A Shock Therapy Against the “Endowment Effect”

Dirk Engelmann (Royal Holloway, University of London)

Guillaume Hollard(Paris School of Economics and CNRS)

The “Endowment Effect”

Exchange asymmetries have frequently been documented, starting with Knetsch (1989) In the classical experiment, two groups are endowed

with goods A and B, respectively Subjects can exchange endowed good for the other

good Prediction: average exchange rate of 50% observed average exchange rate is typically

substantially below 50% Typically interpreted as supporting prospect

theory Plott & Zeiler (2007): “Endowment effect” is

misnomer for this effect, because this entails an explanation, we put it in “…”.

Market Experience and the “Endowment Effect”

To evaluate the impact of such anomalies on actual markets, it is natural to wonder whether the endowment effect disappears with market experience.

List (2003, 2004) finds support for this conjecture List (2004): “prospect theory adequately organizes

behaviour among inexperienced consumers, whereas consumers with intense market experience behave largely in accordance with neoclassical predictions.”

However, a high level of market experience is required to eliminate anomaly (6 or 11 trades a month over years)

Why is learning on the market so slow?

More Fundamental Question:What is Learned on the Market?

List: inexperienced traders are uncertain about their preferences, this uncertainty is diminished with experience

High number of required trades is surprising Further puzzle:

In List (2003) “endowment effect” is tested with items similar to those traded on the market (sports cards)

In List (2004) the test is with different items (mugs & chocolate), results similar

Why any learning required for such simple items? Why do people with lots of sports card trading

experience know their m&c preference better? We believe that another type of uncertainty is

important and difficult to overcome with market experience

Learning on the Market: Two Types of Uncertainty

In a typical exchange experiment, subjects face two types of uncertainty: choice uncertainty: all aspects relating to choice

between the goods, e.g. uncertainty with respect to relative values and preference uncertainty

trade uncertainty: all aspects relating to the trading process, e.g. risk of offending experimenter, others’ behavior; perceived transaction costs, including “moral costs”

Note: Typical choice experiments choose goods of nearly equal value. Hence small degrees of uncertainty can have a major impact.

List’s explanation is based on choice uncertainty

Explanation Based on Trade Uncertainty Is Consistent with List’s Results

If subjects perceive trade uncertainty Overcoming reluctance to trade requires

learning new trade strategies If free to exchange, traders do not make

trades with perceived high uncertainty They do not learn new strategies Slow learning if at all on free market But spillover to other goods (List 2004) is

no problem

A Test of the Importance of Trade Uncertainty

Our hypothesis is that trade uncertainty is crucial for the “endowment effect”

To test for the importance of trade uncertainty, we choose a design where choice uncertainty is constant across treatments, but the opportunities to reduce trade uncertainty vary

The amount of experience with different goods is the same (and small), but one treatment provides incentives to learn new trading strategies

If choice uncertainty drives the “endowment effect” there should be little difference between treatments and since experience is limited, there should be an “endowment effect” in both

If trade uncertainty is (partly) responsible for the “endowment effect”, there should be a treatment effect

“Forced Trade” as a Test of the Importance of Trade Uncertainty

“Forced”-trade treatment: subjects are endowed with an object. If they were unable to exchange the object within a

certain period of time, the object is taken away by the experimenter (exchange or lose)

We compare this “shock therapy” with a similar treatment where trade is not forced but free

“Endowment effect” is tested for in a subsequent part corresponding to List (2003,2004) which is identical in both treatments

If trade uncertainty is (partly) responsible for the “endowment effect”, this shock therapy could reduce it, but not if the effect is driven by choice uncertainty alone

Experimental DesignPart 1 – Market Training

3 rounds of exchange (free or forced) Subjects are all in one room In each round, two real objects are involved (e.g.

pack of coffee and a pack of rice), different between rounds

Subjects can freely examine each of the two goods involved prior to the exchange round

They are randomly assigned an object No particular control is enforced (subjects are free

to interact, move, speak, etc) There is an equal number of subjects endowed

with good X and Y in the first round. Then the number of subjects endowed with good X increases across rounds

Free and Forced Trade

In the forced-trade treatment, subjects are aware that the good they received has to be exchanged within 5 minutes. If they don’t, the good is taken away and lost

In the free-trade treatment, objects can be kept or exchanged as desired

Experimental DesignPart 2 – Test for “Endowment Effect”

A classical test of the “endowment effect” (Identical in both treatments)

Following List’s (2003) test of “endowment effect” for dealers and non-dealers After the third market round subjects in a

session are all endowed with the same good They are asked to fill in a survey They have to pick up their belongings and

move to another room when done They are alone is the room with experimenter They are offered to exchange the last object

they got for another one An exit interview is conducted

Experimental Design

Four sessions (2x2 treatment) Free or Forced trade in Part 1 Endowment object D (DVD) or P

(Paper) in Part 2

About 20 subjects (econ students mostly) in each treatment

April 2007 at the University of Antille-Guyane on Martinique

Results

Free Trade Endowment

P D Total

rev. prefer P 15 7 22

rev. prefer D 5 11 16

Fisher’s exact test: p = 0.047

Results

Forced Trade Endowment

P D Total

rev. prefer P 9 6 15

rev. prefer D 11 10 21

Fisher’s exact test: p = 0.741

Results

Exchange rates

Endowment

P D Total

Force 55.0 % 37.5 % 46.3 %

Free 25.0 % 38.9 % 31.9 %

Results – Summary

The “endowment effect” disappears in the forced-trade treatment

But it remains significant in the free-trade treatment

So forced trade succeeds in eliminating “endowment effect” with very little trade experience

This points to trade uncertainty as a major source of the “endowment effect”

This is consistent with the observations in List (2003, 2004) learning on a free market is slow (if not just driven

by selection) but not specific to the goods traded on the market these observations are hard to reconcile with an

explanation based on choice uncertainty

Relation to Plott & Zeiler (2007)

PZ argue “endowment effect” is artifact of experimental procedures

Typical experiments foster exchange asymmetry, because design and instructions allow for effects of signaling: the experimenter chooses the good other-regarding preferences: trading can be

seen as rejecting a gift possibility for herding controlling for these effects, the exchange

asymmetry disappears

Relation to Plott & Zeiler (2007)

PZ is not about learning but about eliminating effect by proper controls

Their results are also consistent with trade uncertainty playing important role Controls that address choice uncertainty (e.g.

eliminating herding) are insufficient to eliminate the “endowment effect”

Eliminating trade uncertainty (experimenter does not choose object) is sufficient to eliminate the “endowment effect”

Conclusions

We discuss two types of uncertainty as possible factors underlying the “endowment effect”

We argue that explanations for previous results based on choice uncertainty are insufficient

This suggests that trade uncertainty may play a major role underlying the “endowment effect”

We design an experimental test where treatments do not differ in how learning opportunities should affect choice uncertainty but do differ in how learning affects trade uncertainty

The “endowment effect” is strong in the “free-trade” sessions, but disappears in the “forced-trade” sessions.

This supports the view that trade uncertainty plays a major role

This is also consistent with List’s and PZ’s results This does not say that choice uncertainty is irrelevant,

there could be important interactions