The mediation of the endowment effect through the physical and virtual representation of goods

Transcription

1 The mediation of the endowment effect through the physical and virtual representation of goods Dina Gatoff Behavioral Economics Thesis Adviser: Professor Eric Schulz Instructor: Professor Joseph Ferrie May 2014

2 Endowment Effect 1 Table of Contents Acknowledgements... 1 Abstract... 3 Introduction... 4 Literature Review... 4 Methods Results and Statistical Analyses Primary variable of interest Other findings/other variables of interest Discussion and Limitations Conclusion Appendices Appendix A Appendix B Appendix C References... 35

3 Endowment Effect 2 Acknowledgments I would like to thank the Mathematical Methods in the Social Sciences program for providing me with the tools to think critically about research. In particular I am grateful to the director Professor William Rogerson for upholding the rigorous curriculum, the thesis coordinator Professor Joseph Ferrie for overseeing the thesis project, and Sarah Ferrer for always providing helpful answers, especially in helping me apply for the Michael F. Dacey Research Grant. I also wish to acknowledge everyone who helped me in the thesis process. My thesis advisor Professor Eric Schulz who after the development of my ad hoc major helped guide my thesis research in Behavior Economics, and Professor David Rapp and the members of the Reading Comprehension Lab for supervising my experiment so that I could obtain original data, and for helping me throughout the experimental research process. I would also like to thank the generous donors of the Michael F. Dacey Research Grant for enabling me to conduct the research I envisioned. I am grateful to all the professors and administrators who encouraged and supported me in the pursuit of my Behavioral Economics major. Thank you to Professor Jeff Rice for suggesting I apply, to Professors Doug Medin and Schulz for believing in my academic intent and backing my major, and to Dean Sheldon and the curriculum review committee for permitting me to major in a field that I am truly passionate about. Finally, I want to acknowledge my parents and family for their support and encouragement in the past four years; I could not have come this far without them.

4 Endowment Effect 3 Abstract The endowment effect exemplifies a critical limitation for expected utility models. In assuming perfect rationality these models do not match how people actually set preferences and make decisions. In particular, peoples value of an object is not absolute and it changes based on their ownership. The effect is an interesting and robust finding that shows that valuations are not the same for everyone and, that being in the position of buying or selling can change the perceived value of an item. However, the endowment effect is not a fixed formula or coefficient that can uniformly determine discrepancies between people s potential valuations based on their position. In past research other factors including self-threat and time-pressure have been shown to influence people s valuations despite any observed endowment effect. The endowment effect is studied by examining the gap between the price sellers are willing to accept (WTA) and the price buyers are willing to pay (WTP) for the same item. By seeing the differences between subjects, researchers are able to examine if such a gap exists and can measure the size of the endowment effect. This paper explores whether the physical presence of an object, versus interacting with it virtually on a computer, can have an effect on peoples valuations and in particular if it can mediate the magnitude of the endowment effect exhibited by buyers and sellers. This paper also examines if changes are exhibited, what might be causing them, and if the manipulations are not significantly different why that might be. The goal in studying the endowment effect is to better understand the factors in peoples decision making processes that are outside the realm of perfect rationality. In particular, the manipulation of presence challenges if the arbitrary presentation of a good can change peoples behavior.

5 Endowment Effect 4 Introduction The endowment effect has been widely established through various experiments with different stakes, items, and methodologies. The effect shows that people ascribe a higher value to objects they own than to objects they do not own. Essentially, the amount people will accept to part with an object that they own, referred to as their willingness to accept (WTA) is higher than the amount they are willing to pay for the object if they do not own it, known as their willingness to pay (WTP) (Kahneman, Knetsch and Thaler, 1990). By applying prospect theory, this discrepancy can be attributed to loss aversion: losses are weighed more heavily than are gains of an equivalent amount associated with obtaining the same object (Kahneman and Tversky, 1979). Literature Review It is generally accepted that the WTA-WTP gap seen in the endowment effect is attributable to prospect theory (Kahneman et al., 1990). Prospect theory is crucial in interpreting the endowment effect and the experiments that demonstrate it. The theory states that people weigh losses more heavily than they weigh gains. Losing some value, therefore, has a greater effect than does gaining the same value, with respect to an initial reference point, or the status quo. This finding runs counter to the standard expected utility theory underlying most rational economic models. Prospect theory challenges the relevance of expected utility theory in predicting people s decision making processes and implicit utility calculations as standard theories of expected utility do not distinguish between gains and losses. Models of expected utility theory state that people should choose options with the highest expected returns (gains in utility multiplied by the probability of their occurrence). While expected utility models assume that gains and losses are all weighted equally and linearly,

