Predicting Buyer-Seller Pricing Disparities

Numerous studies have shown that compensation demanded (CD) to give up a commodity often greatly exceeds willingness to pay (WTP) to obtain the same commodity, even in incentive compatible experiments that penalize strategic misrepresentation. Observed CD/WTP disparities are too large to be reconciled with traditional assumptions of economic rationality. A prospect theory-based behavioral framework for predicting CD and WTP is proposed which produces five distinct transaction encoding rules, any one of which can in principle apply to a buyer or a seller. According to this framework, CD/WTP gaps occur when buyers and sellers encode the prospective transaction differently, and gaps can occur in multiple ways, and vary in size, depending on encoding. The transaction encoding framework was tested in two experiments. In Experiment 1, model fits to subjects' CD and WTP for lottery tickets were consistent with the hypothesis that buyers and sellers encode transaction problems differently. Moreover, the quite large observed CD/WTP gaps were explained fully by encoding: When differences between buyers' and sellers' encoding processes were taken into account, their estimated utility (value) and probability weighting functions did not differ. The present framework and results show that the widely cited endowment effect is but one of several ways in which loss aversion can give rise to CD/WTP gaps. Consistent with this broadened perspective, Experiment 2 demonstrated CD/WTP gaps in the absence of an endowment effect (and in the absence of rational economic causes). The transaction encoding framework (1) provides a structured approach for predicting and testing the effects of a variety of task factors on pricing behavior and transaction outcomes, and (2) reveals the useful property that, in many cases, the ratio CD/WTP can be interpreted as a direct measure of the degree of loss aversion.