Episode 8: Endowment Effect & Status Quo Bias

Intro

Hey, It’s Dallas, and I have a question for you.

Well actually, I have two questions for you…. Well it’s kind of the same question, but asked two different ways.

For the first question… let’s imagine you’re an employee of a business that’s located in a community that’s been hit hard by a recession and the community is experiencing substantial unemployment. Fortunately, they haven’t had to deal with any inflation issues, meaning the cost of living has remained the same year over year. This company decides that in the upcoming year – due to the recession – they need to reduce all salaries by 7% in order to keep the doors open and keep people employed.

So, do you think this is fair or unfair?

Take a second to consider it….

Okay, I’m willing to go out on a limb here and assume you felt like this was unfair. But, before we go deeper on this, let me reframe that and ask the second question.

For question two, you’re working for the same business in the same community that’s been hit hard by a recession, the community is experiencing substantial unemployment, but this time annual inflation is out of control at 12%. Meaning, next year it will cost 12% more to live than it did this year. With this set of economic challenges, the company decides that in the upcoming year, they can only give their employees a 5% raise.

How do you feel about this? Fair or unfair?

Like I say in every episode, I can’t read your mind so I don’t actually know how you feel. But I do know what the research says, and the research says that in the first scenario, a large majority of employees felt the 7% reduction in salary was unfair. In fact nearly 7 out of 10 felt it was unfair.

But in the second scenario 8 out of 10 employees found the 5% increase in salary to actually be fair, despite the 12% inflation leaving them in the same exact financial scenario.

If that math is hard to follow… in the first scenario you lost 7% salary straight up.

But in the second scenario, once you adjust for the annual increase in cost of living – 12% – with a salary increase of only 5%, you’ll still find yourself 7% down in the upcoming year.

Okay, so that’s more math than I usually ask you to do, so apologies…

But there is something really interesting going on here and I promise it will make sense by the time we’re done with this episode.

So, let’s take a quick break and then we’ll dive in….

The Research

The question I opened this episode with is a variation of a 1991 research study by Daniel Kahneman, Jack Knetsch, and Richard Thaler.

Small sidebar here. You might remember the Nobel Prize winning Richard Thaler from our Episode 6 beer on a beach question. Or if you’re listening to this podcast from newest episode to oldest, you’ll get there soon. Now, Daniel Kahneman, is another Nobel Prize winning economist and author of the legendary book, Thinking Fast and Slow. And Jack Knetsch is often considered the single most cited behavioral economist in the world.

I don’t typically dive into the bios of the researchers, but when these three show up leading the same study, it’s worth investing the time to read and understand their research..

Anyway, back to the question.

In our first question, employees felt the – the 7% reduction of wage was unfair. But in the second scenario – framed as a 5% increase in wages – the majority found it to be fair.

So, what’s going on here?

What we’re talking about here is the endowment effect.

The endowment effect is the phrase coined by Kahneman, Knetsch and Thaler in their paper titled, “Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias.”

But, before we really dive into discussing what the endowment effect is, I want to talk through a few more examples, because I think later it will be a little bit easier to grasp what’s going on when we have a few more real-world examples to lean on.

For example, one study demonstrated that if you give a group of people a ticket to a sporting event – for free, and then you ask a second group of people – people without a ticket – what they’d be willing to pay to purchase a ticket to that same event, the group who was given the ticket values that ticket at a much higher price than what the second group says they are willing to pay for it. The buyers and sellers weren’t even close to landing on a fair market price.

Another famous study had respondents purchase small items from a live auction. Just cheap things like coffee mugs, pens, articles of clothing, and so on. Nothing of any real value. Then the buyers were asked if they wanted to keep the item they purchased, or if they wanted to resell it. The ones who chose to resell the item, now demanded a higher price than what they’d just paid for it. And remember, the point of an auction is to find the fair price, the settling price. Now for some reason, these owners thought the item was worth even more just through possession.

Studies also show the endowment effect’s role in real estate. For example, home owners demonstrate an inflated perception of a home’s value if they’ve personally lived in it. Even when they are selling a portfolio of homes, they’re more likely to appropriately price a home they didn’t live in, compared to the ones they did. The sellers are ascribing a higher price to the homes they lived in, purely for emotional purposes and frankly, the buyer doesn’t care.

