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The Internal and External Validity of Paper "Experimental Tests of the Endowment Effect and the Coase Theorem"

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Experiment on the Coase theorem disrupted a string of experimental successes in the 1980s

The source of their refutation is the endowment effect which generates a reluctance to trade. We use Steven Medema's recent benchmark interpretation of the Coase theorem to subject their experiment to methodological scrutiny, generating four distinct explanations of their findings. We find that their explanation is the only one at odds with the theorem. While Kahneman, Knetsch, & Thaler argued that they undermined the Coase theorem, their result is constrained by the exclusion of the rationality assumption and the adoption of the invariance-efficiency criterion. There is no immaculate Coase theorem and therefore no single experimental test that can falsify it. Instead, different experiments test specific deviations from a benchmark theorem.

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A popular theory of the endowment effect, or what we will call “endowment theory,” says that the simple fact of owning something influences a person’s expressed preferences with respect to it

Our everyday experience might seem to confirm the hypothesis. We feel a special attachment to the house we own, to the car we drive, or even to an old paperback, coffee mug, or well-worn tshirt. A person who would never spend one-hundred dollars on a bottle of wine but receives a one-hundred dollar bottle as a gift will choose to drink the wine rather than sell it. And when in controlled experiments psychologists give subjects pens or mugs or chocolate bars, the recipients tend to hold onto those endowed items rather than trade or sell them. Endowment theory says that such observable events, whatever their other possible causes, are at least partially explained by the general phenomenon of loss aversion. Prospect theory holds that when deciding what to do, people give possible losses more weight than potential gains of the same magnitude. Endowment theory is an application of prospect theory, adding the hypothesis that ownership determines whether one experiences a change as a gain or as a loss. Endowment theory posits that ownership sets one’s reference point, the movement from which triggers either a perceived gain or loss, and that people perceive the transfer or sale of endowments as losses. If correct, endowment theory does two things. First, it explains why people often appear to value what they own more than they value otherwise identical goods they do not own. Loss aversion reduces an owner’s willingness to trade by generating an extra disutility from a loss of a good or right, separate from and in addition to the lost consumption value.

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The Coase Theorem has no doubt left an indelible mark on Law and Economics. The theorem proposes that, absent transaction costs, property will be allocated efficiently regardless of initial entitlement. Widespread acceptance of this assertion has given rise to much legal analysis aimed at reducing transaction costs in order to lubricate bargaining and achieve efficient allocation of property rights

On the whole this is not a bad thing – transaction costs are a major obstacle to efficient bargaining and should be reduced. However, recent studies which indicate the existence of the endowment effect have lead many scholars to re-examine their initial assumptions regarding the importance initial entitlement.[Daniel Kahneman] The main premise of the Coase Theorem is that, absent transaction costs, property rights will be efficiently allocated regardless of initial entitlement. This conclusion leads to two further assertions named invariance and efficiency. Invariance states that, discounting transaction costs, the same efficient ultimate distribution will prevail. Efficiency states that, discounting transaction costs, the ultimate distribution will be efficient. The theorem is used to support the notion that clearly defined property rights will promote efficient distribution of those rights. One of the primary transaction costs is information – the ability and the cost of obtaining it. The importance of information is highlighted by the famous prisoners’ dilemma.[Robert Cooter and Thomas Ulen, 2008] In the prisoners’ dilemma each actor would be better off cooperating instead of refusing to cooperate. However, absent such information and confidence, the dominant strategy is to not cooperate. Accordingly, much attention has been given to the reduction of transaction costs. The endowment effect is essentially the gap between a person’s buy and sell price regarding a specific good. This finding suggests that initial entitlement would play an important role in the efficient allocation of resources because specific valuations will be altered by ownership. In particular, two studies have led to conclusions which could prove influential for a law and economics analysis of the regulation of business transactions.

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Summing up, that the costs of transacting are zero), as long as rights are well-defined

Specifically, it is necessary to know whether the damaging business is liable or not for damage caused since without the establishment of this initial delimitation of rights there can be no market transactions to transfer and recombine them. But the ultimate result (which maximizes the value of production) is independent of the legal position if the pricing system is assumed to work without cost.

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Robert Cooter and Thomas Ulen, Law & Economics, 85-1, 225, 268 (Pearson Addison Wesley 2008)

Daniel Kahneman, Jack L. Knetsch & Richard H. Thaler, Experimental Tests of the Endowment Effect and the Coase Theorem, 98 J. Pol. Econ. 1325 (1990)

Richard Thaler, Toward a Positive Theory of Consumer Choice, 1 J. Econ. Behav. & Org. 39 (1980); ”);

Amos Tversky & Daniel Kahneman, The Framing of Decisions and the Psychology of Choice, 211 Sci. 453 (1981);

Russell B. Korobkin, The Endowment Effect and Legal Analysis, 97 Nw. L. Rev. 1227, 1229 (2003); Jason F. Shogren

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