Nobody Likes a Bad Deal

A new article in the Journal of Marketing Research challenges longstanding opinion on why selling prices often exceed buying prices. In short: nobody likes a bad deal.

August 1, 2014

Selling prices often considerably exceed buying prices. People who indicate $400 as the most they would pay for a Super Bowl ticket appear to value it at $1,000 when indicating the least they would accept for the same ticket. This discrepancy was termed the “endowment effect” in a paper published in 1980 by Richard Thaler (who some regard as the founder of behavioral economics). Thaler posited that consumers evaluate trades with respect to their current holdings and express general aversion to losing things they own, be they cash or tickets.

This explanation has been nearly universally embraced as the correct account of the endowment effect. However, in a recent article in the Journal of Marketing Research, Ray Weaver of Harvard University and Shane Frederick of Yale University propose instead that the endowment effect is often best construed as an aversion to bad deals rather than an aversion to losing possessions. In essence, the endowment effect may not reflect the pain of losing what we own, but the pain of getting ripped off.

This aversion to rip-offs was termed “transaction disutility” in another classic paper published by Richard Thaler in 1985. The most famous part of that paper was a small study called “beer on the beach.” Beer drinkers were asked to imagine that their friend would fetch a bottle of their favorite beer from one of two locations: a run-down grocery store or a fancy resort hotel. Though the consumption context was held constant, respondents authorized their friends to spend only half as much if the beer came from the run-down grocery store. The mere expectation to pay less became a willingness to pay less.

Weaver and Frederick propose that the concept of transaction disutility articulated by Thaler in this 1985 paper actually provides a better account of the endowment effect than the concept of loss aversion that is usually invoked to explain the phenomenon. Weaver and Frederick postulate that the size of the endowment effect — the ratio between minimum selling and maximum buying prices — reflects the difference between a good’s valuation and its reference price. Thus, reducing this gap (by lowering reference prices or raising valuations) serves to attenuate or eliminate the endowment effect.

The endowment effect may not reflect the pain of losing what we own, but the pain of getting ripped off.

Their first study is illustrative: participants were randomly divided into buyers (who had the opportunity to purchase a large box of candy) and sellers (who received said box of candy to be sold). Both groups were told either “As a point of reference, the Harvard Square Theater sells this candy for $4.00 per box.” or “As a point of reference, the Target store in Watertown sells this candy for $1.49 per box.” (Both of these statements were true.)

As their theory predicted, Frederick and Weaver found a markedly higher endowment effect in the high reference price condition than in the low reference price condition. Moreover, nearly all of this effect was driven by sellers demanding more for the candy than buyers were willing to pay when the reference price was high (i.e. $4.00). They found further evidence for their theory in over a dozen other studies, using various manipulations. Among other things they showed that “fans” of a good have a smaller endowment effect than non-fans. For instance, those who could correctly answer the question “Who did the Red Sox defeat in the 2004 World Series?” showed a significantly smaller gap between buying and selling prices of Red Sox tickets.

Understanding the endowment effect as bad deal aversion suggests that free trial periods need to be managed carefully, so as not to establish a reference price of zero; marketers may be better off restructuring free trials as money-back guarantees. On another front, if consumers fear getting a bad deal, then marketers should work to minimize this fear. Auction websites, for example, could post information about past prices on similar products to allay concerns about overpaying. Firms could also do this through price guarantees: find a lower price elsewhere and they refund the difference. But regardless of the particulars, companies would be well served to emphasize the fairness of a transaction, inspiring consumer confidence that the price paid does not exceed any credible referent.