What is Rationality? The Economist on The Endowment Effect

This week’s Economist featured an interesting piece on the Endowment Effect. The effect is explained below:

The endowment effect | It’s mine, I tell you | Economist.com:

I AM the most offensively possessive man on earth. I do something to things. Let me pick up an ashtray from a dime-store counter, pay for it and put it in my pocket and it becomes a special kind of ashtray, unlike any on earth, because it’s mine. What was true of Wynand, one of the main characters in Ayn Rand?s novel “The Fountainhead”, may be true of everyone. From basketball tickets to waterfowl-hunting rights to classic albums, once someone owns something, he places a higher value on it than he did when he acquired it; an observation first called “the endowment effect” about 28 years ago by Richard Thaler, who these days works at the University of Chicago.

The endowment effect was controversial for years. The idea that a squishy, irrational bit of human behaviour could affect the cold, clean and rational world of markets was a challenge to neoclassical economists. Their assumption had always been that individuals act to maximise their welfare (the defining characteristic of economic man, or Homo economicus). The value someone puts on something should not, therefore, depend on whether he actually owns it.

My point, in short, as I just got back to my hotel room from a wedding party: Rationality as defined in an economics textbook is simply a consistency requirement. Preferring things you own to things you do not, net other differences, is perfectly consistent and thus not irrational. Irrationality only enters the picture when your preferences are inconsistent, which is what seems to happen in this case, if you misread it. It seems like you prefer the mug to the chocolate bar in one situation, and the bar to the mug in another (an inconsistency, and thus irrational), but indeed, you prefer a mug that you already own to a chocolate bar that you do not, and vice versa. The whole point of the endowment effect is that ownership of a good makes the good different. But that’s not irrational, unless you have a particular bias in mind. So, I ask the Economist – what do you mean by rational? Clearly, some stronger definition than the one in a standard econ text (e.g. Varian’s Intermediate Microeconomics).

Ok, 2:30 am and I’m exhausted from dancing (poorly). Goodnight all.

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2 Comments

  1. Natalie Cotton

     /  June 22, 2008

    The endowment effect introduces inconsistency. Take your analysis back to the point of purchase: If owning something causes you to value it more, then that means that when you are considering purchasing something, you will rationally *expect* to value it higher when it is owned, and so your valuation of it in bargaining will incorporate that expected value increase of ownership. So yes, attaching a value to ownership is not irrational. However, the fact that we do not ex ante in bargaining realize that we will one moment later value it higher means that there’s inconsistency in the prices we attach to that same good. If you believe in efficient markets, then the endowment effect causes inefficiency in bargaining.

  2. I see where you are coming from, but I think it still needs to be made more explicit in the article before labeling something or someone ‘irrational’. Here then, what is irrational is not the endowment effect, per se, but the failure to predict the endowment effect? (cf. Stumbling on Happiness by Daniel Gilbert for a whole host of similar phenomena.)

    Also, just because the endowment effect tends to occur does not mean it is entirely predictable.