Saturday, October 24, 2015

Is the endowment effect rational?

In comments on the previous post, I entertained the possibility of writing a book -- but what would it be about? Equations kill sales (or so I hear), so after some thought I came up with the idea of something like a inverse Freakonomics: discussion of the many things that economists think are irrational behavior or cognitive biases, but actually make sense from an information transfer standpoint. Unfortunately I had only one example so far (money illusion), so on my flight home last night I tried to come up with another.

It turns out the endowment effect makes perfect sense if you are dealing with non-ideal information transfer.

In the case of non-ideal information transfer, you end up with a price that falls below the supply and demand curves. Let's take it to be the maximum entropy point (see e.g. here). This is illustrated in the graph labeled I below:

The endowment effect in non-ideal information transfer. The initial transaction at price p₁ (I) establishes a lower bound (II) so that a future price p₂ (III) is greater than p₁ (IV).

So the initial sale price p₁ that you buy at creates a new bound for how non-ideal that transaction should be in graph II. You know that the price shouldn't fall below p₁, therefore your asking price might appear near the maximum entropy point in the new smaller space above the red line at  p₂ as shown in graph III. It's below the equilibrium -- the intersection of the supply and demand curves -- and so could potentially be accepted. Therefore (IV), we find that the price you're willing to sell something is higher than the price at which you purchased it: p₂p₁.

Interestingly, this would lead to gradually more and more ideal information transfer as more and more market transactions took place (asking prices above the equilibrium wouldn't get accepted). Therefore maybe the endowment effect is not a problematic cognitive bias, but rather the reason for the existence of markets. If people were more willing to take bad deals (didn't have an endowment effect, less loss aversion), you could get a feedback that goes the other way leading to zero prices and broken markets. 

7 comments:

  1. Hmm, interesting. Never heard of this before.


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  2. O/T: This looked like an intriguing title (I haven't listened to or read it yet). Maybe these forecasting "tournaments" are open for people such as yourself to participate in.
    http://rationallyspeakingpodcast.org/show/rs145-phil-tetlock-on-superforecasting-the-art-and-science-o.html

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    1. I do know something about this. IARPA had a program called ACE (aggregative contingent estimation) which funded efforts like DAGGRE (which I did participate in).

      In fact, "information transfer economics" was an outgrowth of an attempt to use information equilibrium to see if you could create metrics to see if prediction markets like DAGGRE were functioning. However, it didn't really give you much (because of non-ideal info transfer), so I started (well, continued) looking at economics.

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  3. One comment about the difference between price paid and subsequent price asked. Isn't it standard in economics to regard trade as a non-zero sum game? That is, both parties to a trade believe that they have benefited from it. So if I have just bought something for $X, it is typically because it is worth more than $X to me. Why, then, should I propose to sell it for $X?

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    1. If you read the wikipedia article on the endowment effect, you can see the difference. In the classic experiment, people are initially given widget A and are unwilling to trade it for widget B. But then the same people given widget B are unwilling to trade it for widget A.

      So preferences depend on the initial conditions. "Rationally", you should prefer one to the other or prefer them both the same.

      In your example, people initially with the money will want to keep the money, but if they initially have the widget they want to keep the widget. With consistent preferences, they should either want the money (M > W) or the widget (W > M) or not care either way (M = W).

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    2. Actually, I did read the Wikipedia article, but you talked about a trading scenario, which is different from the classical experiment, hence my comment. :)

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    3. You're right -- there's an additional assumption of market equilibrium that is used in the version I'm presenting. In that case the price is at the crossing of the lines and selling an object is at the same price as buying an object and so you'd accept the same amount of money as you'd pay. Basically, the supply and demand diagram.

      I think I'd have to make this argument more explicit using two different goods instead of money and look at the prices

      dA/dB vs dB/dA

      So that depending on the order of the transaction, you' prefer A to B or B to A.

      As it currently is, we are looking at dA/dM and dM/dA and I show someone would prefer A to M and M to A. But since money doesn't do anything on its own, your question above is pertinent.

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