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Endowment Effect

Updated on May 21, 2024
Edited byAaron Crowe
Reviewed byDheeraj Vaidya, CFA, FRM

Endowment Effect Meaning

The endowment effect refers to a cognitive bias that explains how individuals develop an affinity for an object and overvalue it when they own it compared to how they would have valued it if they did not own it. Its influence can lead people to make unwise decisions.

The endowment bias describes why a seller’s expected value for their offering is higher than the market value. Again, the probability of its occurrence is high with situations involving objects having emotional, symbolic, or monetary significance.

Key Takeaways

  • The endowment effect definition in behavioral economics describes an individual’s affinity for objects they own or used against their preference for objects they have not previously owned or used.
  • There are several reasons behind it, like loss aversion, status quo, and psychological inertia. However, it is significant when people deal with objects of emotional attachment or symbolic value.
  • This psychological bias increases the likelihood of retention of an object compared to the likelihood of obtaining the object. Also, the bias causes sellers to price items highly compared to market value.
  • Overcoming emotional bias requires motivation and rational thinking.

How Does Endowment Effect Work?

The endowment effect elucidates that the value people form in their mind for an object is different before and after its possession or usage. People value an owned object favorably compared to a non-owned item. Once an individual owns an object, the perception of its utility will escalate. Scholars use various concepts like loss aversion, status quo bias, and psychological inertia to substantiate the endowment effect.

Endowment Effect

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Loss aversion: According to the concept, if a specific occurrence has two possible outcomes, one is gain, and the other is comparable loss. Simply put, the degree of suffering experienced when losing an object exceeds the intensity of pleasure experienced while acquiring the object. Naturally, individuals will avoid suffering losses rather than benefit from the occurrence.

Status quo bias: People sticking to the status quo is common. There are many reasons like emotional attachment and fear of loss, explaining why people prefer not to sway from their current state.

Psychological law of inertia: It indicates the propensity of people to maintain the status quo unless triggered by motivation favoring the change.

Researchers also use many other theories to explain the endowment bias, like reference price theory and motivated taste change theory. According to reference price theory, various entities participating in trade have distinct reference points that influence their decisions. For example, a seller will not like to price a product below market value, while a buyer expects the rate to be following its worth. Motivate taste change theory implies that in the owner’s perception utility of an item increases after owning it and influences the decisions in the second purchase of the same item.

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Video Explanation of Endowment Effect

 

Example

Mug experiment is a well-known experimental test of the endowment effect conducted by Daniel Kahneman, Jack Knetsch & Richard Thaler. During the study, half of the people were given a mug to create a sense of ownership, and later, they were given a chance to trade the mug. Unfortunately, people who possessed the mug were unwilling to sell it for the market price. Instead, they demanded a price above the market price, and buyers were reluctant to pay the market price to acquire the mug. Furthermore, some people who possess the mug were unwilling to sell it or exchange it for an equally valuable product.

Endowment Effect Examples

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The endowment bias is an example of the application of marketing psychology in business. Nowadays, retailers widely use various tactics to create a sense of ownership in the potential customers to trigger a sale. The most conventional examples are free trials of products or services for a short period to induce affection so that the customer values the product or service further. Other typical applications are distributing free stuff, a free return policy, and virtual try-on plugins on online portals.

How To Overcome Endowment Effect?

The endowment effect is not always a good phenomenon. It restricts people from making profitable decisions in life. It leads potential customers in placing values for products and services irrationally. For instance, investors are holding on to stocks due to emotional attachment even if the evidence points to its underperformance in the future. Overcoming its influence is not easy. The effect stems from feelings, not from logic.

Maintaining objectivity or freedom from bias is essential in making rational choices in every aspect of life. The effort to overcome the behavioral biases should come from the individual itself. Being informative about the endowment bias will help identify and let go of limiting thoughts. You will understand why you’re keeping something that is not so useful to you and makes a more rational decision to get rid of it.

Another meaningful way is the application of motivation in eliminating the endowment bias. Motivation is a psychological factor influencing consumer decision-making, and several industries use motivation-based strategies to change people’s feelings about things. This way, marketers can influence potential customers to change their status quo or make their product seem more valuable.

Frequently Asked Questions (FAQs)

What is the meaning of the endowment effect?

It is a phenomenon of people assigning additional value to the objects if they own it in contrast to tagging low value to the object if they have never possessed it. It is one of the famous concepts in behavioral economics. It has wide application in economics, marketing, legal, etc.

What is an endowment effect example?

The most common examples are manifested by businesses offering free trials of products like a free test drive of cars, a free trial of software products, free samples of newly launched products, and virtual try-on plugins in e-commerce portals. These applications help marketers in the customer acquisition process.

What is the endowment effect in marketing?

Marketers use the endowment effect to stimulate people’s interest in their products. It is used to develop marketing tactics, get people to use the product, and instill a sense of ownership in them.

This has been a Guide to the Endowment Effect and its Meaning. Here we discuss how the endowment effect works with examples and overcome it. You can learn more from the following articles –