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Abstract
The endowment effect, status quo bias, and loss aversion are robust and well documented results from experimental psychology. They introduce a wedge between the prices at which one is willing to sell or buy a good. The objective of this paper is to address this wedge. We show that the presence of asymmetric information in a rational-agent framework can also account for the endowment effect, status quo bias and loss aversion without invoking psychology-based explanations proposed in the past.
Keywords: endowment effect, status quo bias, loss aversion, asymmetric information, bid/ask spread
JEL Classification: D81, D82, G22
The discrepancy between the maximum willingness to pay for a good (WTP) and the minimum compensation demanded to part from the good (WTA) is a robust empirical observation in economics (Kahneman, Knetsch, and Thaler, 1990, 1991). The measures of WTA exceeding the measures of WTP, however, cannot be explained by the neo-classical framework with smooth utility function like that in Thaler and Rosen (1975). The leading alternative explanations for the difference between WTP and WTA are the "endowment effect" (Thaler, 1980) which captures the overvaluation of a good due to possession of it; the "status quo bias" (Samuelson and Zeckhauser, 1988) which is the preference to remain at a current state; and "prospect theory" (Kahneman and Tversky, 1979) where losses impact the agent's utility more than gains of the same magnitude. According to Kahneman, Knetsch, and Thaler (1991, p. 205), "after more than a decade of research on this topic we have become convinced that the endowment effect, status quo bias, and aversion to losses are both robust and important." A large empirical literature, drawing on surveys and psychological experiments, confirms the existence of those effects in many different fields.1
The purpose of this paper is not to dispute the fact that the disparity between WTP and WTA exists but to provide an alternative explanation for these observations within a rational expectation framework. Although both status quo and prospect theory could be explained by our approach, we focus on endowment effect. Specifically, the endowment effect that we have in mind is in respect to initial positions in the risk probability value (Viscusi, Magat, and Huber, 1987) and not in respect to income level. We show that a...