6 Endowment Effect 5 prospect theory introduces the idea that decision makers treat gains and losses differently. In particular, prospect theory indicates that the utility function for gains is concave, with diminishing marginal returns as the gain increases in magnitude. Conversely, the prospect theory function for losses is convex. As losses increase in magnitude, their negative effects are diminished. Further, the loss function is steeper than the gain function therefore; receiving a loss and a gain of equal magnitude will not cancel each other out, but will result in a net negative effect (Kahneman and Tversky 1979). This model of gains and losses is crucial in understanding the endowment effect. If buyers and sellers categorize an item in terms of a gain or loss, respectively, prospect theory would attribute their different valuations to how they identify the item. Kahneman, Knetsch, and Thaler (1990) argued that the endowment effect represented a fundamental characteristic of preferences whereby if people obtain a good they will ultimately shift their reference point to reflect their ownership of a new item. After that point future decisions are judged asymmetrically. Since selling a good is perceived as a loss of that good and weighted more heavily, people will set a higher price as their value for the item in order to counteract the additional weight of loss for the item. On the other hand, people who have not obtained the item do not include in their reference point and accordingly see it as a gain and place less weight on it relative to people who already own it. To exemplify this, take two identical people, with identical preferences and reference points, and give one of them a car. Now if you ask the new car owner to sell the car, he or she will set a price that will compensate for their loss of the car. The price reported will be the magnitude of the loss. The person who never received the car would be willing to buy the car for the sum that he or she deems equivalent to the gain of the car. Now since we assumed these

7 Endowment Effect 6 people are identical according to standard utility theory the car should have an equal value both of them. However, prospect theory would predict that the person who owns the car would set a higher price, because the value of the car is weighted as a loss. The person who never received the car sets a lower price because they classify it as a gain. So, where there could have been an even exchange of the car between two identical people, we see that the price set by the seller is above what the buyer wishes to pay because of how each individual perceives and categorizes the item. The traditional endowment effect experiment uses college students as participants, and mugs bearing the logo of their university as goods. The students are assigned to be endowed with mugs, referred to as sellers, or to merely be able to examine the mug, referred to as buyers. The experiments demonstrate the loss aversion created by owning an object, by showing that students randomly designated as sellers, exhibit a WTA higher than the WTP of the buyers (Kahneman, et al., 1990). This endowment effect is robust, having been demonstrated in many settings with other kinds of objects and experimental manipulations. The endowment effect has been observed using different elicitation techniques. Whether people are privately determining the value at which they are willing to sell at their leisure, or participating in a live auction, they exhibit similar effects (Chuang, 2013). The endowment effect is not without controversy. People understandably struggle to accept the idea that WTA could be substantially above WTP. After all, the economy relies on WTP and WTA correspondences, and matches between the values of buyers and sellers are seen in everyday exchanges. Plott and Zeiler (2005) were especially skeptical, believing that the endowment effect gap observed was attributable to participant misconceptions and misunderstandings of experimental conditions rather than to prospect theory. They set out to

8 Endowment Effect 7 evaluate the endowment effect while controlling for possible misconceptions by including controls such as an explanation of optimal responses, practice rounds, assessments of valuations with an incentive-compatible mechanism, a market environment with incentives, and measuring the gap directly with valuations. Plott and Zeiler (2005) reported, with these various controls, that the endowment effect was not obtained, as the WTA was not statistically higher than the WTP. This opened up the possibility for potential boundary conditions associated with the likelihood of the endowment effect. Furthermore their results suggested that prospect theory was not the only interpretation for the endowment effect findings, or that the endowment effect could not be explained by prospect theory at all. Plott and Zeiler (2007) posed alternate explanations for the WTA-WTP gap exhibited by endowment effect experiments. Their reasoning included that participants, intent not to reject a gift from the experimenter, over-valued the items that has been given to them, or even that even arbitrary changes in procedures could affect results and create erroneous effects (Plott and Zeiler, 2007). Despite the dissenting opinions the endowment effect appears robust across many situations as different variables mediate and change the effect. For example, people are sensitive to the framing of the options they are evaluation and the endowment effect can be changed by their attachment to a status quo. Because of this sensitivity, instructions can mediate the effect when participants are not working directly with material and physical goods as the endowment by framing the situation as a gain or loss. An option asking the WTA for a loss of a public service is likely to be higher than an option eliciting a WTP to avoid losing that service because the question lends a status quo bias to the presence of the good, making the loss of the good salient to the decision maker. By this reasoning, for example, students will be willing to pay a

