October 06, 2009
What's wrong with the "endowment effect"?
Posted by Gordon Smith

John Carney is not sold on the endowment effect, and he has put together an entertaining 16-part post to convince you that "the Endowment Effect may really be a response to the counterparty risk faced by early humans."

I think John Carney is one of the most interesting business bloggers around, but I am not buying this. Why does he have to bring "early humans" into this story anyway? Why not just test people in a context with counter-party risk and compare them to a control group tested without counter-party risk?

The problem for John is that the experiments on the Endowment Effect do not create counter-party risk. The Endowment Effect appears in the lab even when counter-party risk is absent. And that is improper because ...?

According to John, these experiments erred by testing "subjects who had deeply ingrained, hard-wired counter-party risk discounting built into their behavior." As Brian Regan said about the Pop Tart directions, "I see where you're going with this ..."

So I will play along ... how do we know that people are hard-wired for counter-party risk, even when the transaction doesn't involve counter-party risk? At this point, John's version of evolutionary psychology looks a lot like religion, making assertions about human nature that are not susceptible to falsification. Of course, I have nothing against religion, as a general matter, but pardon me if I choose not to worship at this particular altar.

I thought John was going to take on behavioral economists for finding irrationality where none existed, but instead what I found is that he doesn't like the particular brand of irrationality manifested in the Endowment Effect. He prefers a different sort of irrationality that is deeply ingrained and hard-wired by evolution.

At the end of the post, I was still wondering: does it matter which form of irrationality we choose to believe? I don't think so. Slide 14 is entitled, "The Meltdown Shows The Endowment Effect Might Not Be Irrational At All." Nevertheless, two slides later, on the last slide, John is warning us against behavioral economists, and that's a message that resonates with Larry Ribstein.

UPDATE: Some sidebar correspondence with John Carney, Larry Ribstein, and Josh Wright sorted a few things out. Among them, Josh was interested in the answer to the question posed by the title of my post. He rightly observed that I didn't answer the question, but merely criticized John's answer. Fortunately, Josh was able to provide a concise answer of his own at Truth on the Market, including a reference to the Plott & Zeiler paper linked in the comments by BDG. Nicely done, Josh.

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