The study of economics, its models and its concepts rely on the idea that all individuals make rational choices. The field of behavioural and cognitive economics focuses on identifying the deviations from balanced, informed decisions, and attempting to explain why they occur.
An important hypothesis is understanding certain irrational decisions is “The endowment effect” hypothesis; a theory that states that people value a good more once it has been established as theirs. It says that once a person establishes “property rights” on a good, their willingness to retain the particular good (the value at which they may wish to sell it) is greater than the price they were willing to pay to obtain the good in the first place. The endowment effect hypothesis is interwoven with two other concepts. Firstly, there is “loss aversion”, which states that an individual prefers to evade a loss, rather than acquire a gain. An example would be a situation where two employees in a firm are fined £200 and given a bonus of £200 respectively. Loss aversion theory would state that the satisfaction lost by the recipient of the fine is greater than the satisfaction gained the beneficiary of the bonus payment. The second concept linked to the endowment effect is the “status quo bias.” This is a bias which leads people to irrationally prefer things to remain the same, or change as little as possible.
A study was carried out by the economists Jack Knetsch and J.A Sinden, in an attempt to analyse and interpret the effects of the above hypothesis. The study was carried out in a laboratory setting, where they were given (endowed) with one of two options: a lottery ticket or with 2 dollars. After a period of time, they were asked if they wished to switch from ticket to money, and vice versa. Findings showed that very few participants wished to switch, and were happy with the option they had been given, regardless of which one. Some economists argued that this behaviour may disappear if individuals were exposed to an actual market situation.
A laboratory study which tested this was carried out by Kahneman, Knetsch and Thaler on economics undergraduate students at Cornell University. The students were asked to participate in a series of markets.
In the first three markets, students traded various tokens, which had differing values. They were given the following instructions. “In this market the objects being traded are tokens. You are an owner, so you now own a token [You are a buyer, so you have an opportunity to buy a token] which has a value to you of [$x amount]. It has this value to you because the experimenter will give you this much money for it. The value of the token is different for different individuals. A price for the tokens will be determined later. For each of the prices listed below, please indicate whether you prefer to: (1) Sell your token at this price and receive the market price. [Buy a token at this price and cash it in for the sum of money indicated above.] (2) Keep your token and cash it in for the sum of money indicated above. [Not buy a token at this price.] For each price indicate your decision by marking an X in the appropriate column.
The buyers and sellers were then given a form with the option to sell or not sell their tokens at a series of prices ranging from $0.25 to $8.75. Throughout the three trials, all the participants changed between the buyer/seller roles and were given different “actual redemption value” tokens. After each market period (window of buying and selling), experimenters collected the forms, and determined the market clearing price, the number of trades and the occurrence of excess supply/demand at the market clearing price. No physical trades were actually made.
After the three stages of the initial experiment were completed, the experiment progressed to the second stage. Half the participants were given Cornell