Question

What is an endowment effect? Give an example of such an effect.

Answer 1

Sometimes it is observed that consumers are behaving in an exceptional manner. If such behavior are identified and taken into consideration then economist can make a better study about the consumer. Endowment effect is one such special behavior of consumer.

Suppose a product is normally sold in the market at $10. Due to some uncertainty in the economy, demand of the product has increased. A person thinks that due to the prevailing situation of high demand, maximum price of the product should be $20. It will mean he will buy if price is $20. Also as a seller he will be ready to sell at this price if he owns it.

Now suppose actual price is found at $25. He will not buy it as he believes it is too high. On the other hand, if he is a seller, then his normal behavior will allow him to sell the product since the price is more than his expectation.

This normal behavior is sometimes found missing. He is not buying it as the price is high. This behavior is shown by the understated diagram-

In the diagram above, D₁ is the original demand curve. Normal price of the product was $10. At this price Q₁ units are sold. Now due to change in situation, the demand has increased. Demand curve has shifted to the right at D₂.

If price remains at $10, then Q₃ units can be sold. But it will not happen, as the price is expected to go at $20. At this price Q₂ units will be sold which is lower than Q₃ quantity.

Now actual price is above $20. Consumer thinks any price above $20 is too high. Thus at price above $20 his demand curve will be very elastic. It is shown by the demand line D₃. This curve shows that demand is zero at price of $25. Thus consumer has refused the buy the product at this price of $25.

Value of the same product will change significantly as soon as he owns it. After owning the product, its value to him will be much higher than $25.

As a result, after owning the product, he is not ready to sell even at a price of $25. He is now getting satisfaction of more than $25. So he will not be ready to hand over its possession even at this high price of $25.

In this case value of the product is becoming different, when he is a seller. As a buyer he is valuing the product less than existing market price of $25. But as a seller he is valuing the product well above $25. This variation in the valuation of product as a buyer or as a seller is known as endowment effect.

Example: At the time of buying a residential flat at say $100,000, a person may consider it too high. He then put emphasis on the age of the house, maintenance cost, renovation and repairing cost, remodeling cost etc. as a result house was considered purchasable at $80,000 only.

Now suppose he has got the house at $80,000. Immediately after its purchase he observed that location of the house, designing, facilities provided by the flat are very attractive. So it is now very much valuable to him. He is not ready to sell it now even at $100,000.

This change in the valuation of house is due to endowment effect.