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Flawed Theory and the Endowment Effect

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Image: Youkai Chou
It's a happy day. Through some divine stroke of luck you have found yourself with two free tickets to the Rugby Sevens / insert-event-you-want-to-attend. What should you do? Is it a better idea to sell your coveted tickets to the highest bidder or to take along a friend and have a good time? What's a reasonable way to think about this decidedly pleasant dilemma? Homo economicus, the imaginary friend of every economist, may have some advice for you.

So who is Homo economicus? He is the relentlessly optimising, perfectly rational, purely self-interested character who serves as a model for human behaviour. Numerous core economic theories are formulated through the study of how this creature would behave and interact under certain conditions.

Fortunately, for economists and everyone else, humans are indeed often rational actors. For instance, the central economic tenet that, all other things being equal, an increase in the price of a good or service will result in a decrease of the quantity demanded holds up pretty well. Thus, a model predicated on the assumption of human rationality certainly has its merits. 

However, such a model is prone to grossly misrepresenting the behaviour of average humans. Homo economicus does not procrastinate (Hyperbolic Discounting) and never makes a bad decision. Homo economicus has no emotions. Homo economicus would never donate to a charity, help a friend, or contribute to the public good. (Why be so extravagant as to help others when you could help yourself instead?) Homo economicus, if he did exist, would not be human. Some of his traits, such as the ability to perceive information without biases, would definitely be desirable. On the whole, however, he would be something of a cold, calculating monster. 


As a result of their dependence on human rationality, many economic theories do not fare well when tested against empirical realities. The efficient market hypothesis (EMH), for example, postulates that asset prices are accurate reflections of the available information, and are therefore "correct". Should anomalies occur in the market price, they will be instantly identified and removed through arbitrage. The EMH gained a lot of traction in the investment world, and was widely held in reverence. But if the efficient market hypothesis is to be entirely believed, stock market bubbles are theoretically impossible! Emerging bubbles would be identified and quickly eliminated by "smarter" investors. Such a conclusion is demonstrably incorrect. Bubbles in asset prices have always occurred and always will occur. Investors are regularly overconfident and vulnerable to overreaction. Further, you can take the EMH to another equally ridiculous logical extreme and claim that if stocks were perfectly priced there would be no market: no one would trade. In a world of purely rational, faultlessly informed people, who would be willing to buy an asset someone else found necessary to sell? 
Image: Time
For economics to offer more insightful and widely applicable theories, it must move beyond a model that assumes unbounded rationality. Behavioural economics, a field that combines economics and psychology, focusses on studying Homo sapiens, and how they—well, we—differ from the purely rational beings economics has long been obsessed with. 

One of the findings made by behavioural economists is that people exhibit what's called the "endowment effect", they value things they own more than things they could own, but do not yet possess. In other words, we are inclined to demand much more to sell a particular object than we would offer in order to buy it. 

The endowment effect was famously demonstrated in an experiment involving mugs and Cornell students. Researchers Daniel Kahneman, Jack Knetsch, and Richard Thaler arbitrarily selected some students from a class and gave them an ordinary mug from the Cornell gift shop. A "market" was then set up for these mugs. Each student with a mug was asked to discreetly record the minimum price at which they would sell; the students not part of this fortunate group were asked to record the maximum price at which they would buy. Strangely, the average offering price was $7 per mug, but the average bid was only $3. The mugs were worth more than twice as much to those who had them than to those who didn't! 

A more striking example is seen in a study which found that people would pay only $2,000 to lower their chance of death by 1/1000, but would demand $500,000 to increase it by the same amount. (Thaler, 2015) Economic theory and common logic demand that the "buying" and "selling" prices be identical in both cases: such results seem preposterous. Yet, due to the endowment effect, a mug can be worth at least $7 and at most $3. And avoiding an increased risk of death is worth no more than $2,000 but no less than $500,000!

Now back to those Sevens tickets. What we have learnt suggests that we will likely overvalue the tickets merely because they are free. Our perception of the opportunity cost—what we sacrifice in order to use the tickets—is warped because we think of the tickets as "free gifts." However, from an economic standpoint, those tickets are anything but free. The tickets could sell for upwards of HKD 5,000, money which could serve countless other purposes. To adjust for the endowment effect, a more sensible way to think of something "free" is to ask yourself how much money you'd be willing to part with to obtain it. Would you pay HKD 5,000 for a weekend at the Sevens?