Like the real estate example, it’s important to double down on pointing out that the endowment effect can manifest itself in nearly every aspect of our lives – it’s not limited to physical objects. The endowment effect is influencing our decision-making and leading us to make biased valuations – almost everyday – based on very simple things like physical possession and emotional attachment.

And because it touches nearly every aspect of our lives, it’s important that we’re able to recognize and acknowledge this effect so that we can make more unbiased, rational and informed choices on a day-to-day basis.

Why It Works

So for this episode, I’m unraveling the effect a little bit out of order, but on purpose.

I opened this episode with our initial question like usual, and then I jumped straight into giving you a whole bunch of examples of the endowment effect in action. So now I want to circle back and talk more about what the effect actually is and what’s going on.

So maybe you’ve figured it out already, but the endowment effect is a psychological phenomenon that describes the tendency of individuals to ascribe more value to something simply because they own or possess it. In other words, people tend to place a higher value on objects, goods, or even ideas once those become their property, compared to the value they would place on the same item if they didn’t own it.

And like we’ve discussed earlier, this phenomenon has been observed in various studies and has significant implications in our decision-making, particularly in the realms of economics – or financial decisions.

Remember the example with the ticket to the sports event? Even though the first group was given the ticket for free, the value they then ascribed to it was greater than what the market – the second group without a ticket – was willing to pay. Simply because it was their possession, not because it actually held that value. Remember, they got it for free, so if they chose to sell it for the asking price, it’s only profit for them.

This is an example of how the endowment effect can cause us to treat opportunity cost differently than an out-of-pocket cost. These ticket holders are trying to maximize their opportunity. But if the shoe were on the other foot – or the ticket in the other hand – that same person wouldn’t pay out-of-pocket what they are asking for. This approach to a negotiation – where the person in possession unnecessarily overvalues their possession – more often than not, results in a lost opportunity for the seller, because the willingness to accept is far greater than the willingness to pay.

Where this is an example of the endowment effect impacting opportunity cost, it also can impact our acceptance of unfavorable circumstances.

Think back to the opening of this episode. Nearly 80% of employees had no issue when their employer gave them a 5% raise, even when it still put them 7% behind inflation. This is an unfavorable circumstance, but this framing worked because it’s framed as a gain and not a loss. Employees felt they were still gaining 5%.

Whereas in the first scenario, a 7% decrease in salary is taking money away from a salary number they already possessed. That little number on their paycheck that they are so used to is now 7% smaller.

This is because it’s often less painful for people – us, our clients, our customers – to forgo future gains than it is to experience perceived losses.

This can be seen in the real world when businesses who charge cash customers one price and credit card customers a higher price. The business will always refer to the cash price as a discount rather than to the credit card price as a surcharge.

“Save money when you pay by cash!” is much more acceptable to the customer than “all credit card transactions will incur a 3% transaction fee.” Even though again, it’s the exact same thing.

It’s the psychology behind why the majority of Amazon Prime Day deals are marked up, then the marked up price is slashed out, and then the deal price ends up exactly the same price as it was just the day before. But we still jump at buying it because it feels better to us. We feel like we’re gaining back whatever the fake deal price delta is.

And beyond physical objects, finances or possessions, the endowment effect can lead us into situations where we are unwilling to change something we’re already doing, or a service we’re offering, even when it’s objectively a smarter decision to make a change. I tend to think of this as a subcategory that lives right underneath the endowment effect umbrella, and it’s referred to as the status quo bias.

Status quo bias refers to the tendency of individuals to prefer the current state of affairs or the “status quo” over any potential change, even when objectively better alternatives are available.

For example, over time, employees develop an emotional attachment to their current job, their colleagues, and their workplace. They want to maintain this status quo. They want to keep things how they are. As a result, they might be hesitant to leave even when better career opportunities are readily available.

So, that’s status quo bias.

Now let’s touch on the last piece of this puzzle, which is known as loss aversion.

Loss aversion is a cognitive bias that describes the tendency of individuals to feel the pain of losses more strongly than the pleasure of equivalent gains. In other words, the negative emotions associated with losing something outweigh the positive emotions associated with gaining something of the same value. Loss aversion is a significant factor within the endowment effect as people are often more concerned about avoiding losses than they are about maximizing gains.

