What is the Endowment Effect?
The endowment effect is the tendency to value things you own more highly than equivalent things you don’t own. In other words, the price you would want for selling an item is likely to be higher than the price you would be willing to pay to buy the item.
In an experiment by Kahneman, Knetsch, and Thaler, students were randomly given a mug, some chocolate, or neither. They were then asked whether they would prefer the mug or the chocolate. The students who received neither were split roughly equally into those who said they preferred the mug and those who said they preferred the chocolate. But of those who received the mug, a large majority then said they preferred the mug, and of those who received the chocolate, a large majority said they preferred the chocolate. In general, students ascribed higher value to the item they already owned, regardless of which item they were randomly given, and they were unlikely to want to swap it for the other item.
In another experiment, by Ziv Carmon and Dan Ariely, some students were chosen by lottery to receive free tickets to an NCAA tournament. Those who received the tickets were then asked how much they would be willing to sell their tickets for, and those who didn’t receive tickets were asked how much they would be willing to pay for a ticket. Classical economics would predict that the selling prices and the buying prices would, on average, be equal – in other words, that there would be one single market price for a ticket, which represents what the typical student thinks a ticket is worth to them. But the result was that the selling prices were, on average, much higher than the buying prices. The students who had tickets, even though those tickets were assigned to them at random, valued tickets more highly than the students who didn’t have them.
Explanations for the Endowment Effect
Loss aversion is the more general tendency to perceive a loss as larger than an equivalent gain – to perceive the “badness” or negative utility of losing something as outweighing the “goodness” or positive utility of gaining it. The endowment effect could be explained as an example of loss aversion. If you own an item and are considering selling it, you are considering the loss of an item you already have. This feels like a more significant change than the gain of an item you don’t already have, so you demand more monetary compensation for the loss than you would be willing to spend on the gain.
Loss aversion may have an evolutionary explanation: if an organism has just enough food to survive, gaining some additional food won’t make much difference to it, but losing the same amount of food may make the difference between life and death. Something similar applies to many modern humans across the world living close to the poverty line: gaining some money would be nice, but losing the same amount of money could be catastrophic.
The endowment effect has been demonstrated in non-human animals, including great apes and capuchin monkeys, which lends support to an evolutionary origin for the effect.
Some researchers have theorized that the endowment effect is because of emotional attachment. People feel sentimental about the things they own, and may have positive memories involving them, and so value them more highly than an equivalent item which is emotionally neutral and doesn’t come with the same sentimental value.
People sometimes also invest part of their identity in an item – for example, a college shirt. This shirt would be very valuable to its owner, who attended the college during their formative years, and sees being an alumnus of that college as part of their identity; but to a potential buyer who didn’t attend the college, it would be worth as little as any second-hand shirt in a thrift shop.
The IKEA Effect
The effect of emotional attachment is enhanced if someone has been partially or fully involved in making the item. The time and emotional energy they have invested in making it increases its value in their own eyes, but not in the eyes of a potential buyer. This is a factor in real estate valuations: a homeowner will usually have spent time decorating the house according to their own taste, which will add to its value in their opinion, but may be neutral or negative in the opinion of a potential buyer.
The phenomenon whereby people value items more highly if they have been involved in making them is called the IKEA effect, after the Scandinavian self-assembly furniture retailer. This name was coined by Michael Norton, Daniel Mochon and Dan Ariely, whose experiments demonstrated that subjects valued IKEA furniture they had built themselves more highly than IKEA furniture someone else had built.
The same effect is demonstrated in Build-A-Bear toys, which the buyer assembles themselves and customizes, and in boxed cake mixes which need an egg to be added. The first boxed cake mix products only needed the user to add water, but marketers found that consumers valued the cake more if they felt more involved in making it, and having to add their own eggs was the sweet spot between making a cake from scratch and simply adding water to a prepared mix.
The IKEA effect is partly about personalization and identity, as in the Build-A-Bear toys, which are customized to the buyer’s taste; but this does not fully explain the effect, because it applies even with furniture and sponge cakes, which tend to look the same regardless of who assembled them. Another explanation for the IKEA effect, then, is that helping to make an item increases the buyer’s appreciation of the value of the labor that went into it. Most modern consumer goods are built either by machines or by underpaid workers overseas, so buyers in first-world countries are insulated from appreciating the value of the labor that goes into them. Helping to assemble a piece of furniture renews a consumer’s appreciation for the value of labor, and hence for the value of the finished product.
The IKEA effect contributes to the endowment effect in some circumstances, in that if someone has helped to make a cabinet, teddy bear, or cake, they will value it more highly than a cabinet, teddy bear, or cake that someone else has made, and so will demand a higher price for the item they made than the price they would be willing to pay for the item someone else made.