Economics Endowment Effect Questions Medium
Preference reversal refers to a phenomenon in which individuals' preferences for a good or item change depending on whether they own it or not. In the context of the Endowment Effect, preference reversal occurs when individuals value an item more highly simply because they possess it, compared to when they do not own it.
The Endowment Effect is a cognitive bias that suggests people tend to place a higher value on items they own compared to identical items they do not own. This bias was first identified by behavioral economists Richard Thaler, Daniel Kahneman, and Jack Knetsch in the 1990s.
Preference reversal in relation to the Endowment Effect can be explained through the concept of loss aversion. Loss aversion refers to the tendency of individuals to strongly prefer avoiding losses over acquiring gains. When individuals are endowed with a good, they perceive its loss as a loss of utility, which they are averse to. This loss aversion leads to an increase in the subjective value of the endowed item, resulting in a preference reversal.
For example, imagine a person is given a coffee mug as a gift. Initially, they may have had a certain value or preference for the mug. However, once they possess it, they may start valuing it more than they did before. If someone were to offer to buy the mug from them, they might demand a higher price than what they would be willing to pay for the same mug if they did not own it. This difference in valuation is a result of the preference reversal caused by the Endowment Effect.
Preference reversal in the context of the Endowment Effect has important implications for economic decision-making. It suggests that individuals' valuations and willingness to trade are influenced by their ownership of a good, rather than its inherent characteristics or market value. This bias can lead to market inefficiencies, as individuals may be unwilling to sell their endowed items at a fair market price or may demand a higher price for them.