8 - Experimental Tests of the Endowment Effect and the Coase Theorem

Summary

The standard assumptions of economic theory imply that when income effects are small, differences between an individual's maximum willingness to pay for a good (WTP) and minimum compensation demanded for the same entitlement (willingness to accept or WTA) should be negligible. Thus, indifference curves are drawn without reference to current endowments, any difference between equivalent and compensating variation assessments of welfare changes are in practice ignored, and there is wide acceptance of the Coase Theorem assertion that, subject to income effects, the allocation of resources will be independent of the assignment of property rights when costless trades are possible.

The assumption that entitlements do not affect value contrasts sharply with empirical observations of significantly higher selling than buying prices. For example, Thaler found that the minimal compensation demanded for accepting a .001 risk of sudden death was higher by one or two orders of magnitude than the amount people were willing to pay to eliminate an identical existing risk. Other examples of similar reported findings are summarized in Table 8.1. The disparities observed in these examples are clearly too large to be explained plausibly by income effects.

Several factors probably contribute to the discrepancies between the evaluations of buyers and sellers documented in Table 8.1. The perceived illegitimacy of the transaction may, for example, contribute to the extraordinary high demand for personal compensation for agreeing to the loss of a public good. Standard bargaining habits may also contribute to a discrepancy between the stated reservation prices of buyers and sellers.