Flawed Theory and the Endowment Effect

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.