Download Microeconomics for MBAs: The Economic Way of Thinking for

Microeconomics for MBAs: The Economic Way of Thinking for Managers, Second Edition
Richard B. McKenzie and Dwight R. Lee
Monopoly power and firm
pricing decisions
CHAPTER
10
Reading 10.3: The “endowment effect” and pricing
In a perfectly competitive market, buyers and sellers have absolutely no control over price. They
accept or reject the going market price, all very rationally. But then if people are not actually as
rational as economists posit in their theories, perhaps buying and selling prices might diverge,
suggesting that pricing strategies might emerge from other than external market forces. There
could be internal (mental) forces at work on pricing strategies, or so say behavioral economists.
Again, standard microeconomic theory posits that a rational person unwilling to pay $200
for a football ticket should be willing to sell such a ticket he is given, or has bought at a much
lower price, if the ticket can be sold for at least $200. The reasoning is straightforward: The
person unwilling to pay $200 for the ticket is saying that he has something better to do with
$200, or else he would buy the ticket. The utility of the something else is greater than the utility
of seeing the game. If the person has been given the ticket, then he still has something better to
do with the $200, unless something has changed. He should sell the ticket and do the something
else that is more valuable to him.
We both have taught at major sports universities where our students have all admitted in
class that they would not pay the scalping price of, say, $200 for a ticket to a sold-out “big
game.” However, when polled, those same students who had “free” student tickets also would
not sell their tickets for the scalping price. What’s going on with our students? Are they
irrational? Or are economists wrong to presume that people are rational?
Behavioral economists (or economists who maintain that people’s decision-making
ability falls far short of the level of rationality that mainstream economists assume and who look
to laboratory and survey evidence on how real-world people make decisions) have evidence that
people don’t behave as rationally as economists posit. Indeed, behavioral economists (and
psychologists) argue that people are so consistently irrational in a variety of ways that they are
“predictably irrational” (Ariely 2008; Thaler and Sunstein 2008). We can’t cover here all the
behavioral economists’ findings, but we can report on a pricing argument that they make under
the tag of the endowment effect. (A longer discussion of findings in behavioral economics can
be found on the website for this book, as well as in the books just cited.)
The endowment effect is the inertia built into consumer choice processes due to the fact that
consumers value goods that they hold more than the ones that they don’t hold.
University of Chicago economist Richard Thaler (2000) argues that, as in the case of
student tickets, people are commonly willing to pay less to obtain many goods than they are
willing to accept as payment on selling the goods, a fact of human decision making that has
implications for a firm’s pricing strategies. Thaler notes that “income effects” and “transaction
costs” can explain the differences between people’s buying and selling prices. Students who are
given a ticket to their university’s football game are, in effect, given a real income grant, which
results in a higher wealth. Students’ greater wealth might result in a suppression of their need to
Microeconomics for MBAs | Richard McKenzie & Dwight Lee | Cambridge University Press 2010
Microeconomics for MBAs: The Economic Way of Thinking for Managers, Second Edition
Richard B. McKenzie and Dwight R. Lee
2
sell the ticket, which shows up in their asking for a greater price to sell the ticket than the price
they would be willing to pay, absent the wealth represented by the ticket.
But in another experiment, behavioral researchers gave coffee mugs to some subjects in
the group and found those who were given the mugs set their selling prices two to three times the
buying prices of those who were not given mugs (Kahneman, Thaler, and Knetsch 1990).
These researchers conclude that people’s difference between “willing to buy” and “willingness to
pay” are “too large to be explained by income effects” alone (1990, 1325). The income and
wealth effects involved in things like tickets must be minor, if not trivial, when compared to
people’s expected total lifetime wealth, according to the behavioralists.
Thaler suggests a more “parsimonious” explanation for the differences between people’s
buying and selling price, the endowment effect, which is different from the wealth effect noted
above (Thaler 2000, 273-6).
Thaler traces the endowment effect to a difference (not recognized in conventional
microeconomics) between opportunity costs and out-of-pocket expenditures, with many
consumers viewing the former as forgone gains and the latter as losses. Given people’s observed
inclination toward loss aversion (which behavioralists have found in their laboratory
experiments), the pain of loss will suppress consumers’ buying prices below their selling prices.
Similarly, their required selling prices can be inflated because decision weights for gains
(implied in the selling price of a good received free of charge or bought at a lower price) are
subjectively suppressed.1
Thaler argues that the endowment effect suggests that buyers will have a decided
preference for receiving discounts from high prices rather than incurring surcharges imposed on
low prices, even though the discounts and surcharges lead to the same final price (2000). This
would suggest that firms should have a bias toward “overpricing” their products. If they have to
adjust their prices, they can upset their customers less by discounting or reducing their prices
than if they “underprice” and later have to hike their prices. This implies that overpricing can
lead to higher equilibrium prices than would be achieved with underpricing, and greater profits
for firms.