9 Endowment Effect 8 lower sum of money to avoid the suspension of winter shuttle service than the tuition refund they would expect, if asked, in return for the suspension of the same service. Similarly, if the two options asked how much people would be willing to spend (WTP) to supply a public good or service versus how much they would be willing to accept instead of having the public good, the WTA would again be higher. While the endowment effect occurs in both of these situations the willingness to accept instead of losing a public good is higher than the willingness to accept instead of having the free good because there is a status quo bias afforded to the pre-existence of the service (Ortona and Scacciati, 2003). Even people presented with theoretical situations in which they were asked to judge the relative fairness of a situation, as opposed to monetary value, have exhibited an endowment effect. Kahneman, Knetsch and Thaler s experiment (1990) demonstrated that the endowment effect is not limited to monetary values and transactions. Participants were able to discern between differences that were equal in magnitude with respect to a loss or reduction in gain. When asked, participants believed that the reduction of a gain was favorable and fairer than an equivalent loss as the reduction was not weighted as heavily in their minds. For example, a price raised a total of $X up to market value was seen as more fair than a price raised a total of $X above market value, even if the starting and ending prices and the reasoning behind raising the prices were all identical (Kahnman, Knetsch and Thaler, 1991). This shows that the endowment effect is not just about monetary value, but is about the inherent gains and losses created by the values people attribute to items and rewards associated with decision making processes. The endowment effect is also mediated by social factors. People place a premium on objects that serve as an inflation of identity defending against self-threat. There is an intrinsic value in possessing a good that can be linked to oneself and one s self-worth. When participants

10 Endowment Effect 9 in a seller condition feel threatened by an out-group or even a memory of rejection, they value a good they own even more highly than do the participants in a buyer condition as the value of the item becomes linked to their intrinsic self-worth. Threatened sellers exhibit an inflated WTA than do members of a control group valuing a good without any accompanying self-threatening manipulation. However, self-threat does not affect WTP prices, likely because buyers do not have any personal ties with an object they do not yet own (Dommer and Swaminathan 2012). These effects show that the endowment effect does not exist isolated from other social factors. The endowment effect describes a pattern of people s preferences that is inherently linked to their everyday social interactions: ownership changes how people look at an object and its value, and it also changes how people look at the situation and themselves. The endowment effect therefore has interesting applications outside of purely economic transactions. Another factor that has been demonstrated as a determinant in examining the endowment effect is time pressure. Most experiments are not conducted with time pressure, but in the real world, for example in auction conditions, time can play a critical role in buying and selling negotiations. Under low time pressure situations, such as those traditionally tested in experiments, the endowment effect holds. However, when high time pressure is introduced into the interaction, sellers often lower their prices to increase demand, and buyers are willing to pay more as they fear losing the opportunity to purchase a good. In some instances involving substantial time pressure, the endowment effect even switches directions, with the WTP of buyers greater than the WTA of sellers. This has been interpreted as the impact of high transaction demand causing buyers to raise and sellers to lower prices, as artificial demand is instantiated by the time pressure environment. This finding shows that time pressure can change the way people view their endowments, as individuals under pressure to sell an item often end up

11 Endowment Effect 10 devaluing it (Chuang, 2013). The time pressure creates an additional factor for people to deal with that effectively overrides their loss aversion. If people feel that they need to sell an item, they know that the best way to do that is to lower their price below competition prices. This might help explain how markets still function despite a WTA-WTP gap: adequate demand drives buyer prices up and seller prices down to create a market clearing price. Rather than the diminishment of the endowment effect showing it to be fragile, the fact that the effect can be predicted based on a variety of factors and interactions suggests that it is robust. There are several other findings that demonstrate that the endowment effect is not limited to mugs and physical objects. As decisions in society become increasingly abstract, and those decisions complicated by multiple options and the availability of vast amounts of information, people s strategic decisions might change to reflect such contingencies. Whether the decisions reflect real world issues involving, as examples, job offers or traffic penalties, people are inclined to stay with the originally endowed option. 1 This implies that when people are made offers, be they vacation days and salary packages or traffic schools and fines, the actual terms of the offer are not as important as the people proposing the offers (e.g. human resources managers or judges) believe. People have an inherent tendency to maintain the status quo, rather than switch to the non-endowed option that most heavily influences preferences. This suggests that ownership or prior random assignment a given offer is more important to decision making or more predictive than the offer itself (Brenner et al., 2007). Further removed from the physical sphere are the decisions that people make entirely based on online or virtual interactions with goods, such as during online shopping. The 1 This was the case in options with positive valence options; in a similar study, when endowed with an option that was inherently negative people, were inclined to switch (Brenner et al., 2007).

12 Endowment Effect 11 endowment effect has been demonstrated in experiments that have not presented a physical mug, but instead used a computer to present a picture of a mug for participants to consider (Chuang, 2013). The endowment effect was also observed in a completely virtual environment in which the objects and their usage were entirely confined to an online game setting (Sousa and Munro, 2012). These studies demonstrate that the endowment effect extends beyond objects with which a physical attachment can be made. While the endowment effect has been observed in various settings with a variety of methods, the many of the different methods that have been employed have not, to date, been compared within the same experiment. Such an examination would provide an analysis of the strength of the endowment effect as a function of critical variables. For example, and specific to the current project, do endowments that are not physical or materially present have the same effect magnitude as compared to physical objects? Given that ownership can effect loss aversion, and even people s perception of themselves, do people react differently when the item in question is not present? While the endowment effect holds when items are presented virtually, it remains unclear how that effect compares to that exhibited in an experiment with a physically present object. In today s society, in which items are increasingly digitally-presented and our interactions with objects are often online, it is relevant to consider how the physical versus virtual presence of an object might change the relationship of WTP and WTA. With the frequency of online shopping, people often do not get to hold and see an object before they purchase and own it. They often base their judgments on images and reviews prior to the purchase point. Several questions can be raised as a function of this relationship including: Does presence impact the ownership relationship with objects? Do people attach the same value to

