The Endowment Effect

Take the first list and write down the dollar amounts it would take to get you to part with each item. If it helps, imagine someone standing nearby, wallet open, ready to give you the cash. Do this before going on to the next part of the experiment, even if its only one item.

Next, take the second list and look at the same items, one by one, and imagine yourself at a second-hand sale. Imagine seeing each of these items offered for sale, and then write down the price you would be willing to pay for each one. Delivery would be free, and the items would be put back where they are now.

If you've answered the way most people do, you'll notice much higher values on the first list than on the second. Psychologists call this the endowment effect, and it's so named because people seem to endow items they own with special value. No one knows why this effect exists. It is one of those peculiar regularities in thinking that psychologists can observe, but they can't explain. It is a mystery, but the mystery may soon be ending.

Eric van Dijk, from Leiden University in The Netherlands, devised an experiment to test a theory posed some years ago to explain the endowment effect. This theory suggests that loss aversion causes the effect, that is, it appears when people irrationally fear that they will lose what they already possess. Essentially, when people compare the known and familiar to the unknown and unfamiliar, they feel fearful and choose the known and familiar. Further, people are coaxed into expressing this fear in a variety of situations, and many of these intrude into our conduct of our businesses.

Van Dijk's experiment was designed to shed light on this fear.

Van Dijk gave test subjects bottles of wine as payment for participation in a study, and then, just before they left, he offered them the option to trade their bottles among themselves. He watched carefully what happened next. When it was difficult to put a value on the bottles of wine, people chose not to trade and displayed the endowment effect -- an aversion to loss. But when it was easy to value the wine, and when these values were roughly equal, people were more willing to trade. In the first case, they displayed the endowment effect, and in the second, their fears disappeared, and so did the effect.

Van Dijk stated the principle this way: The more difficult it is for people to compute the net gains of a trade, the more likely it will be for them to feel fearful and to hang on to what they have . . . to display the endowment effect. Or, you could state it in terms of a cure: reduce the uncertainty in valuing and comparing, and the endowment effect will disappear.

The most obvious example of the endowment effect in our businesses occurs as prospective employees walk away from their interviews with us. Much is swimming through their minds, and valuing and comparing everything you have said with other potential employers and with their current jobs invites the emergence of the endowment effect. Consider, for example, benefits packages, and total compensation. Comparing competing packages can be difficult.

You have an advantage in valuing benefits packages, and you are in a position to help prospective employees do their math and make an objective comparison. If you do your homework and be ready to fill this role, you'll be less likely to find good prospective employees choosing to stay where they are out of fear of losing what they have when it is actually inferior to your offer.

Reference: van Dijk, Eric and Daan van Knipenberg (1998) Trading Wine: On the Endowment Effect, Loss Aversion, and the Comparability of Consumer Goods. Journal of Economic Psychology, 19, 485-495. www.businesspsych.org

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