gain. As the loss looms larger than the gain preferences are biased by ownership: the same individual values the good more in the role of a seller than as a buyer, his WTA exceeds his WTP (Thaler, 1980) (Tontrup, 2017).

Prospect Theory, however, does not clarify the cognitive process that causes the different experience of losses and gains. It cannot explain why social factors affect the size of the EE when they do not change endowment status. For instance personal attachment (Strahilevitz & Lowenstein, 1998) (Tontrup, 2017) and self-association with the traded good tend to intensify an owner`s EE (Maddux et al., 2010) (Tontrup, 2017).

Given their effect, both factors must interfere with the cognitive process that causes the bias. The same holds for the strategic incentives we study: we expect them to affect the EE without altering endowment status.

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For analyzing the incentives` influence on the EE we need an understanding of the cognitive process that drives loss aversion. Recent studies have tried to provide this understanding (Brown, 2005; Morewedge, et al., 2009). Carmon and Ariely (2000) for example propose that the EE is caused by a cognitive focus on the forgone: sellers focus on the good they give up and buyers on the money they spend.

Query theory suggests that the retrieval of positive and negative attributes of an entitlement from memory is biased by endowment status (Johnson, et al., 2007) (Tontrup, 2017). Other attention based concepts show (Ashby et al., 2012) (Tontrup, 2017)that also information uptake is biased: Possession focuses sellers on positive, value increasing information, because owners lose these benefits when they sell their entitlement; negative aspects will not be missed and receive less attention.

Buyers in turn, focus on the opportunity costs of obtaining the good. In consequence the subject`s weighing of positive and negative aspects of the transaction is biased creating the characteristic gap between WTA and WTP prices. Unlike Prospect Theory attention based theories predict that social factors can increase or reduce the EE if they affect the seller`s focus of attention (Tontrup, 2017).

Self-association and personal memories for example focus owners on their entitlement and thereby increase the EE. Strategic incentives have the opposite effect: They draw the sellers` attention from the attributes of their entitlement to the social and economic context of the decision making situation; trading focuses the seller on the profit he wants to earn and on estimating the WTP of his potential partners to accomplish a successful deal.

In line with the attention based theories we assume that the information about markets, prices and trading partners etc. that the subjects have to process when they trade refocuses their attention, weakens their biased fixation on the entitlement and thereby substantially reduces or even eliminates their bias.

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