What's Wrong With the Endowment Effect?

Cite this Article
Joshua D. Wright, What's Wrong With the Endowment Effect?, Truth on the Market (October 06, 2009), https://truthonthemarket.com/2009/10/06/whats-wrong-with-the-endowment-effect/

Gordon Smith asks the question in response to a 16 part post (with slides and pictures!) from John Carney offering up the explanation that the behavioral economists have overclaimed and that “the Endowment Effect may really be a response to the counterparty risk faced by early humans.”  Larry Ribstein chimes in with support for Carney and a general word of caution about behavioral finance.

Gordon doesn’t like John’s explanation because “the Endowment Effect appears in the lab even when counter-party risk is absent” and replacing irrational preferences with a just so story about evolutionary psychology involves “making assertions about human nature that are not susceptible to falsification.”  That’s all fair enough.

But what about the answer to the question?  What’s wrong with the endowment effect?

Ok, bait taken.

One possible answer is behavioral literature repeatedly has shown that some cognitive biases that are robust in the lab aren’t so robust in actual markets, where the repeat play and the profit motive at work.  So perhaps doing this in the laboratory with undergraduates performing tasks will show less than we think.

But that’s not the biggest problem.  The real problem with the endowment effect in particular is that, as of yet, EVEN the experimental findings are not robust.   And certainly not sufficient to stand as the intellectual foundation of an new paternalistic regulatory regime.  In other words, somebody has already taken on the behaviorists for finding irrationality where it doesn’t exist. Zeiler & Plott (or here), in my view, provide burden-shifting quality evidence that the endowment effect observed in the literature is better explained by experimental procedures than preferences.  Proponents of regulation based on the endowment effect, in my view, need not agree with my interpretation of these findings but they ought to respond to them if they want to be taken seriously.  Unfortunately, as I discuss here, out of the 255 articles in JLR discussing the endowment effect (210 also discuss regulation, btw), only 16 cite either Zeiler and Plott article.  I find that ratio discouraging for the discipline of behavioral law and economics generally.

It strikes me that all the discussion about plausible alternative stories for explaining the endowment effect are very interesting and important (including both rational and irrational accounts), but they miss the incredibly important point that we’ve currently got folks in areas ranging from finance to consumer protection to antitrust creating regulatory agencies, and proposing regulations that will surely have significant consequences (intended and otherwise) on the basis of a phenomenon for which we do not have compelling evidence.

And that is the problem with the endowment effect.