The endowment effect and loss aversion makes pulling back government benefits challenging.
Removing government benefits is an arduous task for the incumbent government even if it is replaced with other benefits. A recent example could be seen when states opposed the delinking of the Centrally Sponsored Schemes (CSS) from support of the Centre. The reasoning behind this opposition lies in the concept of immediate endowment explained by Amos Tversky and Daniel Kahneman in their paper, “Loss aversion in riskless choice”.
The broader finding of the paper is that the losses have a higher impact in preferences than gains, also known as loss aversion. As a part of this study they show that an immediate impact of loss aversion can be seen in giving up the ownership of a good. This is a continuation of the endowment effect, which refers to “a hypothesis that people value a good more, once their property right over it has been established.” However, the authors go further to show that the utility loss from giving up valued goods is more than the utility gain from receiving it.
In order to study these characteristics, authors conduct an experiment in which the students are made to sit in a manner that one third of them have a mug at their table (referred to as “sellers”). The ones with the mug are told that they now own the mug and are asked to choose whether they would sell or take it home for a list of prices ranging between $0.50 and $9.50 in steps of 50 cents. The rest of the class (referred to as “choosers”), on the other hand, is given the option between receiving the mug or a sum of money, which would be determined later. The result of this experiment showed that the “sellers” value the mug at $7.12 on an average while the “choosers” valued it ay $3.12.
The reason behind this difference in valuation lies in the immediate sense of endowment. The “choosers” evaluate the options facing two favourable choices between getting a mug or a sum of money. However, the “sellers” have to choose between retaining the status quo and giving up the mug in return of the money. Hence, keeping the mug is considered as a gain by the ones without the mug and as a loss by the others. This can be seen in the figure where choosers evaluate their choice from ‘t’ and thereby have two positive choices to choose from. However, the “sellers” of the mug are at ‘Y’ and thereby have to choose between staying at the status quo or to shift to X
Fig: Multiple reference points between X and Y
This reasoning explains the opposition raised by the states against the delinking of Centrally Sponsored Schemes from support of the Centre, as recommended by the 14th Finance Commission. As per the report the states have been provided a 10% increase in the share of states in central tax revenue. Along with which many schemes on the state subjects have been delinked from central support. Going by the loss aversion theory, the states consider the utility loss from delinking the schemes to be higher than the utility gained from the increased transfers. This is one of the explanations for why states opposed the move even though it assured them a net gain.
These dissents created due to endowment effects affect the political support for the incumbent government and are, thereby, make retracting government provisions an unpopular move. One possible solution to evade the opposition would be to add sunset clause to the government schemes such that the ownership period is pre-defined. This would not only ease the ability of the administrators to modify the schemes but also help reduce the sense of permanent ownership within the beneficiaries.
Devika Kher is a Research Associate at Takshashila Institution. Her twitter handle is @DevikaKher.