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BEHAVIOURAL ECONOMIC ANALYSIS OF DECISION MAKING:

A CASE OF MARKETING
by
Zhang Yu
Submitted in partial fulfillment of the requirements
for the degree of Master of Arts
at
Dalhousie University
Halifax, Nova Scotia
April 2007
Copyright by Zhang Yu, 2007
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TABLE OF CONTENTS
List of Tables........................................................................................................................... vi
List of Figures........................................................................................................................ vii
/
Acknowledgements............................................................................................................... viii
Abstract.....................................................................................................................................ix
Chapter 1: Introduction............................................................................................................ 1
Chapter 2: A Brief History of Economics and Psychology................................................... 5
Chapter 3: Psychological Foundations for Behavioural Economics.................................. 12
3.1 Psychological Determinants of Behavioural Economics..........................................12
3.2 Bounded Rationality.....................................................................................................17
3.3 Bounded Self-Interest.................................................................................................. 25
3.4 Measurement of Happiness.........................................................................................30
Chapter 4: The Basic Themes of Behavioural Economics..................................................38
4.1 Heuristics and Biases................................................................................................. 38
4.1.1 Representativeness............................................................................................... 39
4.1.2 Availability.............................................................................................................43
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4.1.3 Anchoring and Adjustment................................................................................. 46
4.2 Prospect Theory...........................................................................................................51
4.3 Reference Dependence and Loss Aversion............................................................... 58
4.3.1 Framing Effect..................................................................................................... 58
4.3.2 Endowment Effect............................................................................................... 60
4.3.3 Mental Accounting..............................................................................................63
Chapter 5: Prospect Theory and Extensions: Evidence from Marketing.......................... 68
5.1 Asymmetric Price Elasticities of Consumer Goods..................................................70
5.2 Exclusion versus Inclusion Option-Framing for Consumer Choice....................... 73
5.3 The Endowment Effect of Retail Purchase and Direct Marketing......................... 76
5.4 Mental Accounting, Preferences States and Framing Effect in Price Changes 78
Chapter 6: Conclusion............................................................. 83
References.............................................................................................................................. 87
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LIST OF TABLES
Table 4.1: Preferences between Positive and Negative Gambles........................................54
Table 5.1: The Field Phenomena Consistent with Prospect Theory................................... 69
Table 5.2: Design Summary.................................................................................................. 80
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LIST OF FIGURES
Figure 4.1: The Value Function............................................................................................. 56
Figure 4.2: The Weighting Function......................................................................................57
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ACKNOWLEDGEMENTS
First of all, I would like to thank my supervisor, Professor Kuan Xu, for his patient
and knowledgeable guidance. Without his support and encouragement, this thesis would
not be finished. I also would like to thank Professors Melvin Cross and Yulia Kotlyarova
for their insightful suggestions and valuable corrections. In addition, thank you to my
friends for their help and encouragement. Finally, I would mostly thank my parents for
their enduring love and strong support during my graduate studies in Canada.
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ABSTRACT
Economics and psychology are both sciences that have the common goal of
studying human behaviour. These two disciplines have a close relationship. However, the
concept that psychology is an integral part of economics was not considered by
mainstream economists in the first half of the twentieth century. However, many scholars
found that some anomalies that occur in economic life cannot be explained by
conventional economic theories. Because of this, the emergence of behavioural
economics provides realistic psychological foundations to enhance the explanatory power
of economics. Behavioural economics is a growing discipline that combines economics
with psychology. This discipline has been successfully applied to many areas, such as
macroeconomics, labor economics, finance and marketing in the recent past.
This thesis first introduces the development of behavioural economics and reviews
three basic themes: Heuristics and Biases, Prospect Theory, Reference Dependence and
Loss Aversion, and then explores how these three basic ideas of behavioural economics,
especially prospect theory, can be applied to the firms decisions in marketing. The
purpose of the thesis is to draw the attention of economists to this new field and
encourage scholars and marketers to better understand behavioural economics and apply
its tools in research.
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CHAPTER 1
Introduction
Behavioural economics is a new field of economics that combines economics and
psychology (Mullainathan and Thaler, 2000). Economics and psychology are both
sciences that study human behaviour. Although they have a common theme, classical
economics has not incorporated many psychological factors into the analysis of human
behaviour. In classical economics, the individual is regarded as homo economicus or
economic man. Homo economicus is completely rational and selfish when he or she
makes decisions and his or her tastes do not change. The assumption of homo
economicus is too ideal. As Kahneman said in 2003, no one ever seriously believed that
all people have rational beliefs and make rational decisions all the time (Kahneman,
2003). Many scholars questioned this assumption and many empirical studies found that
their results are inconsistent with economic predictions. Consequently, the assumption of
homo economicus has been increasingly criticized and the belief of economics as Queen
of the Social Science has been challenged. These questions and critiques lead to the
emergence of a new field Behavioural Economics (Frey and Benz, 2002). Unlike
classical economics, behavioural economics applies psychological insights to economic
analysis so that it could increase the explanatory power of economics (Camerer and
Loewenstein, 2004).
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Behavioural economics modifies the assumptions of classical economics, such as
rationality and selfishness, in various economic theories, such as the expected utility
theory, social utility, revealed preference theory and so forth. Theories in behavioural
economics have successfully solved many anomalies (e.g. asymmetric price elasticity
(Hardie, Johnson, Fader, 1993) and equity premium puzzle (Benartzi and Thaler, 1995))
which cannot be explained by assumptions of classical economic theories. Although
behavioural economics has not yet been widely accepted by mainstream economists, so
far it has also been fruitfully applied to finance1, macroeconomics, labor economics and
law.
