How The Trendiest Economists Got Their Prized Discovery Terribly Wrong

emotions

behavioural Economics is all the rage these days. But one of its key findings—the discovery of something called the Endowment Effect—is probably a misreading of human behaviour.

Despite what numerous experiments by behavioural economists seem to show, people do not magically over-value stuff they just happen to already own.  What’s really going on in these experiments is something else entirely—people are exhibiting a wariness to trade what you have for a promise to receive something else from a stranger.  Whether this is irrational or not depends on the circumstances of the trade. But the behavioural economists are wrong to assert it is evidence of a general irrationality.

This misreading likely stems from economists who took too narrow of a view of the forces shaping human behaviour. They just do not pay enough attention to recent developments in human evolution and biological psychology to properly evaluate what looks to them like irrational behaviour. This is a surprising error to discover in behavioural economics, a school of economics which prides itself on being open to findings about human actions and motivations outside of the field of economics.

Want to know more about why the prize finding of the trendiest school of economics is wrong. Well, the best place to begin to understand the Endowment Effect is with basketball.

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[slide
permalink=”how-to-score-tickets-for-a-duke-basketball-game-1″
title=”How To Score Tickets For A Duke Basketball Game”
content=”Basketball is a very popular sport at Duke University. Every year the demand for tickets far exceeds the number of tickets available. The tickets could be given out to the highest bidders or by a pure lottery, but the university is wary of shutting out die-hard fans in favour of merely wealthy or merely lucky ones. So they’ve adopted a complicated selection process meant to reward the determined fans.

Starting around a week before a game, students and other fans begin pitching tents on the lawn in front of the stadium. A tent colony springs up with lots of people actually living on the lawn full time to get tickets. University officials sound an air-horn at random intervals. When the horn is sounded, fans have to check in with the ticket line officials during the next five minutes. Anyone who doesn’t check in gets cut from the waiting list.

For important games against key rivals or during championships, even this ordeal isn’t enough to whittle the number of ticket-seekers down to the number of available seats. In this circumstances, waiting it out the entire time only guarantees entry into a lottery that determines who gets the tickets.

In 1994, a pair of economists, Dan Ariely and Ziv Carmon, decided to conduct an experiment to see whether the most famous insight of behavioural Economics could be detected among the ticket-seekers at Duke. They were testing whether those die-hard fans exhibited the so-called “Endowment Effect” — the tendency of people to require more in payment to surrender something they already possess than they would be willing to pay for something which they don’t.”
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[slide
permalink=”challenging-the-coase-theorem-2″
title=”Challenging The Coase Theorem”
content=”The discovery of the Endowment Effect was a major milestone for behavioural Economics. It allowed the Behavioralists to attack one of the cornerstones of mainstream economics–the Coase Theorem. Named for Chicago economist Ronald Coase, the theorem describes how–under certain circumstances, the final distribution of goods will be efficient regardless of the initial distribution. That is, the buying an selling of goods will inevitably put those goods in the hands of the people who value them the most.

As Coase himself emphasised, the efficient outcome could only be counted on to come about if several assumptions held true. Those assumptions include the absence of wealth effects, the absence of significant transaction costs, and the rational valuation of goods and rights. To put it differently, when we suspect that goods are inefficiently distributed we should look for what might be impeding the market. Typical impediments include the unavailability of financing to counter-act wealth effects, government regulations that increase transaction costs or price-controls that prevent those who place a high value on a good from paying a high price for it.

The Behavioralists challenged the assumption that there was ever a good reason to assume that people always, or even most of the time, value goods rationally. They conducted experiments that seemed to show that people will often and genuinely value an item they have just acquired at a significantly higher dollar amount than the maximum price they would have paid for that item the instant before they acquired it. That is, once someone owns something it often appears to acquire extra value to him–as if out thin air–by the mere fact of ownership. The concept of “sentimental value” seemed to have an economically important reality.”
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[slide
permalink=”duke-basketball-fans-exhibit-the-endowment-effect-3″
title=”Duke Basketball Fans Exhibit The Endowment Effect”
content=”Carmon and Ariely conducted their experiment during a Final Four game, when there was an abnormally high demand for the tickets and so they were being distributed by raffle. Importantly, all the students surveyed the economists had stuck it out on the lawn through the entire process in order to get into the lottery. On average, the students who had won a ticket told the economists that the lowest amount they would accept for their ticket would be $2,400. Those who hadn’t won a ticket said the most they would pay would be $170. In other words, students who had won the tickets placed a value on the tickets roughly fourteen times higher those who had not won the tickets.

