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The Endowment Effect

by Phyllis Pollack

From the Blog of Phyllis G. Pollack.

Phyllis  Pollack

       No doubt, you have been part of a negotiation or a mediation in which the following oxymoron is apparent: one party wants to be rid of something she claims has no value, but, yet, at the same time is reluctant to part with it. Have you ever wondered what is causing this seemingly “irrational” behavior?

       About twenty-eight years ago, Richard Thaler first observed “the endowment effect” which is “once someone owns something, he places a higher value on it than he did when he acquired it.” (“It’s Mine, I Tell You.” The Economist [June 19, 2008] Science and Technology Section.)

       This observation was controversial for many years since it stems from “irrational” behavior. As economists always assumed that “individuals acted to maximize their welfare,” they could not accept the notion that the “. . .value someone puts on something. . . depends on whether he actually owns it.” (Id.).

       But, thanks to modern science, researchers have been able to actually view the “endowment effect” on the brain and determine that it effects the brain “. . .by enhancing the salience of possible loss.” (Id.) That is, the endowment effect causes individuals to feel a sense of loss. But why? Does it stem from “irrational” or “differently” rational behavior?

       It seems that the endowment effect has nothing to do with wealth, transactional costs or even emotional attachment. Rather, as Owen Jones, a professor of law and biology at Vanderbilt University and Sarah Brosnan, a primatologist at Georgia State University suspect,

      “. . .in the evolutionary past, giving things up, even when an apparently fair exchange seemed to be on offer, was just too risky. These days, . . .there are contracts, rights and other ways of enforcing bargains. Animal societies have none of these mechanisms. As Adam Smith observed in the “Wealth of Nations,” “nobody ever saw a dog make a fair and deliberate exchange of one bone for another with another dog.” ”

       Experiments have revealed that the endowment effect has deep revolutionary roots but that the strength of the effect varies with the “evolutionary salience” of the item in question. The effect is shown when food is being traded, but not when the trade involves toys or bones. Food is important to us all, but not toys or bones! (Id.)

       An alternative theory is that the endowment effect relates to trade. According to Steffen Huck, an economist at University College, London,

      “In societies with markets, customers can go elsewhere. But in a small, tribal society there may be no alternative seller. In that case, those who were reluctant to trade might get better prices. It may thus make sense for an owner to be psychologically predisposed to hold out for a high price as soon as someone else expresses interest in one of his possessions. . . .” (Id.)
 
       With a moment’s reflection, one can readily see the results of this “endowment effect” in negotiations and mediation. In my mediation practice, I handle many lemon law disputes in which the consumer is seeking to have the automobile manufacturer repurchase or replace the vehicle now claimed to be “lemon.” While at the same time, the consumer urges that the vehicle is a “lemon” (which means, under California law that it has a “non-conformity” that substantially impairs the use, value or safety of the vehicle) and thus, theoretically, has little or no “value,” the same consumer displays the endowment effect by being unwilling to return the vehicle to the manufacturer unless he receives a lot of cash in exchange. Many times, in the end, the consumer is willing to keep the vehicle, if she is paid some cash by the manufacturer for her “inconvenience.” That is, as much as she wants to get rid of the vehicle because it is “unsafe,” at the same time, she does not want to suffer the sense of “loss” that goes along with returning the vehicle to the manufacturer. The consumer’s behavior is similar to those of students in a famous experiment in which they “. . .were surprisingly reluctant to trade a coffee mug they had been given for a bar of chocolate, even though they did not prefer coffee mugs to chocolate when given a straight choice between the two.” (Id.)
 

      So, the next time you are negotiating and find that either you or the other party seemingly wants to trade a tangible or intangible item of value, yet, as the same time, balks at doing so, remember – it is not “irrationality” that is causing this behavior but rather the sense of loss stemming from the endowment effect.

      . . . Just something to think about.

Biography


Phyllis Pollack with PGP Mediation uses a facilitative, interest-based approach. Her preferred mediation style is facilitative in the belief that the best and most durable resolutions are those achieved by the parties themselves. The parties generally know the business issues and priorities, personalities and obstacles to a successful resolution as well as their own needs better than any mediator or arbitrator. She does not impose her views or make decisions for the parties. Rather, Phyllis assists the parties in creating options that meet the needs and desires of both sides.  When appropriate, visual aids are used in preparing discussions and illustrating possible solutions. On the other hand, she is not averse to being proactive and offering a generous dose of reality, particularly when the process may have stalled due to unrealistic expectations of attorney or client, a failure to focus on needs rather than demands, or when one or more parties need to be reminded of the potential consequences of their failure to reach an agreement.



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