ECON30019 Chap.5 Reference Dependence and the Endowment Effect
Reference Dependence and the Endowment Effect
Ask one person two questions about the same object: the minimum price they would accept to give it up if they have it, and the maximum they would pay to get one if they do not. Under the standard model both questions have the same answer, because the object has one value and it does not depend on who is holding it.
The subject writes that benchmark as two indifference conditions and then reports that in many settings the elicited numbers are very different, which it names the endowment effect and calls a violation of rationality because an object is valued differently once it is yours.
The explanation needs two ingredients working together, reference dependence and loss aversion, and the chapter builds the value function that encodes them, the two-component model that weights the level against the deviation, and the counter-evidence about market experience and experimental procedure.
What this chapter covers
- 01
Willingness to accept and willingness to pay, defined precisely
- 02
The two indifference conditions, and why the standard prediction is exact equality
- 03
The classic randomised design, and why randomisation is doing the work
- 04
Reference dependence and loss aversion, and why neither is enough alone
- 05
The value function: over changes rather than totals, with a kink at zero
- 06
The loss-aversion inequality in both of its equivalent forms
- 07
The functional form, its exponents, and the loss-aversion coefficient
- 08
Reference-dependent utility, and the weight that decides which term dominates
- 09
Where the reference point comes from, and why that is the model's weakest joint
- 10
Four counter-results on experience and procedure, and the ownership-attachment alternative
The wedge between two prices
- 1Fix each reference point at the person's own position: the owner's includes the bicycle, the non-owner's does not.
- 1The owner giving it up moves below the reference point, so the loss branch applies and the magnitude is lambda times x.
- 1The non-owner not acquiring it forgoes a gain rather than suffering a loss, so the gain branch applies and the magnitude is x.
- 1The ratio is lambda to one, which is the wedge between the two elicited prices. The standard model predicts a ratio of one, since the object's value cannot depend on who holds it.
Key terms
- Willingness to accept
- The minimum price a person will take to give up an object they currently hold, defined by the indifference that leaves total utility unchanged.
- Willingness to pay
- The maximum price a person will pay to acquire an object they do not currently hold, defined by the matching indifference condition.
- Endowment effect
- The finding that preferences appear to depend on what a person already possesses, so the two elicited prices differ. It violates rationality because value changes with ownership.
- Value function
- A function measuring the utility of an outcome relative to a reference point. It ranges over changes in endowment, where a utility function ranges over total endowments.
- Loss-aversion coefficient
- The multiplier on the loss branch of the value function. Values above one encode loss aversion, and reported estimates sit around 2.25 to 2.5.
- Ownership attachment
- A competing explanation under which owners simply see what they own as more valuable, rather than experiencing its loss more sharply.
Reference Dependence and the Endowment Effect FAQ
Why does the standard model predict the two prices are equal?
Because moving from no units to one unit produces the same absolute change in utility as moving from one unit back to none: it is the same step traversed in opposite directions. The subject states the conclusion plainly, that the answer to both questions should be whatever sum leaves you exactly on the fence between it and the object. One object, one value.
Has the endowment effect been refuted?
Not refuted, but bounded, and the subject presents the counter-evidence rather than hiding it. The gap is not observed for token-like goods, is absent among experienced traders, and disappears after adding very careful controls to the experimental procedure. The defensible statement is conditional: robust for consumption goods among inexperienced participants, and sensitive to experience and to procedure.
What is the weight in the two-component model actually doing?
It sets how much the level of wealth matters relative to the deviation from the reference point. Total wealth carries a bigger weight as it increases, so a large value collapses the model toward the standard one where only the level counts, and a small value makes the direction of travel dominate where a person ends up.
Exam move
The assessed questions here are branch questions, so build the branch habit before the arithmetic. Write the deviation with its sign on its own line, decide the branch from the sign, then apply the slope.
For the two-component model, do not test values one at a time: set the two expressions equal and solve for the weight, which answers the comparison for every value at once and protects you against computing both utilities correctly and then reporting the wrong verdict. Learn the four counter-results as a list, since evaluation questions here reward a conditional claim rather than a verdict.
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