Now perhaps the lottery was divinely directed to deliver the tickets to those who genuinely wanted them more. But this seems unlikely and the possibility of divine providence is usually considered out of bounds in economic papers. So instead Camron and Ariely took this as confirmation of the real world existence of the Endowment Effect.”
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[slide
permalink=”coffee-mugs-and-chocolate-bars-4″
title=”Coffee Mugs And Chocolate Bars”
content=”The most famous test of the Endowment Effect involved college students who were divided into three groups. In one group, students were offered a choice between a coffee mug and a chocolate bar as compensation for completing a questionnaire. Students in the second group were given a coffee mug at the outset, and later told they could trade it for a chocolate bar. Students in the third group were given a chocolate bar, and later told they could trade it for a mug.

In the first group that was given the choice, a majority of the students–56 per cent–selected the mug. For the assigned the mug to begin with, 89% refused to trade it for chocolate. For the group assigned the chocolate to begin with, 90% refused to trade it for the mug.

If we rule out the possibility that the students thought it was wrong to contravene in the divine providence that had delivered them the mug or chocolate, this looks like pretty good evidence for the endowment effect. People who were assigned one or the other wanted to hang on to what they already had.”
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[slide
permalink=”what-this-means-for-financial-markets-banks-and-housing-5″
title=”What This Means For Financial Markets, Banks and Housing”
content=”What does all this have to do with financial markets? Quite a lot, in the view of many behavioural Economists. It seems to explain why investors might hold on to losing stocks more than they should. It also might explain some of the behaviour we’ve seen in banks recently–where the banks refuse to sell assets at market prices and refuse to mark those assets down to the current prevailing price. The banks aren’t cheating–they honest believe the assets they own are worth more. It could even explain why people seem to value homeownership over renting–the fact of ownership seems to create its own psychological value–a clear factor in inflating the housing bubble.”
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[slide
permalink=”still-lots-of-doubts-about-the-endowment-effect-6″
title=”Still Lots Of Doubts About The Endowment Effect”
content=”There is still a lot of controversy over the existence of the Endowment Effect. Some economists have claimed that it is really a product of the conditions of the experiment–such as participants not understanding the nature of the experiment. When these conditions are controlled for, some experiments have shown that the Endowment Effect vanishes altogether.

What’s more, other economists have shown that experienced traders don’t exhibit the Endowment Effect at all. Duke students might exhibit for something they rarely trade, but ticket scalpers are quite good at finding market prices for their tickets.”
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[slide
permalink=”where-does-the-endowment-effect-come-from-7″
title=”Where Does The Endowment Effect Come From?”
content=”But even if we accept the presence of the Endowment Effect in markets, it remains a bit of a mystery. Why do people value things they have more than those they don’t. The standard behavioural Economics explanation is that the Endowment Effect is a subset of Loss Aversion–the notion that losing some thing weighs more heavily on people’s minds than gaining the same thing from someone else, even though these are economically equivalent. In short, people are irrationally fearful of losses and this distorts their decision making.

There is something deeply unsatisfying about this view of the Endowment Effect. It explains one kind of seemingly irrational behaviour with another kind of irrationality. Which means that it comes very close to not explaining anything at all.”
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[slide
permalink=”evolution-created-the-endowment-effect-8″
title=”Evolution Created The Endowment Effect”
content=”Fortunately, there is a better explanation available. It comes to us not from behavioural Economics, which is rooted in psychology, but from Evolutionary Psychology and biology. The findings in this area suggest that the Endowment Effect could be a product of evolution, an adaptation that flourished because circumstances rewarded higher valuations on items possessed than those that had to be traded for.”
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[slide
permalink=”even-chimps-exhibit-the-endowment-effect-9″
title=”Even Chimps Exhibit The Endowment Effect”
content=”In 2004, two economists conducted an experiment with chimpanzees using peanut butter inside a PVC tube and fruit juice popsicles. (Those two items were chosen because they can’t be devoured immediately, making them available for trading.) As a group, 58% of the chimpanzees preferred the peanut butter to the juice when given a choice between the two. However, when the chimps were first given the peanut butter, 79% preferred to keep the peanut butter rather than exchange for juice. Likewise, when given the juice pop to start, 58% chose to keep the juice. In short, the chimps exhibited the Endowment Effect.

The presence of the Endowment Effect in chimps implies that it has very deep roots in human development. Most likely it became part of human psychology at a very early evolutionary stage. So this leads to the question–why were early humans so protective of what they had and sceptical of paying full price for what they did not yet have? Or, to put it differently, what were the circumstances under which exhibiting the Endowment Effect was advantageous?”
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[slide
permalink=”the-endowment-effect-is-really-just-counter-party-risk-10″
title=”The Endowment Effect Is Really Just Counter-Party Risk”
content=”The answer seems to be that trading involves risk–specifically the risk that the other party will not perform on the terms of the trade. Early humans would have lacked an easily available enforcement mechanism to punish defectors, which would make defections more likely. In short, they would have built in a discount for possible cheating into the price they were willing to pay for things.

