Endowment effects. Becker-DeGroot-Marschak mechanism. ECON4260 Behavioral Economics. Endowment effects and aversion to modest risk

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1 ECON4260 Behavioral Economics 3 rd lecture Endowment effects and aversion to modest risk Endowment effects Half the group get an mug the other half gets 5 $ (sometimes a 3. group gets nothing) The mug owners will sell for 7.12 $ The others will buy for 2.87 $ The choosers choose money or a mug. (mug value 3.12 $) True willingness to pay? Can transaction costs explain it? What has the Coase theorem got to do with it? Why a group of choosers? Becker-DeGroot-Marschak mechanism How to avoid incentives to sell at high price and buy cheap? BDM-Mechanism (seller) The seller states a minimum price X A random price P is drawn Sold at price P if P X Incentive compatibility. True value W Seller losses if W < P < X X P <W Optimal to state X = W. 1

2 Transaction costs Same experiment with poker chips Each participant has a given exchange rate If it is worth 5$ to me and 3$ to you both will benefit if you sell it to me for 4$. Demand and supply functions derived Can find market equilibrium prediction, provided no transaction costs. RESULT: Outcome equals prediction No transaction cost Reluctance to sell or to buy? Three groups Sellers; Get the mug first Buyers; Get $5 first Choosers; get to choose: the mug or X Mean valuations Sellers $7.12, Buyers $ 2.87, Choosers $ 3.12 Note Sellers and Choosers formaly equivalent Rules out any possible income effect Buyers are similar to Choosers Endowment effect, not reluctance to buy. Exchange Half the group get the mug Independent of mug-valuation The 50% with highest mug valuation will be divided: One half got a mug The other half did not Expect half the mugs to be traded Actually about 10-20% are traded Are indifference curves independent of endowments? 2

3 The Coase theorem The Doctor and the garage Garage disturbingly noisy, one must move With one owner: Total value maximized if the one with the lowest relocation cost moves With separate ownership the same outcome The one with highest relocation cost will rather pay the other one to move. Even with externalities ownership structure has no effect (besides income effects) NB: In the absence of transaction costs. Coase claimed that Pigou got it wrong, externalities no problem. Testing the Coase theorem (Bargaining Potential Pareto improvement) Sellers got a chocolate bar Buyers got a ticket worth $ 3 to them $ 5 to the sellers $ 2 surplus available First 29 of 35 agreed on ticket bargain Then they bargained over chocolate Only 7 out of 17.5 expected bargains succeeded Endowment effects in The Edgeworth box Crossing indifference curves Pens for Money Money for Pens Kinked indifference curves around status quo E.g. the Edgeworth box Pens Dollar P for M M for P 3

4 The Status Quo Bias Samuelson and Zeckhauser (1988): A: You inherit a large sum of money from your uncle. B: You inherit a portfolio A significant portion invested in modest risk company. The choice: Moderate risk company; high risk company, treasury bills, municipal bonds. Result: An option is more likely to be selected when it is designed as the status quo. Fairness Q 1a: A shortage has developed for a popular model of automobile, and customer must wait two months for delivery. A dealer has been selling the car at list price. Now the dealer prices the model 200 $ above list price Acceptable (29%) Unfair (71%) Q 1a:... A dealer has been selling the car 200 $ below list price. Now the dealer prices the model at list price Acceptable (58%) Unfair (42%) Why are we this way? Are we born with a tendency to defend property? Animals often fight over resources Food, areas, harems In an encounter between two rivals, they both have two strategies (after first measuring strength) Fight or run Both fight is disastrous When both run, none get the resource There are two Nash-equilibrium But encounters are not symmetric, one had the resource first A coordination equilibrium: The challenger runs (if equal strength) Tests confirm hypothesis, two butterflies given the same area on consecutive days, then placed there both, They fight fiercely. 4

5 Endowment and Loss aversion Obvious parallel Selling is loosing the mug Buying is gaining the mug But: Loss aversion is with money gain and endowment effect don t apply to money Found litle aversion to buy (give up money) Plott and Zeiler s critique Endoment effect not found in all studies Differences in procedures Endowment effect depend on procedures Concern about misunderstanding Do subject understand true value Anonymity Do high-bidders apear naive? Misconceptions Revealed theory approach 4 Controls Incentive compatibility Training Paid Practice Paid Practice Anonomity Situation trigger selling behavior, i.e. selling high. Not fully understant auction mechanism Behave as if an standard acution. 5

6 Design and results Invoke all controls Training, paid practice, incentives (BDM) and anonymity Main result: No WTA-WTP gap That is: No Endowment effect True even without paid practice What about exchange-effect Not in the paper Plott claim: Remove the word gift and the exchange effect disappear. Is there an endowment effect? Yes; But maybee not part of preferences A result of misconception? Or something we may learn to avoid when appropriate No predicted endowment effect on objects made to be sold; do the procedures invoke this setting? Is Plott and Zelner evidence against Propspect theory? Endowment effect usually seen as aspect of CPT But why is loosing mugs different from loosing money? Rabin s theorem Suppose a person is indifferent to (0) and a lottery (+100 Kr, 67% ; -100 Kr, 33%) The person would be indifferent irrespective of income level Assume the person maximizes expected utility For what values of X will he prefer the lottery (X, 50% ; -100, 50%) to (0)? 6

7 Lotteries and wealth x i is payoff from a lottery The subject has additional wealth and income W. The lottery changes the total wealth from W to W+x i Expected utility should thus be written Eu( W + x) = n i= 1 u( W + x i ) p i Indifference for any W 12 Indifference implies 11,5 (2/3) u(w + 100) ,5 (1/3) u(w -100) ,5 =u(w) Δu + =u(w+100)-u(w) Δu - =u(w)-u(w-100) Δu - = 2 Δu + 12, , ,5 10 9, Sketch of proof u(w+300) = u(w+300)-u(w+200) + u(w+200)-u(w-100) + u(w+100)-u(w) = Δu + /4 + Δu + /2 + Δu + = Δu /4 + Δu /2 + Δu u(w+ n 100)-u(W) = ( (n-1) ) Δu + < Δu - Eu = 50% u(w+ n 100)+50%u(W-100) Eu-u(W)= 50% [u(w+ n 100) - u(w)] - 50% [u(w) u(w-100)] < 0 7

8 Almost any risk aversion yields similar results A person who turns down a lottery (100, 51%;-100,49%) at any income level Will also turn down ( , 51%, , 49%) If such conclusions are implausible, EU imply risk neutrality towards modest risk. Indifference for W < W Is the problem that the person is indifferent for any level of W? 12,5 12 With W0 = , 11, in the figure is only 10, ,5 Turn down 9 (-100,55%; ,45%) Prospect theory, by contrast, yields modest risk aversion Reference point is current wealth. Choices should be independent of wealth Plausible? Could you think of an experiment to test it? Can the theory easily be adjusted to account for wealth? Loss aversion implies risk aversion even for modest risk. 8

9 Mental accounting Imagine that you are about to purchase a jacket for ($125)[$15] and a calculator for ($15)[$125]. The calculator salesman informs you that the calculator you wish to buy is on sale for ($10)[$120] at the other branch of the store, located 20 minutes drive away. Would you make the trip to the other store A: (Numbers). Most will make the trip B: [Numbers]. Few will make the trip Both cases save $5 at the cost of a 20 minutes trip. Why do people choose differently in A and B? 9