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Women enjoying a coffee in an outdoor cafe

Bloomsbury blog The economic theory that helps explain our everyday thinking

Bloomsbury newsletter, 31 December 2017

What is a coffee mug worth?

Different people would assign a variety of values to a mug, depending on, among other things, their personal preference for hot drinks. All their preferences would be reflected in the price they were willing to pay.

So, a mug has a value, and the value is associated with a price.

Let's say that, rather than buying a mug, you were given the mug you intended to purchase. It was now your possession. It's a nice mug and I'd like to purchase it from you, and to sweeten the deal I'll offer 50 cents more than you were willing to pay for the mug originally.

Would you sell it to me?

No, you probably wouldn't.

How can I be so confident? Nobel Laureate Richard Thaler ran this exact experiment at Cornell University several decades ago, and since then it has been replicated many times.

To summarise, Thaler buys mugs from the university book shop and randomly gives them out to half the students. The half with mugs can either retain or sell the mugs. The half without mugs can buy a mug if they choose.

"We began by putting a coffee mug in front of every other student. The students who got a mug were owners and potential sellers; the others where potential buyers. Everyone was told to inspect the mug, either their own or their neighbour's, to ensure they all had equal information about the products."

While economic theory would predict that half the mugs traded hands, Thaler and his team predicted significantly fewer trades.

"Our prediction was right... Those who got the mugs were reluctant to sell them; the median reservation price for sellers was $5.25 in each of the four rounds. But those who did not have a mug were not eager to buy one; the median reservation price for buyers was $2.75 in one round and $2.25 in the others." (Richard H Thaler, Misbehaving, page 153).

You'd expect about half the mugs to sell, based on the simple assumption that, because it was randomly decided who received a mug, some students who did like mugs didn't receive one, and vice versa, meaning there should be students who were willing to trade.

However, far less than half the mugs sold every time the experiment was run, even though Thaler ran it four consecutive times.

Cornell University mug

What was going on?

When the students who didn't get mugs were asked what they'd be willing to pay for one, they said around $2.25. The students who did get mugs were willing to sell them for around $5.25.

This experiment tells us that something holds more value in our mind, just because we own it. In other words, everything in this world has two prices - the price we'd be willing to pay for it and the price we'd be willing to sell it for. The sell price is generally about twice the buy price.

Thaler calls this the endowment effect, and puts it this way, "The endowment effect experiments show that people have a tendency to stick with what they have, at least in part because of loss aversion. Once I have that mug, I think of it as mine. Giving it up would be a loss." (Misbehaving, page 154)

In other words, economists have concluded that, when you sell something, you process it as a loss. Losses hurt roughly twice as much as gains feel good. Therefore, you require twice the price to sell as to buy, even for the identical object.

How does this explain how we think, in an everyday context?

This fact that everything has two prices explains all sorts of behaviour:

  • It explains loyalty. If it's mine - my kids, my religion, my country, my family, my house, my political party - I immediately count it as being at least twice as great as someone else might view it, or how I would view it if it wasn't mine.
  • It explains why 'fair' is so difficult to achieve. Let's say that one child has more than the other, and you try to even it up. The child with more perceives their loss as far greater than their sibling's benefit, so even if the overall outcome is that things are now fair in reality, emotionally, they don't feel this at all and resentment generally ensues.
  • It explains why it's nearly impossible to unwind social benefits once they're passed out, even when it becomes clear the policies aren't good or society can't afford them. Before it was given away, people didn't know if they wanted it; after they have it, they'll fight tooth and nail to keep it. Obamacare in the US falls neatly into this category.
  • It explains why we keep things given to us as a gift or inheritance, where, if we were simply given the equivalent money the gift was worth, we would never buy those same objects.
  • It explains why we hoard money. Before you spend money on a holiday you are convinced it's not worth the cost, because the 'loss' of the money feels painful. After you've spent the money, you wouldn't trade the experience for anything.

Everything in our life has two prices. Mugs, holidays, houses, vehicles, pens... The result is, we probably overvalue what we own (put kindly, we are loyal to it) and undervalue what we don't.

Who knew that economic theory could be so useful in explaining how we think?