13 Endowment Effect 12 owning something that they have seen and held, as compared to something they only saw online? Is the ownership value of a virtual object weaker, and does the virtual object have less effect on people s valuations of objects? Do physical versus virtual interactions change the amount that people are willing to pay for an object? The answers to these questions could have implications in the ways that retailers market products. Especially for those retailers that maintain a presence online as well as in brick and mortar stores. By endowing a student with a mug, either by placing it in front of them or by presenting them with images on a computer screen, I sought to observe whether people attribute more value to a physical object than to the imagery and the promise of one. Also, to test whether the representation of the object in the experiment interacts differently with people s valuations based on their designation as a buyer or a seller. To separate the effects of ownership from the effects of object presentation, the current experiment involved four conditions: the participant as buyer or seller in a condition with the object physically present, and the participant as buyer or seller in a condition in which the object was only represented on the screen. One possibility is that the virtual versus physical interaction with the mug might result in a difference in the ownership effect for the sellers and/or buyers. Ultimately the differences could speak to how an increasingly digital society has altered our relationship with, and valuation of, objects that we do not physically interact with. I expected to find the endowment effect in the conditions involving a physical object and the conditions involving virtual representation of the object. The physical manipulation partly serves as the control to replicate previous experiments which have also involved a physical object and also as a baseline for comparison. For the virtual condition, I hypothesized that an effect will be observed, given that some previous experiments have examined parameters of the

14 Endowment Effect 13 endowment effect with the object displayed on a computer screen (Chuang, 2013). In addition, I predicted that the endowment effect will be smaller in the virtual condition as compared to the physical condition, because while studies have shown the effect does exist with virtually presented objects, the two conditions have yet to be directly compared. This prediction aligns with the notion that a lack of physicality will diminish attachment and would weaken the loss felt by sellers. I further hypothesized that the presence of the object lends to changing peoples reference points to a greater magnitude, and its physicality interacts with peoples identity to a greater extent as it becomes theirs. Without the virtual sellers experiencing strong ownership preferences, or the virtual buyers experiencing salient potential gain, their valuations will be closer to those of the buyers and the endowment effect will not be as strong. Between the different presentations of virtual and physical, I hypothesized that buyers and sellers in the virtual condition will value the good at a lesser price whether they are submitting their WTP or WTA (as compared the values for the physical variation). The lack of physicality and inherent immediacy that goes with having the object in front of them will potentially diminish the ownership effect for sellers. Especially buyers could exhibit a lower WTP because they might associate the virtual representation with buying items on the internet, and people often turn to the internet to find cheaper prices and gather more information on buying an item so that they do not overpay. This particular effect might be mediated based on how frequently people interact with online shopping websites and virtual commodities, or if people use online shopping for convenience in contrast to value. Based on the manipulation and data collected I hoped to create a model describing how presence and ownership can predict valuations of goods.

15 Endowment Effect 14 Methods Core aspects of the experiment replicated the methods of the original endowment effect experiment, using mugs bearing a university logo 2 (Kahneman, Knetsch and Thaler, 1990). The current study was run for minutes, one participant at a time. While previous experiments created more of a market environment with multiple participants, the constraints on organizing such an experiment prevented replication of that aspect of the design. Instead, the instructions were written to put people in the mindset of an existing market. (Possible shortcomings of this approach will be discussed in limitations of the project). Half of the participants were randomly assigned to the role of buyers and half as the sellers. Within those roles they were also randomly assigned either to the physical variation, in which the mug was physically present, or the virtual variation, in which the mug was shown only on the computer screen in front of them. In the virtual variation, participants interactions with the mug were limited to switching between a picture of the front or back of the mug. This created a total of four conditions: Buyer-Physical, Buyer-Virtual, Seller-Physical and Seller-Virtual. A total of 68 Northwestern undergraduates participated, 17 in each experimental condition. Participants were recruited through three channels: introductory psychology students: students who completed the experiment as part of their course s experimental participation requirements; volunteers: students who were recruited through and were told they had a small probability (estimated at 1/70) of winning an Amazon gift-card; and cognitive psychology students recruited also through but had an additional incentive to volunteer to receive an excused homework assignment. 2 The mugs were created and ordered for the experiment but a similar mug at the bookstore sells for about $9.99

