Endowment effect is seen best in housing market

Endowment effect is one of the most important concepts in behavioral economics. It was shown by Richard Thaler and it is amazing how much you see it in everyday life

In sum it says, people value a product more once they own it.  In an experiment Thaler found students assign a lower price to a coffee mug when asked how much will they buy it for. The same set of students increase the price substantially when asked how much will they sell it for. This was not in line with the standard economic theory as prices should be same on both the sides.  I call this difference between buyer and seller perception of price as endowment spread.

I see this endowment effect happening so much in current housing market in Mumbai. Sometime back this endowment spread was a lot lower and transactions were happening. Now with much higher prices, the spread has become much larger and not enough transactions are happening.  As a buyer you want lower prices and would want prices to correct. As a owner/seller you want higher prices and prices to go up further. But still because of the endowment effect, sellers are not lowering their prices. Unless, market fundamentals deteriorate substantially, the spread will not contract.

There is already news in the market that prices are slipping but it is only in the news. The builders/sellers continue to raise their prices. I am wondering whether they would behave the same way if they were buyers instead.

What I also find questionable is the various surveys that report the per square feet in various areas of Mumbai. They give a range say Rs 4000- Rs 6000 per sq ft. but you hardly get any deal in the lower range, no matter what the area, quality etc. Everyone just quotes near the top end rate.

I also keep thinking whether we should allow trade in houses the way we trade in equities, bonds etc. In a bullish growth phase, the house prices go up big time and devoid many people to buy their own homes. It is only in growth times, when incomes are higher, can people buy homes. But can’t. In times of bearishness, people have to stick onto their jobs and even if prices are lower,it is difficult to buy. Everyone wants to buy a house and it has to be affordable.

With persistent endowment effect, it has been a long wait for any price correction. And we know how dangerous rising housing prices can be. Unfortunately, no one seems to be working at ensuring some standards in housing markets.

3 Responses to “Endowment effect is seen best in housing market”

  1. Avid reader Says:

    Amol, do you really think what is happening in the housing market is endowment effect? I believe that prices went up too high and too fast because of a combination of loose credit and consequent speculation. Perhaps there were no good alternatives for investing this sudden flood of capital and (to indirectly accept your point) ordinary people didn’t know of any alternative even if they existed.

    I think the prices are going down because credit has tightened and expectation of price increase have lowered or even ceased. People are coming back to reality. But those people who bought at inflated prices are in no position to accept reality. That will affect their pockets.

    In the US, which is a very mature market, it is said that housing slumps last several years and indeed it has to do with the sellers’ reluctance to come to reality. They are reluctant simply because they have invested their life savings in this and do not want to lose. If someone invested his whole lifesavings in stocks, I am sure he will show the same reluctance.

    If the US market is any indication, the sellers will start bringing down the price as the economy remains in doldrums. As the price corrects, the buyers will show up.

  2. Amol Agrawal Says:

    Hi Avid Reader,

    Thanks for your comments after a long time.

    Well your comments are another example of endowment effect- “it is said that housing slumps last several years and indeed it has to do with the sellers’ reluctance to come to reality. They are reluctant simply because they have invested their life savings in this and do not want to lose.”

    That reluctance to sell at a lower price just because you own it is what keeps prices upwards for a longer time. I am not saying it is only endowment (other factors like demand, supply, easy credit etc) but is surely an important factor. It keeps prices up longer than desired.

    In stocks we have a very popular idea called disposition effect- where people hang on to loosers (stocks at prices lower than purchase price) for a much longer time. So, the endowment effect becomes a disposition effect. 🙂

  3. House prices in Mumbai refuse to decline « Mostly Economics Says:

    […] city, the prices are still very strong and infact continue to rise. Why should this continue? I had pointed to the presence of endowment effect being present in the housing market. This is just getting […]

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