For example, an investor may be unwilling to sell a stock that has already declined significantly in value, hoping it will recover, even if there are more promising investment opportunities available. They fear the regret and pain of realizing the loss more strongly than they’d feel the joy and success of selling that stock, investing in a new one and eventually accruing an overall profit.

You can separate status quo bias and loss aversion, by thinking about it like this.

Status quo bias is about the preference for maintaining the current state, regardless of its objective merits, due to comfort and familiarity with the existing situation.

Loss aversion is about the tendency to fear losses more than seeking gains, which often leads to conservative decision-making to avoid potential losses.

But both are variations of the endowment effect which is when we ascribe more value to something simply because we own or possess it.

So now that we understand these three principles and we have a lot of hypothetical real world examples to draw analogies to, let’s talk more about what you can do about this on a day-to-day basis.

What To Do About It

Most business owners, most leaders, most successful entrepreneurs, most of the people listening to this episode – myself included – we tend to think of ourselves as strong decision-makers. We’re analytical. We tell ourselves that we operate on facts, and on upside and future opportunities. We tell ourselves that we’re not emotionally tied to the decisions we make. That we’re agile and adaptable. You know, all of this stuff we fill our heads with that comes from those leadership books and business groups. And a lot of that is probably true.

But what’s tricky about most of what this podcast covers, and especially this episode’s topic – the endowment effect, is that it impacts us on a subconscious level. It’s harder to recognize than something like multitasking which happens on a physical level, or decoy pricing which occurs when actively looking at multiple price points on a menu for example.

The endowment effect is emotional. It’s nostalgia. It’s attachment. It’s often our gut reaction to things.

For organizational leaders this often manifests in the ideas we hold, or the decisions we’ve made. For example, it’s easy that as we get further along in our careers, we continue to lean on the skills, the tools, the knowledge and the experiences that have gotten us to that point, resulting in us doing the same thing, over and over again. Answer questions in the same way. Approaching problems and opportunities in the same way.

But, the world moves on. And it moves on really fast. Digging your heels in and resisting the opportunities to tailor your approach to the world we live in is a form of endowment effect. It’s status quo bias. But guess what? The world doesn’t care about you and I and how we’d like things to remain. These changes – technology, tools, new ideas, innovation, AI – they are going to run right over you if you’re clutching your pearls about the way the world was 10 years ago. The way things used to be.

The world needs new approaches. It needs fresh eyes. It needs you to solve tomorrow’s problems without yesterday’s map. Everyday that passes, yesterday’s solutions become less and less valuable, while unsolved problems – or problems solved in new ways continue to increase in value.

It’s on you. It’s on you to pay attention and recognize when you find yourself in a situation where you’re refusing to change your current state or your current workflow, when you’re presented with new better alternatives.

If you’re still reporting campaign performance in a word doc, or a manually updated spreadsheet – you’re resisting adopting automated reporting tools which will be more accurate and save you time.

If you’re manually crafting every social media post, email newsletter, piece of website copy or blog article when things like ChatGPT exist – you’re resisting an unstoppable force and it’s costing you time.

If you’re not collecting, consolidating, segmenting and repurposing customer data in a time where these things have never been as easy and impactful as they are today – you’re falling behind your competitors who have a true data management strategy.

If you’re insistent on only hiring local talent and forcing them to come into your office every morning in the name of productivity, when you could be hiring the best available talent nationally or globally, you’re limiting the depth of talent you could be offering your customers.

The only real reason you’re doing these things is the endowment effect. It’s status quo bias. You’ve built your business or your career to this point based on the things you’re comfortable doing and these are all examples of things that make you uncomfortable. And rather than stepping out of your comfort zone – potentially future proofing your position and your business – you’re pretending like these things don’t exist, or worse yet, you’re telling yourself that they don’t work.

But every single day – and at a rate that is accelerating so fast that we probably can’t even fathom it – we’re each going to be faced with decisions where we can choose to stick with what we know, what we’ve done hundreds of times in the past. And get a result pretty close to what we have before.

Or we can choose risk. We can choose non-conformity. We can take on a beginners mindset and break free from the comfort of routine and step into the stage of evolution. Of personal evolution. Of career evolution, and embrace change. Adopt new tools. Test new approaches.

When you find yourself at the crossroads of familiarity and audacity, it’s important to remember that every major milestone in your personal and professional life has come from choosing to step into the unexplored horizons of possibility, and embracing the fear and risk that comes along with that.

Dallas McLaughlin