16 Endowment Effect 15 All sellers were selected to receive the mug at the beginning of the experiment. They were presented with a mug and told, Here is a mug, it is yours, and you own it and will be able to take it with you. In the marketplace you are also able to sell objects which you own in exchange for receiving money. In the virtual condition participants were given the same instructions except they were shown pictures of the mug on an adjacent screen. While they did not see the physical mug, they were told that they would be able to take the represented mug with them at the end of the experiment. Buyers in the physical condition, who were selected to bid on the mug, were told, Here is a mug we will use in this experiment. You may inspect it, and in the marketplace you could pay money to purchase the mug and take it with you. Again, in the virtual condition they were given the same instructions but were only able to see the mug as presented on the adjacent screen when making their evaluation. Importantly, incoming participants believed that they would not benefit from the study beyond either the course credit they were receiving or entry into a raffle. They were not specifically told a priori about the mug or any additional payment beyond the consent form, which alluded to the opportunity to receive items of value through their participation but did not indicate that everyone would be receiving the same payment. So, the manipulation of buyer versus seller was the first the participants heard about the potential receipt of a mug. Participants were timed from the moment they were given the mug until they were ready to continue the experiment. They were then given instructions about the marketplace that they were participating in, and the bidding process that would take place. They were also timed while reading the instructions for the valuation process. The transaction process was explained to the participants as follows:

17 Endowment Effect 16 For buyers: In the marketplace, a transaction occurs when an owner of an item sets a price that is less than or equal to a price that a buyer in the marketplace is willing to pay You choose a price at which you will purchase the mug By choosing a price, you are indicating that you would be happier to have the mug than to keep that amount in cash In a market transaction, you receive the mug in exchange for that sum of money For the following reasons it is always optimal to choose a price equal to your true value of the mug: If you choose a price above your value of the mug, you pay more money than the mug is worth to you If you choose a price below your value of the mug, you might not have the opportunity to buy the mug even when there was someone in the market who would sell it at your value For sellers: In the marketplace, a transaction occurs when an owner of an item sets a price that is less than or equal to a price that a buyer in the marketplace is willing to pay You can set a price for the mug that you own By setting a price, you are indicating that you would be happier to have that amount in cash than to keep the mug In a market transaction, you receive that sum of money in exchange for the mug For the following reasons it is always optimal to set a price equal to your true value of the mug:

18 Endowment Effect 17 If you set a price below your value of the mug, you may receive less money than the mug is worth to you If you set a price above your value of the mug, you might not sell the mug even when there was someone in the market who would buy it at your value The purpose of explicitly explaining the transaction process to participants was to make them understand that submitting their true value was optimal in order to get their true WTA or WTP and to control for their misconceptions 3 by explaining the optimal responses that to be made. Since participants were taking part in the study voluntarily or for course credit and not expecting monetary payment, it was important to get them to submit a serious valuation. Furthermore monetary payment was specifically not used to recruit participants as it could change their reference point as participants in the study in case the point at which people felt they acquired the money (i.e., by showing up, or not until they had received it) were different for different participants and could change their reference points and skew the data accordingly. After reading the instructions, participants were asked to provide their value of the mug. Importantly their response indicated either the value they would need to receive to part with the mug, or the value they would be willing to pay for the mug. They were then asked a question in similar language confirming that was the value they would ascribe to the mug, to ensure that they understood what the number represented. If participants decided based on the presented statement that they had misunderstood the instructions they could go back and resubmit their value for the mug. This effectively created practice rounds within the experiment design. After submitting their value of the mug, participants filled out a short survey about gender, experience with economics classes, their familiarity with the endowment effect, and their 3 Plott and Zeiler, 2005

19 Endowment Effect 18 tendency to shop online. While not related to the endowment effect, online shopping questions were included to help explain, as a function of experience in interacting virtually with goods, a potential difference between the physical and virtual condition. Finally, participants were debriefed and all received a physical mug, regardless of their assigned condition. Participants were then asked not to share information about the experiment to avoid compromising the purpose of the study. Results and Statistical Analyses Primary variables of interest The dataset was examined for outliers 4 but given the relatively small range of answers and the high standard deviations there were no datapoints that could be corrected towards the mean. The intention had been to generate a rough predictive formula of valution by controlling for presence of the item and ownership using dummy variables, and by further controlling for individual differences like the example shown in Figure 1. However, given the limited nature of the data, a full predictive model was not the best way to analyze the results. Instead the endowment effect and the difference between conditions were evaluated using t-tests to check if the difference between groups was significant. Similarly, they were evaluated using Ordinary Least Squares (OLS) linear regressions to illustrate the coefficients that could help predict variation in valuations. Figure 1 4 By classifying outliers as any values reported that were more than two standard deviations outside the mean.