To put it differently, the Endowment Effect may really be a response to the counterparty risk faced by early humans. The behavioural Economists have focused on the wrong thing–the value of possessing an item–rather than the real issue–the cost of trading with other independent agents.”
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[slide
permalink=”the-endowment-effect-experiments-were-misleading-11″
title=”The Endowment Effect Experiments Were Misleading”
content=”You can see how the behavioural Economists were misled by their own experiments to read evolutionary counter-party risk discounting as an Endowment Effect. In their experiments, no counter-party risk existed. But they were testing subjects who had deeply ingrained, hard-wired counter-party risk discounting built into their behaviour. The conditions of the experiment left out the actual conditions of the real world that condition human behaviour. And it turns out that humans in behavioural Psychologist labs act a lot like humans outside the labs. So the Behavioralists missed the fact that it wasn’t Endowment that was creating value–it was that trading was understood to be risking value.

This is something that should have occurred to any economist familiar with the basic idea of “the seen and the unseen.” French Economist Frederic Bastiat once decribed how it was misleading to pay attention to only the transactions that occurred and not to those that were foregone. So when we see a broken window and think that replacing it will be good for the economy, we miss out on the idea that the price paid to rebuild the window would have been paid to purchase something else. In discovering the Endowment Effect, behavioural Economists missed out on the fact that by not trading the students were avoiding something that never occurred–people who didn’t fulfil their part of the bargain. The seen masked the unseen.”
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[slide
permalink=”evolutation-explains-why-experienced-traders-dont-exhibit-the-endowment-effect-12″
title=”Evolutation Explains Why Experienced Traders Don’t Exhibit The Endowment Effect”
content=”This evolutionary perspective might also help explain why the Endowment Effect can be switched off under certain circumstances. For instance, among experienced traders who regularly deal with each other, the endowment effect vanishes. This may be due to a diminishing sense of counter-party risk among participants. Perhaps the hard-wiring can be overcome through experience.

Or, more likely, the hard-wiring includes a bias against trading with strangers under strange circumstances. Early humans would likely have found that they needed to be more wary of trading with other bands of humans than their relatives. In modern society, this translates into discounting less for counter-party risk among those we are used to trading with.”
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[slide
permalink=”no-one-has-shown-the-endowment-effect-is-irrational-in-the-real-world-13″
title=”No One Has Shown The Endowment Effect Is Irrational In The Real World”
content=”Now it would be tempting to reply to this by arguing that this doesn’t tell us anything about whether or not the Endowment Effect is irrational in actual markets that exist today. It is possible that behavioural traits that were adaptive in early times are maladaptive under modern circumstances. A formal legal system and a liquid market may mean that automatic counter-party risk discounting is irrational.

And what the behavioural Economists seem to have shown is that under some circumstances in which there is zero counter party risk, people will still exhibit the Endowment Effect. After all, the students in the labs probably weren’t afraid they’d be cheated out of their mug when they chose to keep their chocolate.

But the fact that the condition of zero counter party risk can be created in a lab tells us absolutely nothing about the rationality of the Endowment Effect in real world markets. In order to test whether counter-party risk discounting was irrational in the real world, we would have to know the actual reasonably expected level of risk involved in trades of all sorts. So far, none of the behavioural Economics folks have tried to show that the Endowment Effect is actually maladaptative in real world circumstances.”
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[slide
permalink=”the-meltdown-shows-the-endowment-effect-might-not-be-irrational-at-all-14″
title=”The Meltdown Shows The Endowment Effect Might Not Be Irrational At All”
content=”Recent experience in financial markets suggests that the Endowment Effect is not maladaptive. If anything, we may have gone too far in diminishing the counter-party risk discount. Experience in the financial markets created a sense of security among the key players beyond what was actually justified. The breakdown of 2008–especially the collapse of Lehman Brothers, General Motors, and AIG–indicates that people weren’t discounting the risk of trading with other market actors enough.

The evolution of our legal and financial system may have diminished the risk of outright defection and cheating by making contracts enforceable but it has invented new risks of illiquidity, insolvency, complexity and unpredictable government internention. At the very least, there’s no obvious reason to assume that the Endowment Effect is maladaptive these days.”
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[slide
permalink=”irrational-rationality-15″
title=”Irrational Rationality”
content=”This means that what the recent financial crisis might have demonstrated is the existence of something that can be called ‘irratiional rationality’–behaviour that might be irrational on an individual level in a lot of circumstances is socially beneficial when aggregated across the economy. The trade wariness that was mistaken for the Endowment Effect actually helps keep us from becomes victims of losses stemming from financial and legal complexity. The real risk isn’t irrationally applying the Endowment Effect, it is too many people rationally overcoming it.”
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[slide
permalink=”reasons-to-be-skeptical-about-behavioral-econ-16″
title=”Reasons To Be sceptical About behavioural Econ”
content=”The behavioural Economists have gotten a lot of mileage out of the notion that market participants sometimes act irrationally. But a discovery so central to their school as the Endowment Effect is actually a misreading of human behaviour, we might want to hesitate before rushing headlong into adopting the public policies many behavioural Economists advocate.”
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[/slideshow]

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