Endowment Effect in Business and Marketing -An Example
In the 1980s, to increase the car sales, Lee Iacocca, then CEO of Chrysler, proposed an idea of thirty days money-back guarantee if any customer was not satisfied with his newly bought Chrysler car. Everyone in the company was shocked and called the idea outrageous. They were worried that people would return the car en masse and would state any reason for not liking the car. The management was afraid of potential financial losses. But to everyone’s surprise, the total number of returns was less than two-tenths of one per cent of total Chrysler cars sold in that year.
Why did so many customers not return the car and use the opportunity?
As expected, the thirty-day money back guarantee helped the consumers to overcome the resistance to buy the car. Once they brought the car to their home, their perspectives shifted -As they became the owner of the car, they unknowingly began to treat it as part of their family. They began to form pleasant memories while using the car. Consequently, the customer began to view returning the car as a loss.
“Losing something makes a person feel more depressed and painful than the happiness which he would get from gaining the same thing”.
Psychologists call this as ‘The endowment effect’ through ownership -A cognitive bias that says that once we own something (or have a feeling of ownership) we irrationally begin to value the product more than its objective value.
The Buyers and Sellers
Sometimes, the ‘Endowment effect’ creates market inefficiencies and irregularities in valuation between buyers and sellers. In fact, if we are selling something, most of the time, we would be charging more than what we would prefer to pay for the same product.
Professor Richard Thaler performed an experiment to prove this -In his class, he gave coffee mugs (with an embossed logo of University) to half of the students and told them they could either keep the mugs with themselves or they could sell it to the students who did not receive the mugs. He invited the other half of students to buy those mugs. He asked the students to indicate at what price they would be willing to sell or pay for the mug. The results showed that the students with mugs priced their product twice than that of the price quoted by the other group. Richard Thaler replicated the experiment many times with a various group of students at different universities and the results were almost the same.
“People often require more money to give up ownership of an object than they would be willing to pay to acquire that same object” -Kahneman, Knetsch & Thaler.
Endowment Effect in selling a business -To counter the growth of Google, Microsoft offered to buy Yahoo for $45 billion. But Yahoo’s co-founder Jerry Yang felt the offer was too low and rejected it. Within a few months, Yahoo’s stock pummeled to $19 billion.
Foursquare rejected a $200 million offer from Yahoo. Foursquare’s radical concept of ‘checking in’ to restaurants or other destinations through social media interaction was so simple that other companies copied them soon.
A few years back, one of my friends wanted to sell his service business. He saw his client list as one of his strengths but the buyer saw that the list had no multi-national companies. He was proud of the completed projects but the buyer saw the relinquished projects that seriously questioned the company’s commitment and grittiness.
Endowment Effect Through Investment Of Time and Effort
Endowment effect also happens through another factor -When we invest time and effort in any activity or product or business, we begin to value it more.
In 2011, Dan Ariely and Michael Norton conducted a study to prove it -A group of students were given the task of assembling an origami crane and asked them to specify a price in order to purchase their own creation. Another group of students (They were unaware of who made the origami) were asked to bid on the origami. The results showed that those who made their own creation valued their creation five times higher than the second group’s valuation.
In another experiment, a group of students were given a prize on completion of a task where they had to exert effort. The second group of students called the ‘non-effort group’ were given the same product free without any conditions. The experimenters then invited the two groups to specify a price at which they would be willing to sell. As expected, the students who put effort to gain the product developed a sense of attachment to the product and was not willing to give away. Some of them priced higher than the price quoted by the second group. The results showed that ‘effort’ group students exhibited an elevated sense of endowment effect compared to the non-effort group.
This is also widely called the IKEA effect — IKEA exploits the hidden benefit of making the customers to invest their physical effort and time in assembling the products which they buy -As customers assemble the product, they began to love their furniture and value it more than its objective value. Thus IKEA builds its brand loyalty.
Many businesses leverage this ‘Endowment effect through effort’ to build customer loyalty.
A lot of brands try to get users to invest effort upfront in order to increase the ‘Endowment effect’ -The one way is to provide a trial period -Netflix provides one-month free subscription. As you watch more movies during this trial period, Netflix through the ‘Cinematch Experience’ program collects a lot of real-time data points about your interests, likes and desires and customizes your experience. The more time you spend on Netflix, the better the experience. You would soon see a personalised page with the list of movies or other video content that you will have a little chance of discovering on your own. As you have already put the effort in training the Netflix programme to understand you, will you leave Netflix now?
Premium car dealers encourage customers to take a longer test drive in order to increase the endowment effect.
Facebook makes a new user to invest time and effort by encouraging them to post the personal content, upload photos, add friends, follow friend’s stories, garner appreciation etc… The more time and effort you invest, you begin to find the service more valuable and useful.
In Quora, investing time and effort in following the right people and right topics displays interesting and relevant content. As you spend more time, the content gets better and better and you would soon love Quora.
CONCLUSION
‘Endowment Effect’ affects our decision making. Sometimes we miss better alternatives as we unknowingly continue to invest our time and effort in activities or businesses we had earlier invested in. Ownership Endowment Effect makes us unnecessarily to cling on to objects or processes for a long time. The first step in protecting our decisions is to be aware of the various cognitive biases that reside in our brain.
References: IACOCCA: An Autobiography, The Mustang Story from the Ford website, The Art Of Thinking Clearly by Rolf Dobelli, Study of Endowment Effect and Effort by students of the City University Of Hong Kong, Article in humanhow.com by Tomer Hochma, Nudge by Richard Thaler, Predictably Irrational by Dan Ariely, Thinking Fast and Slow by Daniel Kahneman.