20 Endowment Effect 19 The mean values across the four conditions: Buyer-Physical, Buyer-Virtual, Seller- Physical, Seller-Virtual; are shown in Table 1 and Figure 1. While there was an endowment effect measured, where the average WTA was higher than the average WTP, in both the physical and virtual variations in the physical variation, the assignment of buyer or seller was not significant in predicting the subjects valuation of the mug (p-value=0.43). However, in the virtual variation, the distinction between the buyer and seller conditions was significant (pvalue=0.05), see Figure 2 5 for a prediction of the endowment effect within virtual participants. Buyer/WTP (SD) Seller/WTA (SD) All Physical $ 7.63 (2.72) $ 8.84 (5.68) $ 8.24 (4.43) Virtual $ 7.03 (2.45) $ 8.84 (2.75) $ 7.93 (2.73) All $ 7.33 (2.57) $ 8.84 (4.40) $ 8.09 (3.66) Table1 1 Average Value by Condition $10.00 $9.00 $8.00 $7.00 $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $- Figure 1 Virtual Physical All Buyer Seller 5 Where * indicates significance at the 5% level.

21 Endowment Effect 20 Figure 2 Table 2 shows a summary of the endowment effect, defined as the difference between the mean WTA and WTP in each variation between subjects. Across the two variations, the assignment of buyer and seller was not statistically significant in predicting participants values. An ANOVA determined that the WTA-WTP difference between the buyers and sellers in all variations was marginal (p-value=0.09). WTA-WTP Physical $ 1.22 Virtual $ 1.81 $2.00 $1.80 $1.60 $1.40 $1.20 $1.00 $0.80 $0.60 $0.40 $0.20 $0.00 Table 2 All $ 1.51 Endowment Effect by Variation WTA-WTP Gap Physical Virtual * All *Indicates that the difference was statistically significant at the 5% level Graph 3 Overall, valuations were higher in the physical than virtual versions of the experiment. However, the differences were only marginal. The data, as is illustrated in Figure 4 and Table 3,

22 Endowment Effect 21 at best is only suggestive as to the differential effects of virtual versus physical presentation in each condition. Average Value by Variation $10.00 $9.00 $8.00 $7.00 $6.00 $5.00 $4.00 $3.00 $2.00 $1.00 $- Figure 3 Buyer Seller All Virtual Physical Buyer (WTA) Seller (WTP) All Physical - Virtual $ 0.60 $ 0.01 $ 0.30 Table 3 Other Findings/Other Variables of Interest The experiment, especially the questions at the end, captured additional data points beyond the valuation and condition of participants. Not all of these data points were directly related to the manipulated variables. These variables were collected to see if other metrics of the evaluation process and other demographic features could impact and help predict the effect, or help remove the noise. These variables included timing the participants through different stages of the experiment, tracking how many clicks they made, and asking about their major and

23 Endowment Effect 22 familiarity with the endowment effect. 6 While many of these variables were insignificant, and it was difficult to ascertain the impact of these additional variables on the endowment effect given the limited evidence for the effect in the data, some of the variables collected were correlated with people s valuation of the mug. These variables that were correlated with value, the dependent variable, are helpful in modeling how people made their valuation of the mug. One of the variables that had a negative correlation with valuation of the object was whether or not participants had been recruited through the psychology department course requirement (ρ=-0.24). In particular, students recruited through the psychology department course requirement (N=26), as opposed to the volunteers recruited through , undervalued the mug. This is demonstrated in Figure 5 7 which shows that the psychology student dummy variable had a statistically significant negative coefficient for predicting value (p-value=0.05). Figure 5 Additionally, if the these psychology students were removed from the pool of participants and the only data used was from the participants recruited as volunteers (N=42), the p-value for the WTA-WTP gap between buyer and seller (the validity of the endowment effect) improves to 0.002, so it is also significant at the 1% level. The OLS model for the volunteering participants in the virtual condition is shown in Figure 6 8. Also, the coefficient of Seller in Figure 6 is higher than that of Figure 2, while the constants are almost the same. This suggests that the assignment to buyer or seller is a better predictor of the subject s value for the mug if the subject was a volunteer, and shows that the psychology requirement students had a smaller increase in WTA, and a smaller endowment effect. Figure 5 also demonstrates how students recruited through the 6 A complete list of the variables is available in Appendix B 7 Where * indicates significance at the 5% level. 8 Where ** indicates significance at the 1% level.

24 Endowment Effect 23 psych department on average valued the mug at a lower price. This is slightly problematic as for the experiment it is ideal that all the populations recruited perform homogeneously in the task. Figure 6 Additionally, Gender (a dummy variable that was labeled as 1 for male and 0 for female) was negatively correlated with the valuation of the mug (ρ= -0.25). Meaning, men in the seller position valued the mug at a lower price than the women, this effect was exhibited overall. In particular this effect was stronger in the seller condition (ρ= -0.29). This means that gender was predictive in the valuation of items. In particular, men exhibit less of a tendency than women to overvalue items which they own. Figure 7 9, where MaleSeller is a variable indicating if a participant was both male and in possession of the item, illustrates how while sellers overall have a higher valuation for the mug if the seller is male the effect essentially cancels out. However, if the participant was male and a buyer, or a female seller then they valued the mug similarly to the rest of the sample. Figure 7 Discussion and Limitations The data show that the endowment effect, while present in both the physical and the virtual variations, is only statistically significant in the virtual. While initially the intention had been to compare the magnitude of the two effects this is not as valuable given the insignificant effect in the physical condition. It does appear the virtual variation of the experiment had a larger endowment effect, but since there was not a significant difference between the virtual and physical responses overall it is unclear that this effect would hold. Another important note to 9 Where * indicates significance at the 5% level, and ** indicates significance at the 1% level.