Credit card companies charge retailers for customers’ use of their cards. Retailers can
accommodate for these fees either by imposing a surcharge on credit card transactions or by
granting cash customers a discount. Understandably from the perspective of the endowment
effect, credit card companies have prohibited retailers from charging credit card customers a
price different from cash customers. When Congress began investigating the banned price
differential for credit card and cash payment, an economist at the Federal Board of Governors
argued that, from an economic perspective, surcharges and discounts cannot be distinguished
conceptually, although he agreed that surcharges and discounts had “psychological effects.” The
surcharge might be viewed as a penalty for credit card use and a discount as a reward for cash
1
To support his endowment effect arguments, Thaler points to an experiment with MBA students by
other researchers (Becker, Ronen, and Sorter 1974). The students were given a choice between two
projects that differed in only one regard: One project required the students or their firms to incur an
opportunity cost. The other project required that the students or their firms make out-of-pocket
expenditures. “The students systematically preferred the project with the opportunity cost” (Thaler 2000,
274). This finding suggests that the students should be willing to accept a lower rate of return on
opportunity-cost investment projects than on out-of-pocket-expenditure projects of equal amounts.
Microeconomics for MBAs | Richard McKenzie & Dwight Lee | Cambridge University Press 2010
Microeconomics for MBAs: The Economic Way of Thinking for Managers, Second Edition
Richard B. McKenzie and Dwight R. Lee
3
use.2 That is precisely why the credit card companies lobbied for discounts for cash purchases, if
there were to be a price difference between credit card and cash purchases. Citing the
endowment effect, Thaler would add that the credit card industry’s bias for the cash discounts
“makes sense if consumers would view the cash discount as an opportunity cost of using the
credit card but the surcharge as an out-of-pocket cost” (2000, 274), which implies that discounts
for cash purchases could lead to higher prices and profits for retailers (and higher fees and profits
for credit card companies) than would be the case under surcharges for credit card use. Retail
sales also would be higher for discounts for cash customers than surcharges for credit card
customers, suggesting that retailers might be expected to favor credit card companies’
prohibition against surcharges.
Thaler argues that the endowment effect can also help explain why stores widely employ
money-back guarantees on purchases for some set time period, such as thirty or ninety days
(2000, 275). Because the shopper may not have experienced the use of the good when the good
is purchased, the shopper might reason that with the money-back guarantee, the most that can be
lost is the transaction cost of buying the good and returning it. If the buyer perceives the value of
experiencing the good for up to thirty days is greater than these transaction costs, then he will
buy it. Once the shopper has experienced the good, however, the good becomes a part of his
endowment. The price of the good is no longer an out-of-pocket cost. Rather, the potential price
received on the product’s return is converted to an opportunity cost, which means that at that
point the shopper might keep the good in spite of the fact that the experience with the good
proves that the value of the good was not worth its purchase price. Paradoxically, the shopper
would not buy the good again, but he keeps it anyway. This means that the retailers can charge
more for goods when they offer money-back guarantees and can increase sales over and above
what they would be able to charge if shoppers knew the true value of the good at the initial
purchase point.
Finally, the endowment effect helps explain the paradox of holiday gift giving among
individuals and firms. Since money is fungible (can be used to buy any number of things people
value), a $100 gift in the form of an object or service, or in kind, is likely to be less valuable to
recipients than $100 in cash. If the recipient gets $100 in cash, then the recipient can always buy
the in-kind gift that would have been purchased, or the recipient can use the dollars to buy
something else that is more valuable to him. Only when the in-kind gift can be easily sold (with
zero transaction costs), or the giver happens to select exactly what the recipient would have
purchased with $100, will the recipient view the cash and in-kind gifts as equivalent.
But from the perspective of the endowment effect, the in-kind gift can be more valuable
than the cash gift. First, the recipient may not have been willing to spend $100 on the particular
in-kind gift, partially because he does not want to incur the added pain of transaction costs and,
especially for behavioral economists, the added pain associated with an out-of-pocket
expenditure for the good. Second, the gift can take on greater subjective value than the $100
cash gift. This is because, if the endowment effect is to be believed, the gift-recipient would
demand more than $100 before he or she would sell the good. The endowment effect offers the
gift-givers some confidence that while the in-kind gift is something the recipient would not buy,
it is also something that the recipient would not readily sell. If there were no endowment effect,
gift-givers would be more inclined to give cash, perhaps in an amount less than would be spent
on the in-kind gift, because givers’ in-kind gifts would be so readily converted to cash and spent
2
See Thaler (2000, 275, note 6).
Microeconomics for MBAs | Richard McKenzie & Dwight Lee | Cambridge University Press 2010
Microeconomics for MBAs: The Economic Way of Thinking for Managers, Second Edition
Richard B. McKenzie and Dwight R. Lee
4
on something else. And, without an endowment effect, givers would not so readily be able to
affect the actual endowment of goods of the recipients, which could undercut the value of giving
to the givers.
The bottom line
Research has found that people’s buying price is often lower than their selling price. Behavioral
economists tend to ascribe the price difference to the “endowment effect,” which is to say that
possession can add value to goods.
Review questions
1
2
Why is there a difference between people’s buying and selling prices?
If there is an endowment effect, can businesses make money off of it?
Microeconomics for MBAs | Richard McKenzie & Dwight Lee | Cambridge University Press 2010