Final Answer:
The endowment effect refers to the psychological phenomenon where people tend to assign higher value to items merely because they own them. This represents a violation of the normative theory of expected utility, as rational decision-making would suggest that ownership should not influence perceived value. Prospect theory, with its S-shaped value function, helps explain the endowment effect by highlighting the asymmetry in how gains and losses are perceived, with losses having a greater psychological impact than equivalent gains.
Step-by-step explanation:
The endowment effect challenges the normative theory of expected utility, which assumes that individuals make decisions based on the intrinsic value of an item and not on its ownership status. In reality, people often ascribe greater value to items simply because they own them, leading to reluctance in parting with possessions even when objectively equivalent alternatives are available. This behavior suggests that the subjective valuation of an item is influenced by ownership, deviating from the rational expectations of utility theory.
Prospect theory, developed by Daniel Kahneman and Amos Tversky, provides insights into the endowment effect. The value function in prospect theory is characterized by an S-shape, indicating that individuals are more averse to losses than they are attracted to equivalent gains. In the context of the endowment effect, owning an item represents a gain, and the reluctance to part with it can be attributed to the asymmetry in the value function, where the perceived loss of giving up the item is greater than the gain associated with acquiring a similar item.
An example of the endowment effect from personal experience might involve a cherished possession, such as a childhood toy or a sentimental item. Even if one recognizes that a similar item could be purchased at a reasonable cost, the emotional attachment and the sense of ownership often lead to an inflated subjective value of the possessed item, contributing to the endowment effect.