In Kahneman, Knetsch, and Thaler's mug experiment, subjects randomly given mugs demanded a median selling price of $5.25, while subjects without mugs offered a median buying price of $2.75. The best explanation for this gap is...
AThe mug-owners had more wealth and therefore valued mugs more
BLoss aversion — giving up the mug is a loss that looms larger than the gain of acquiring it
CStrategic bargaining — sellers always ask for more than their true value
DThe mugs given to subjects were of higher quality
Random assignment eliminates wealth and quality differences. Strategic bargaining cannot explain the gap because incentive-compatible mechanisms (real transactions) were used. Loss aversion explains the WTA-WTP gap: for sellers, parting with the mug is a loss evaluated on the steeper part of the value function; for buyers, acquiring it is a gain evaluated on the flatter part. The roughly 2:1 ratio is consistent with the typical loss aversion coefficient.
Question 2 True / False
The endowment effect is equally strong for all types of goods, including goods held for trade or resale.
TTrue
FFalse
Answer: False
Research shows that the endowment effect is weaker or absent for goods held for exchange rather than use. Experienced traders in markets show reduced endowment effects compared to novices. The effect is strongest for goods that have been 'appropriated' — psychologically incorporated into the self-concept (personal possessions, familiar objects). Goods held purely as inventory or for resale are less likely to trigger loss aversion because the reference point is exchange value rather than ownership. This boundary condition helps identify when the effect will and will not appear.
Question 3 Short Answer
What are the implications of the endowment effect for the Coase theorem?
Think about your answer, then reveal below.
Model answer: The Coase theorem states that in the absence of transaction costs, bargaining will lead to efficient allocation regardless of initial property rights assignment — because parties will trade until gains from trade are exhausted. The endowment effect undermines this by creating a gap between WTA and WTP that reduces trading below the efficient level. When owners overvalue what they have (due to loss aversion), some mutually beneficial trades fail to occur. This means the initial allocation of property rights does affect the final allocation, contradicting the Coase prediction.
Kahneman, Knetsch, and Thaler directly tested this by creating markets where efficient allocation required trading. They found far fewer trades than predicted — roughly half the efficient volume — because endowed owners demanded prices that exceeded non-owners' willingness to pay. This has practical implications for environmental economics (emissions trading), intellectual property markets, and any context where efficient outcomes depend on voluntary exchange from an initial allocation.