The Endowment Effect and Legal Analysis

Abstract

Most legal scholarship implicitly adopts the assumption of the Coase Theorem that the value an individual places on a legal entitlement is independent of whether or not the individual has physical possession of or a legal right to that entitlement. This is true of both traditional law and economics analysis concerned with the efficient allocation of resources and scholarship that is not self-consciously in the law and economics tradition but is concerned with law's effects on incentives. A robust body of social science scholarship, however, demonstrates that the assumption is incorrect, at least in many circumstances. The much studied "endowment effect" is that people tend to value goods more when they own them than when they do not. A consequence of the endowment effect is the "offer-asking gap", which is the empirically observed phenomenon that people will often demand a higher price to sell a good that they possess than they would pay for the same entitlement if they did not possess it at present. A third term - the "status quo bias" - is often used interchangeably with the other two, but actually has a slightly broader connotation: individuals tend to prefer the present state of the world to alternative states, all other things being equal. Whatever the label, this insight is the most significant finding from behavioral economics for legal analysis to date.

This article reviews the empirical evidence of the endowment effect and considers a variety of possible causes of the effect. It then explores how the endowment effect can affect the positive and normative analysis of legal rules that (1) assign or transfer legal entitlements, (2) facilitate the private exchange of legal entitlements, and (3) enforce the rules of property and contract. The discussion demonstrates that the endowment effect is relevant to the analysis of virtually every field of law. It also shows that careful normative legal analysis based on the endowment effect must take into account the context-dependent nature of the effect and the causes of the effect, neither of which are fully understood. Thus, when the endowment effect is used as a basis for normative claims, these claims must often be qualified and contingent.

Keywords: Endowment effect, status quo bias, behavioral law and economics, Coase Theorem