Testing the Endowment Effect for Default Rules

Isabel Marcin; Andreas Nicklisch

doi:10.1515/rle-2016-0010

Article

Testing the Endowment Effect for Default Rules

Published/Copyright: February 21, 2017

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From the journal Review of Law & Economics Volume 13 Issue 2

Abstract

This paper explores potential endowment effects of contractual default rules. For this purpose, we analyze the Hadley liability default clause in a model of bilateral bargaining of lotteries against safe options. The liability default clause determines the right for the safe payoff option. We test the model in series of laboratory experiments. The results reveal a substantial willingness-to-accept to willingness-to-pay gap for the right to change lotteries against safe options. Even if we apply the incentive compatible Becker-DeGroot-Marschak value elicitation mechanism, there is a significant gap indicating a robust endowment effect caused by default rules. Differences of expected values of the lotteries and the safe options consistently decrease the gaps. Implications for applications of default rules in the law are discussed.

Keywords: default rules; endowment effect; lotteries

JEL Classification: C91; K00; K12

Funding statement: This research is partly funded by the University of Hamburg and by the German Research Foundation under project Ni 1610/1-1.

Acknowledgments

We gratefully acknowledge the many useful comments provided by Christoph Engel, and Oliver Kirchkamp. We also thank participants of the IMPRS Ph.D. seminar, the Cleen Conference, Bergen, Norway, and the ECORE Summer School, Leuven, Belgium, for helpful comments.

Appendix

A Incentive-compability

In bilateral the expected surplus for the player who indicates her WTAˆ from exchanging contract A against contract B, ΠWTA, is given by

[1]ΠWTA=(WTAˆ−WTA)⋅F(WTPˆ≥WTAˆ)

with F(⋅) denoting the probability that WTPˆ≥WTAˆ. Equation [1] reflects the gains the player can make in case the stated WTP, WTPˆ, is larger than or equal to the stated WTA, WTAˆ. She gains the difference between her stated WTAˆ and her true valuation WTA. To maximize the expected surplus, the first-order condition of ΠWTA with regard to WTAˆ, denoting f(WTPˆ>WTAˆ):=∂F(WTPˆ≥WTAˆ)∂WTAˆ, yields

[2]WTAˆ=WTA−F(WTPˆ≥WTAˆ)f(WTPˆ≥WTAˆ)

Since the partial differential of the distribution function F with respect to WTAˆ is negative, f(WTPˆ≥WTAˆ)<0, one can write

[3]WTAˆ=WTA+F(WTPˆ≥WTAˆ)f(WTPˆ≥WTAˆ)

According to eq. [3], WTAˆ is greater than or equal to WTA. Hence, in bilateral, players face the incentive to indicate a WTAˆ that is larger than their actual valuation. Accurate information on the density function f(⋅) would allow to define WTAˆ explicitly.

The player indicating her WTPˆ faces an incentive-compatible mechanism. This becomes obvious when we consider the player’s expected surplus from exchanging contract B against contract A, ΠWTP:

[4]ΠWTP=(WTP−WTAˆ)F(WTPˆ≥WTAˆ)

She can only profit from buying contract A if the price WTAˆ is smaller than her actual valuation WTP. Consequently, for any WTPˆ<WTP increasing WTPˆ increases the chance for changing the contracts without increasing its price. On the other hand, stating any WTPˆ>WTP in comparison to WTPˆ=WTP increases only the chance for a loss due to WTPˆ>WTAˆ>WTP. Thus it is the player’s weakly dominant strategy to announce her real value. Thus, in bilateral only the WTA bid might be slightly upward biased; the WTP bid should not differ from the actual WTP valuation.

B Additional tables

Table B:

Between-subjects WTA/WTP ratios for contracts in bilateral.

#	1		2		3		4		5		6		7
	1st	2nd	1st	2nd	1st	2nd	1st	2nd	1st	2nd	1st	2nd	1st	2nd
n	15	15	14	15	15	15	15	15	15	15	15	15	15	15
Mean	1.39	1.08	1.43	1.60	1.18	1.38	1.38	1.58	1.41	1.31	1.48	2.95	1.56	1.74
Median	1.22	1.13	1.37	1.38	1.09	1.33	1.33	1.29	1.47	1.28	1.42	1.38	1.42	1.75
Test^1	***		**	***		***	***	***	***	***	**	**	***	***

Notes:1 Significance levels: *** p<0.01, ** p<0.05, * p<0.1. Test based on signed ranks (two-tailed Wilcoxon signed rank test). 1st stands for the first time the between WTA/WTP ratio was elicited in each group and 2nd for the second time,respectively. In bilateral WTA and WTP values are calculated as the average of all matching groups’ average WTA and WTP. The WTA/WTP ratio is calculated first for each matching group and then averaged over all matching groups.

Table B2:

Determinants of WTA/WTP gap.

	(1)	(2)	(3)	(4)	(5)
unilateral	0.294	0.300	0.304	0.385	1.121
	(0.562)	(0.561)	(0.561)	(0.561)	(1.738)
highstake		0.908**	1.418***	–0.0564	–0.219
		(0.368)	(0.430)	(0.977)	(1.073)
ΔEV			–0.437**	–0.512**	–0.445**
			(0.193)	(0.203)	(0.218)
period				0.223*	0.229
				(0.127)	(0.140)
distance				0.253*	0.289*
				(0.153)	(0.164)
highstake_unilateral					1.302
					(2.754)
ΔEV_unilateral					–0.454
					(0.631)
period_unilateral					–0.0804
					(0.340)
distance_unilateral					–0.253
					(0.472)
constant	1.950***	1.433***	1.502***	0.348	0.255
	(0.218)	(0.302)	(0.303)	(0.652)	(0.702)
Observations	688	688	688	688	688
Number of groups	32	32	32	32	32
Wald test	0.27	6.36**	11.57***	15.72***	17.21**

Notes: Significance levels: *** p<0.01, ** p<0.05, * p<0.1. This table reports coefficients using a mixed effects regression model (including random effects at the subject level and matching group level) with WTA/WTP gaps as dependent variable. unilateral is a treatment dummy variable taking the value of 1 for unilateral and 0 for bilateral, period assigns the period the gap was first elicited and and distance the absolute difference in periods between WTA and WTP valuations. highstake is a dummy variable taking the value of 1 for high stake periods and 0 for low stake periods. ΔEV depicts the absolute difference in expected value of the lotteries. The remaining variables are interaction terms. Standard errors are indicated in parentheses.

C English translation of the instructions for the bilateral treatment

Please find the English translation of the original German instructions of the bilateral treatment in the Supplementary Material.

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Keywords for this article

default rules; endowment effect; lotteries