Suffering from the endowment effect

B. Venkatesh

Consider this. You buy an apartment for Rs 75 lakh and do some minor modifications to the living room. Soon thereafter, your employer asks you to relocate to Europe. You now want to sell your three-month old apartment. How much will you demand? If you are like my friend who found himself in a similar situation last month, you would want one crore! Why?

My friend suffers from what behavioural economists call as the endowment effect. It is a behavioural bias that prompts us to place a higher value for an object that we own than the value we are willing to pay to buy it.

Take the apartment. I am sure my friend would be willing to pay not more than Rs 60 lakh if he were a buyer. His argument then would be that real estate prices have declined sharply since 2008!

This phenomenon is true of the stock market as well. You would always find the ask price (seller’s price) to be higher than the bid price (buyer’s price). Why?

There could be two reasons for the endowment effect. One, we experience pain when we part with our possession. That is one of the reasons why you and I refuse to give away even stuff that we do not use!

Higher price, a premium

Experiments in neurosciences do, indeed, show that our insula is activated during selling; insula is the region in the brain that is associated with the prediction of monetary losses. The higher price is, perhaps, a premium for suffering the pain.

The second reason is that we simply like the objects we own. Of course, sometimes the objects that we own may be appealing because we have to justify our choices. And that prompts us to demand a higher price.

Whatever the reason, the endowment effect explains why sellers and buyers almost never agree on the price of an object. As economists state, the minimum willingness-to-accept a good is almost always higher than the maximum willingness-to-pay to acquire it.

(The author is a self-styled investment psychologist. He can be reached at enhancek@gmail.com)

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