Question

3. Give someone a chance to buy a good X at price $1 and they refuse. But then, give them the good and ask them to sell it for $1 and, strangely, many times they refuse and demand a higher price. This is called the “endowment effect” - and in fact some evolutionary biologists believe it is an ingrained phenomenon that is completely explained when one looks at the long history from which we evolved. Economist John List investigated this effect with sports memorabilia traders at trade shows. He had two goods (A and B) that had very similar market values. Traders were randomly given one of the goods (so about half were given A and half B). If they were given good A they were asked if they would like to trade for good B, and if they were given good B they were asked if they would like to trade for good A.

a-i. Suppose, absent any endowment effect, everyone prefers good A. What fraction of the people in the experiment would you expect to ask to trade?

a-ii. Suppose, absent any endowment effect, half the people prefer A and half B. What fraction of the people in the experiment would you expect to ask to trade?

a-iii. Suppose, absent any endowment effect, X% of people prefer A and (1 - X)% prefer B. Show that you would expect 50% of subjects to ask to trade.

Answer 1

a-i) In absence of the endowment effect, 50% people in the experiment would expect to ask to trade. Because, the trader possessing good A, would not like to trade for good B as everyone prefers good A.

a-ii) In absence of the endowment effect, 50% people in the experiment would be expected to ask to trade. Because, out of the total population half will be preferring good A and other half good B. whosoever, is possessing either good(A or B), would like to trade for another good.

a-iii) In absence of the endowment effect, 50% people in the experiment would be expected to ask to trade. As the total market is divided between good A and good B. Whosoever is possessing good A would like to trade for good B and vice-versa. Whatever value is for X the final probability will come as 50%. Let’s take an example – let us suppose 10% people prefer good A, so rest 90% would prefer good B.

Mathematically,

0.1X probability of each person preferring A over B+ 0.9 X probability of each person preferring B over A

= 0.1X0.5+0.9X 0.5

=0.05+0.45

=.50

Therefore , 50% people in the experiment would ask to trade.