The endowment effect and environmental discounting

There is a considerable body of evidence from behavioural economics and contingent valuation showing that our preferences exhibit both reference dependence and loss aversion, a.k.a. the endowment effect.

In this paper the authors consider the implications of the endowment effect for discounting future improvements in the environment. They show that the endowment effect modifies the discount rate via (i) an instantaneous endowment effect and (ii) a reference-level effect. Moreover they show that these two effects often combine to dampen the preference to smooth consumption over time.

What this implies for discounting future environmental benefits may then depend critically on whether environmental quality is merely a factor of production of material consumption, or whether it is an amenity. On an increasing path of material consumption, dampened consumption smoothing implies a lower discount rate. But on a declining path of environmental quality and where we derive utility directly from environmental quality, it implies a higher discount rate. On non-monotonic paths, loss aversion specifically can give rise to substantial discontinuities in the discount rate.

This paper was originally produced in August 2016 and was updated in December 2018.