25 Endowment Effect 24 make about the lack of significance in the physical dataset is that the standard deviation in the Seller-Physical condition was higher at 5.68 where all the other standard deviations were fairly consistent at about half that. This violates homoscedasticity and also suggests that there might have been an issue with that particular condition throughout the experiment. One possible explanation for the different effects observed in the physical and virtual variations is credibility. While the mug was presented to sellers and they were told they would be able to keep it there was no receipt or confirmation of the transaction prior to their submission of their value. They might have merely believed that it was a deceitful manipulation of the experiment. In the physical condition especially, participants were less likely to believe that there were actual mugs at stake, as it is not common for experiments to involve giveaway prizes. Therefore, it is possible that those in the seller condition did not believe that they would in fact be keeping the mug and so did not exhibit ownership effects. Similarly the endowment effect emerged in the virtual condition may have mapped more closely to a real buying situation for students. Because the experiment question were asked on a computer more closely mirrored the environment of actual online shopping, creating a more credible atmosphere and allowing participants to more accurately display their true behavior regarding gains and losses. This might explain how participants in the Buyer-Virtual condition may have been primed to bid less relative to the other designated buyers due to their preexisting associations with online shopping and receiving a lower price. It is interesting that the seller condition valued the mug almost exactly the same regardless of how it was presented (the means for sellers in the virtual and physical variations were the same). Perhaps the participants assigned to the Seller-Virtual condition overvalued the mug when taking a seller s perspective because they truly believed there was nothing on the line.

26 Endowment Effect 25 That is, they could bid a price above what they rationally should because they had no expectation of keeping/selling the mug either way. Conversely, those in the Seller-Physical condition might have valued the mug higher had they truly believed that they would be keeping the mug at the end of the experiment. Additionally, it is possible that the act of the experimenter giving the mug caused them to ascribe additional value to the item, perhaps beyond their own attachment, manifested by a desire to perform well in the circumstances of the experiment. The additional value they attributed to the object had less to do with loss aversion or the mug presentation, and more to do with their desire to perform correctly in the task, or to appease the experimenter. By Plott and Zeiler s (2005) logic of creating a market environment with incentives for participation and true valuation, perhaps the incentives (i.e., the mug) in the physical condition were more incentive compatible than those in the virtual condition because of the presence of the mug. Thus in the physical condition the misconceptions in valuations created by lack of relevant incentives 10 were better controlled thereby diminishing the endowment effect. Either way, it is evident that the endowment effect can be diminished by exercising various controls so it is problematic if those controls differed between the variations of presence. Another issue of concern, when looking at the averages across conditions and variations, is that participants in the Seller-Physical condition have far more variation in their responses (i.e., $1.03 to $20) than did participants in any of the other conditions. Valuations in this condition do not converge on similar mean, indicating little in the way of consistency among the responses for this group of individuals. Perhaps, as Plott and Zeiler (2005) suggested was necessary, the experiment controlled for the many possible misunderstandings of the task, thus eliciting people s true and random valuations for the item and diminishing the endowment effect. 10 Plott and Zeiler listed creating a market environment with incentives as a way to control for the misconceptions that they believe lead to the observation of the endowment effect (2005).

27 Endowment Effect 26 There is the concern that the endowment effect failed to replicate across the manipulation because the virtual and physical experiments were not exactly the same. The slides presented to those in the virtual manipulation, which can be seen in Appendix A, were designed to look like a basic online shopping page. However, they contain the text Northwestern University Mug, with no equivalent statement during the presentation of the physical mug indicating it was a Northwestern Mug. While both the physical mug and picture bore an identical Northwestern logo, the text in the virtual slides might have inadvertently contributed to positive feelings for the virtual item, leading the sellers, or participants from both conditions, to overvalue the item due to its association with their school. This explanation could explain why participants in the Seller- Virtual condition did not value the item below those in the Seller-Physical condition, since the mean values in these two conditions were the same. The additional value they ascribed to the Northwestern affiliated item might have canceled out an effect of the objects absence in their valuations. There are some limitations and concerns for the current study. Firstly, there were two critical differences between the current methods and the methods from the study originally describing the endowment effect (Kahneman et al., 1990). The first is the valuation method: in the original study, participants were presented with incremental values; in the current study, participants were presented with a slider to select their value. However, given that the language was carefully based on the language from the original study, this adjustment should not have unduly influenced participants valuations. Secondly, participants in the current study were run individually, while participants were run in a big group in the original study. For the current project, this means that participants were not aware of the students participating in other conditions (buyer or seller) while completing their valuation; awareness of those students might

