A Shock Therapy Against the “Endowment Effect”

1. A Shock Therapy Against the “Endowment Effect” Dirk Engelmann (Royal Holloway, University of London) Guillaume Hollard (Paris School of Economics and CNRS)

2. The “Endowment Effect” • Exchange asymmetries have frequently been documented, starting with Knetsch (1989) • In the classical experiment, two groups are endowed with goods A and B, respectively • Subjects can exchange endowed good for the other good • Prediction: average exchange rate of 50% • observed average exchange rate is typically substantially below 50% • Typically interpreted as supporting prospect theory • Plott & Zeiler (2007): “Endowment effect” is misnomer for this effect, because this entails an explanation, we put it in “…”.

3. Market Experience and the “Endowment Effect” • To evaluate the impact of such anomalies on actual markets, it is natural to wonder whether the endowment effect disappears with market experience. • List (2003, 2004) finds support for this conjecture • List (2004): “prospect theory adequately organizes behaviour among inexperienced consumers, whereas consumers with intense market experience behave largely in accordance with neoclassical predictions.” • However, a high level of market experience is required to eliminate anomaly (6 or 11 trades a month over years) • Why is learning on the market so slow?

4. More Fundamental Question: What is Learned on the Market? • List: inexperienced traders are uncertain about their preferences, this uncertainty is diminished with experience • High number of required trades is surprising • Further puzzle: • In List (2003) “endowment effect” is tested with items similar to those traded on the market (sports cards) • In List (2004) the test is with different items (mugs & chocolate), results similar • Why any learning required for such simple items? • Why do people with lots of sports card trading experience know their m&c preference better? • We believe that another type of uncertainty is important and difficult to overcome with market experience

5. Learning on the Market: Two Types of Uncertainty • In a typical exchange experiment, subjects face two types of uncertainty: • choice uncertainty: all aspects relating to choice between the goods, e.g. uncertainty with respect to relative values and preference uncertainty • trade uncertainty: all aspects relating to the trading process, e.g. risk of offending experimenter, others’ behavior; perceived transaction costs, including “moral costs” • Note: Typical choice experiments choose goods of nearly equal value. Hence small degrees of uncertainty can have a major impact. • List’s explanation is based on choice uncertainty

6. Explanation Based on Trade Uncertainty Is Consistent with List’s Results • If subjects perceive trade uncertainty • Overcoming reluctance to trade requires learning new trade strategies • If free to exchange, traders do not make trades with perceived high uncertainty • They do not learn new strategies • Slow learning if at all on free market • But spillover to other goods (List 2004) is no problem

7. A Test of the Importance of Trade Uncertainty • Our hypothesis is that trade uncertainty is crucial for the “endowment effect” • To test for the importance of trade uncertainty, we choose a design where choice uncertainty is constant across treatments, but the opportunities to reduce trade uncertainty vary • The amount of experience with different goods is the same (and small), but one treatment provides incentives to learn new trading strategies • If choice uncertainty drives the “endowment effect” there should be little difference between treatments and since experience is limited, there should be an “endowment effect” in both • If trade uncertainty is (partly) responsible for the “endowment effect”, there should be a treatment effect

8. “Forced Trade” as a Test of the Importance of Trade Uncertainty • “Forced”-trade treatment: • subjects are endowed with an object. • If they were unable to exchange the object within a certain period of time, the object is taken away by the experimenter (exchange or lose) • We compare this “shock therapy” with a similar treatment where trade is not forced but free • “Endowment effect” is tested for in a subsequent part corresponding to List (2003,2004) which is identical in both treatments • If trade uncertainty is (partly) responsible for the “endowment effect”, this shock therapy could reduce it, but not if the effect is driven by choice uncertainty alone

9. Experimental DesignPart 1 – Market Training 3 rounds of exchange (free or forced) • Subjects are all in one room • In each round, two real objects are involved (e.g. pack of coffee and a pack of rice), different between rounds • Subjects can freely examine each of the two goods involved prior to the exchange round • They are randomly assigned an object • No particular control is enforced (subjects are free to interact, move, speak, etc) • There is an equal number of subjects endowed with good X and Y in the first round. Then the number of subjects endowed with good X increases across rounds

10. Free and Forced Trade • In the forced-trade treatment, subjects are aware that the good they received has to be exchanged within 5 minutes. If they don’t, the good is taken away and lost • In the free-trade treatment, objects can be kept or exchanged as desired

11. Experimental DesignPart 2 – Test for “Endowment Effect” A classical test of the “endowment effect” (Identical in both treatments) Following List’s (2003) test of “endowment effect” for dealers and non-dealers • After the third market round subjects in a session are all endowed with the same good • They are asked to fill in a survey • They have to pick up their belongings and move to another room when done • They are alone is the room with experimenter • They are offered to exchange the last object they got for another one • An exit interview is conducted

12. Experimental Design Four sessions (2x2 treatment) • Free or Forced trade in Part 1 • Endowment object D (DVD) or P (Paper) in Part 2 About 20 subjects (econ students mostly) in each treatment April 2007 at the University of Antille-Guyane on Martinique

13. Results Fisher’s exact test: p = 0.047

14. Results Fisher’s exact test: p = 0.741

15. Results

16. Results – Summary • The “endowment effect” disappears in the forced-trade treatment • But it remains significant in the free-trade treatment • So forced trade succeeds in eliminating “endowment effect” with very little trade experience • This points to trade uncertainty as a major source of the “endowment effect” • This is consistent with the observations in List (2003, 2004) • learning on a free market is slow (if not just driven by selection) • but not specific to the goods traded on the market • these observations are hard to reconcile with an explanation based on choice uncertainty

17. Relation to Plott & Zeiler (2007) • PZ argue “endowment effect” is artifact of experimental procedures • Typical experiments foster exchange asymmetry, because design and instructions allow for effects of • signaling: the experimenter chooses the good • other-regarding preferences: trading can be seen as rejecting a gift • possibility for herding • controlling for these effects, the exchange asymmetry disappears

18. Relation to Plott & Zeiler (2007) • PZ is not about learning but about eliminating effect by proper controls • Their results are also consistent with trade uncertainty playing important role • Controls that address choice uncertainty (e.g. eliminating herding) are insufficient to eliminate the “endowment effect” • Eliminating trade uncertainty (experimenter does not choose object) is sufficient to eliminate the “endowment effect”

19. Conclusions • We discuss two types of uncertainty as possible factors underlying the “endowment effect” • We argue that explanations for previous results based on choice uncertainty are insufficient • This suggests that trade uncertainty may play a major role underlying the “endowment effect” • We design an experimental test where treatments do not differ in how learning opportunities should affect choice uncertainty but do differ in how learning affects trade uncertainty • The “endowment effect” is strong in the “free-trade” sessions, but disappears in the “forced-trade” sessions. • This supports the view that trade uncertainty plays a major role • This is also consistent with List’s and PZ’s results • This does not say that choice uncertainty is irrelevant, there could be important interactions