(As an aside, it would be interesting to see the difference between what an average student would pay for a chance to turn a B to an A, as opposed to what they would demand in order to stand the risk of having an A turn into a B!) 

Perhaps the best outcome would be for economics to advance current theoretical understanding by assimilating psychological insights into the fallibility of human rationality. Economists have long studied Homo Economicus. Now, they should study Humans too. 

For those interested, there's a neat Freakonomics podcast on what it would be like to live as Homo economicus:
http://freakonomics.com/2015/06/04/should-we-really-behave-like-economists-say-we-do-a-new-freakonomics-radio-podcast/
If you want to know more about behavioural economics, Richard Thaler's recently published a book, Misbehaving, is a great read.

Comments

  1. UnknownJuly 19, 2015 at 12:53 AM

    Though many terms are beyond my ready understanding,I entirely agree that human beings are not only rational beings but are greatly influenced by human psychology.One may therefore be more inclined to spend an interesting weekend with a good friend than to earn $ 5000 by selling the two free tickets,even though a purely rational person may take the opposite decision. However psychology plays its role only when basic human needs are fulfilled. That's why we do not find marginal persons dabbling in stock market.
    Well presented!
    Love
    Nanaji

    ReplyDelete
    Replies
    1. YashJuly 20, 2015 at 5:40 AM

      Thank you for the insightful comment, Nanaji! Glad you enjoyed the post. It is indeed interesting to observe instances in which humans stray from rational behaviour and the particular conditions under which such an effect is most apparent.
      Love
      Yash

      Delete
  2. UnknownAugust 24, 2015 at 7:49 AM

    This comment has been removed by the author.

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  3. UnknownAugust 24, 2015 at 7:50 AM

    I think you have a misunderstanding here. The purpose of assuming full rationality is not to *explain* human behaviour, but to *describe* its outcomes. Regardless of how individuals really are, economists find that assuming perfect rationality is the best predictor of how humans act in a group. It fits the data best.

    At the end of the day, it doesn't really matter whether you feel benevolent today, or whether I go for that short term reward (in terms of economics). The reality is that the actions that we end up taking by and large match up with what rational economics would expect.

    (Sorry, I removed the earlier comment, as it was badly phrased)

    ReplyDelete
    Replies
    1. YashAugust 24, 2015 at 7:34 PM

      Thanks for your comment, Jonathan!

      I agree that the practical usefulness of economics is in its ability to describe the outcomes of, instead of simply explain, human behaviour. The assumption of rationality certainly has merits and is appropriate in a broad range of situations, as I mentioned in my article. However, it is precisely in describing the outcomes of human behaviour where the rational agent model can be insufficient. This is particularly true with regards to the fact that individuals indeed do not demonstrate consistent preferences and are influenced by "supposedly irrelevant factors" such as loss aversion and the "availability bias"—our tendency to only reference information that is easily retrievable.

      However, two examples, one concerned with our individual behaviour and one with our behaviour in a group, can also demonstrate "long term" shortcomings of a model that assumes rationality.

      Saving for retirement is a fantastic example in which short term bad choices aggregate to a problem of much larger scale. A rational agent would, through some means or another, would always save enough for a retirement deemed satisfactory. This hypothesis is inconsistent with reality. Furthermore, a behavioural approach to saving has been empirically shown to increase savings rates considerably, an outcome that would not be logical under an assumption of rationality.
      If you scroll down to "Saving" on this link, a more eloquent explanation is provided: http://www.econlib.org/library/Enc/BehavioralEconomics.html

      Financial markets provide an excellent example of how the actions of a group also defy rationality. Two of the core tenets of the efficient market hypothesis are that stock markets are fundamentally unpredictable and investors "price in" all available information. This finding is untenable considering the presence of stock bubbles as well as various research findings showing that stocks that outperform over a five year period consistently underperform in the subsequent period, and vice versa. This suggests that the market as a whole can be susceptible to irrational overreaction. Additionally, it has been consistently shown that the close-ended funds—those which are tradable on the market—trade at significant discounts to their NAV, a result that defies an assumption of rationality in the overall market.

      Delete

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