28 Endowment Effect 27 have offered an additional consideration and comparison point for making their valuation decisions. Finally, the current dataset had a relatively small number of observations per condition because there were effectively four conditions instead of two. Another limitation to note is that it is unclear how the Seller-Virtual condition translates to a real situation. People selling an item, even online, nearly always have the item present with them, especially if they own and are selling the individual item. While the closest situation to this in the experiment was the Seller-Virtual condition the participants in this condition were selling at item they had not interacted with physically. If people do not often sell items that are theirs without actually physically interacting with the items, the findings from the current experiment might not be generalizable. Additionally, it is unclear how the prevalence of the endowment effect translates to objects with greater worth. A college mug is popular in studies because it is a fairly neutral object that is relative cheap, and the value is not obvious to participants, although it falls within a reasonably calculable range. However, with larger, more valuable objects, including electronics or furniture, which people are also likely to buy online, it is unclear if the same endowment effects be exhibited, and if there will be similar effects of the physical of virtual representation. Conclusion While this study failed to identify a meaningful difference between the virtual and physical examination of the endowment effect, it did raise further questions as to the existence of the endowment effect and the validity of ascribing the effect to prospect theory. While the study demonstrated the endowment effect in the virtual and not the physical conditions, it is unclear if the finding was attributable to physical condition possessing better mediation of subject

29 Endowment Effect 28 misconceptions (such as meaningful incentives, and practice rounds) that might lead to an observation of the endowment effect or if there was some other difference between the two variations that created an erroneous effect. What can be concluded from this study is that the endowment effect, to the extent that it can be created or observed with physical objects, can also be observed with virtual objects. Therefore, online markets, especially ones that are reliant on self-set prices, are potentially susceptible to price mismatches between buyers and sellers. The fact that the endowment effect was observed in the virtual condition suggests that ownership can be established through a virtual interaction. If the WTA-WTP gap holds then it shows that virtual interactions can create effects similar to that of physical ones. While it is unclear exactly how physicality of an item can predict its value to a person, if people can feel ownership without directly interacting with an item it opens a realm of possibilities for future study. In particular one issue this study was concerned with was the method of compensation. The participants in the study were not paid in an effort to avoid changing people s status quo of wealth. This study would suggest that people might recognize the money, or an item, as theirs before it is in their possession. Therefore, an item they have not yet received may impact their decision making. It would be interesting to study at what point people feel that items become theirs. In the example of compensation do people recognize the additional wealth when they book the experiment? Or when they arrive to participate? Perhaps these differences are mediated by personal differences. More closely related to the experiment at hand, when people buy items online do they recognize it as theirs the moment the credit card transaction goes through? Or perhaps when it is shipped? These differences could impact how people evaluate their current wealth and perhaps change their behaviors in future buying or selling transactions.

30 Endowment Effect 29 As this study was unable to show two significant endowment effects using the same methodology future studies could examine if it is possible for the endowment effect to exist in the same controlled setting with both physical and virtual interactions with goods. These studies would not only have the particular purpose of examining the magnitude of the endowment effect, but they could also examine if the controls that create or destroy the effect are the same across the two settings. Determining what mediates the endowment effect in each setting could be an important key to unlocking how peoples valuations change in different environments. While Plott and Zeiler (2005) claim that the endowment effect is not evidence for prospect theory their claims must be further examined. It is not enough to say controlling for several aspects of the experiment destroying the effect is proof that it does not exist. Rather the endowment effect has been shown be mediated by different factors. To further examine the relationship between the effect and prospect theory researchers could take an experiment where the endowment effect does exist and perform it with objects of increasing value. This would allow multiple data points where they could map the endowment effect to the proposed curves of prospect theory by graphing the sellers value as the values of loss, and the buyers as the gain. An experiment like this would allow people to see if the endowment effect is really driven by imbalanced preferences and if, as prospect theory suggests, the indifference curve for losses is steeper than that for gains. The question of how valuations interact with the presence of goods remains for future exploration. As stores increasingly occupy both online and physical retail settings simultaneously, knowing how people change their valuations across situations is valuable. Sellers should understand how buyers react to different prices based on presence and other demographic factors. Online advertising advances increasingly allow retailers to gain access to

31 Endowment Effect 30 information, it is important that they understand the best way to use it. If the endowment effect is at play then they can either exploit, or do their best to mediate the effect. Ultimately the endowment effect is still important to understanding preferences; it just might be challenging to test the variables that can most aptly contribute to our understanding of how peoples values interact with the presence of goods.

32 Endowment Effect 31 Appendix A Slides presented in virtual variations, mug pictured is the same as mug presented in the physical variation of the study