Why is 'Prospect theory' better than 'Utility theory' in understanding the endowment effect of valuing valuables? – Chapter 27

Imagine looking at a graph displaying someone’s ‘indifference map’ for two goods: income and vacation days. This map specifies particular combinations. Each curve connects the combinations of the goods that are equally desirable: they have the same utility. The convex shape suggests diminishing marginal utility: the more vacation days you have, the less you care for one more, and each added day is worth less than the previous one. The more income you have, the less you care for an extra euro, and the amount of money you are willing to give up for an extra vacation day increases. All locations on an indifference curve are equally appealing.

All economics textbooks for students contain images of indifference curves, but only a few students have noticed that something is missing: an indication of the person’s current income and vacation days, also known as the reference point. This is another example of Bernoulli’s error. The utility is not completely determined by your current situation, the past is also relevant. The missing of the reference point is also an example of theory-induces blindness.

Richard Thaler introduced the ‘endowment effect’: owning a good increases its value, especially if the goods are not regularly traded. Imagine you bought a ticket for a major soccer match for the normal price of € 300. You are a big fan of the participating team and would have been willing to pay a maximum of € 600. You read online that all tickets are sold and people now offer € 3.500. Would you sell your ticket? Probably not: your lowest selling price is € 3.500 and your maximum buying price is € 600. The endowment effect can be explained by the prospect theory. The willingness to sell or buy depends on the reference point: whether or not the person currently owns the good. If he is the owner, he considers the pain of giving up the good. If he is not the owner, he considers the pleasure of getting the good. The values are not equal because of loss aversion: giving up the good is more painful than getting a similar good is enjoyable. The reaction to a loss is stronger than the reaction to a corresponding gain.

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