Economics Prospect Theory Questions Medium
The endowment effect refers to the tendency of individuals to value an item or good more highly simply because they own it. In other words, people tend to place a higher value on something they already possess compared to the value they would place on acquiring the same item.
The endowment effect is closely related to Prospect Theory, which is a behavioral economic theory developed by Daniel Kahneman and Amos Tversky. Prospect Theory suggests that individuals make decisions based on potential gains and losses rather than on the final outcome itself. According to this theory, people tend to be risk-averse when it comes to potential gains and risk-seeking when it comes to potential losses.
The endowment effect can be explained within the framework of Prospect Theory. When individuals own an item, they perceive it as a potential gain. As a result, they become more risk-averse and tend to overvalue the item. This overvaluation can lead to a reluctance to part with the item, even if it means forgoing potential gains.
For example, imagine you own a rare collectible item that you have no intention of selling. If someone were to offer you a substantial amount of money for it, you might still refuse the offer because you value the item more highly due to the endowment effect. This behavior is consistent with Prospect Theory, as individuals tend to be risk-averse when it comes to potential gains.
In summary, the endowment effect is the tendency for individuals to value something more highly simply because they own it. It relates to Prospect Theory as it aligns with the theory's notion that individuals make decisions based on potential gains and losses rather than on the final outcome itself.