The definition of marketing is a controversial topic. But different definitions
represent a common belief that marketing is a discipline of studying how individuals and
firms facilitate and expedite exchanges in markets (Pride and Ferrell, 1977). In other
words, marketing is an applied science that studies consumer and firm behaviour in
markets. It has the same goal as behavioural economics. In addition, economics and
psychology are the two most influential foundations for marketing (Ho, Lim and Camerer,
2006). Unfortunately, the relevant works that studied how the opinions from behavioural
economics can be used in marketing practices are relatively few.
1 When I finished this thesis, the book Behavioural Economics and Its Applications written by Peter
Diamond and Hannu Vartiainen will be published in April 2007. In this book, Diamond and Vartiainen
think behavioural economics was successfully applied to only one field of applied economics finance.
However, this thesis found a different opinion that behavioural economics has not merely been applied to
finance, but also has been used to analyze marketing.
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This thesis has two purposes. One is to review this new field by introducing the
development of behavioural economics and its basic themes. Behavioural economics and
its applications have been a growing literature. This thesis focuses only on three main
themes: Heuristics and Biases, Prospect Theory and Reference Dependence and Loss
Aversion.
Another purpose of this thesis is to apply behavioural economic analysis to firms
decision, in particular the decision making in marketing. Marketing is an action of firms
to increase the awareness of the public about the goods and services so that this action
can affect client behaviour and the sales of goods and services. Behavioural economics
studies decision making of individual firms and consumers. As a result, how behavioural
economics can be used to analyze marketing is an interesting and meaningful issue. This
issue has not attracted too much attention from scholars.
The rest of the thesis is organized as following. Chapter 2 will briefly introduce the
history of behavioural economics and the relationship between economics and
psychology. Chapter 3 will discuss the psychological foundations for behavioural
economics and state the challenges for the assumptions of classical economics so that it
provides the reader with an overview of psychological underpinnings of economic
behaviour. Chapter 4 will illustrate three basic themes of behavioural economics:
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Heuristics and Biases; Prospect Theory; and, Reference Dependence and Loss Aversion.
Chapter 4 will also discuss some applications of Heuristics and Biases in marketing
practices. Because Reference Dependence and Loss Aversion is considered an extension
theory of Prospect Theory, Chapter 5 will focus on prospect theory and its applications in
marketing practices. Chapter 6 will provide some conclusions including the limitations of
this thesis and future research.
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CHAPTER 2
A Brief History of Economics and Psychology
In a history that spans more than one century, behavioural economics has
significantly contributed to progress in economic research. In fact, the relationship
between economics and psychology is close. Some scholars thought that most of the
ideas in behavioural economics are not new (Camerer, 1999; Camerer and Loewenstein,
2004). But its course of unification of economics and psychology has been arduous. This
chapter is intended to provide readers with a brief history of psychology and economics.
The roots of behavioural economics can be traced back to three centuries ago.
Adam Smith, the founder of modem economics, mentioned psychology in his book
entitled The Theory o f Moral Sentiments. This book refers to psychology of human
behaviour, some of which signifies current developments in behavioural economics
(Camerer and Loewenstein, 2004). For example, Adam Smith commented (1759/1892,
311) that we suffer more.. .when we fall from a better to a worse situation, than we ever
enjoy when we rise from a worse to a better.(Camerer and Loewenstein,2004). Smiths
view implicitly reflects the nature of Loss Aversion that is a basic theme in behavioural
economics. In 1776, Adam Smith wrote the second of his famous books, The Wealth of
Nations. But in this book, the content of psychology receives much less attention.
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French social psychologist Gabriel Tarde wrote Za Psychologie Economique in
1881 which was published in 1902. In this work, he claimed that he was the person who
first applied psychology to economic theories. In Tardes opinion, it was regrettable that
Adam Smith described psychology of human beings in Theory o f Moral Sentiments
(1759) but did not utilize psychological insights in his book The Wealth o f Nations
(Wameryd, 1988). However, Reynaud (1964) disagrees with Tardes claim, and believes
that there were some attempts to combine economics and psychology long before Tarde
(Wameryd, 1988).
Jeremy Bentham (1789), an early advocate of Utilitarianism, argued that utility
could be measured by means of a persons happiness. The greatest happiness principle
which he advocated is regarded as the core of the utilitarian moral theory for determining
individuals level of utility. In addition, Benthams utility concept is considered important
in forming the foundation of classical economics (Loewenstein 1999). Edgeworths
Theory o f Mathematical Psychics (1881) introduced a simple social utility model in
which one individuals utility is influenced by another persons payoff (Camerer and
Loewenstein, 2004). Edgeworth also wanted to measure utility in terms of cardinal
numbers. But the concept of measurable cardinal utility was questioned by Robbins
(1932). Later, the cardinal utility was replaced with a preference index of ordinal utility
which can be represented by the indifference curves. From then on, the content of
psychology in economics was gradually neglected by economists.
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Why did classical economics ignore psychology? The answer is that most
economists thought psychology provided an unsteady foundation for economic reasoning
(Camerer and Loewenstein, 2004). To make economics more general and accurate,
economists, like Samuelson, Arrow, and Debreu, strived for presenting and interpreting
economic problems in the form of mathematics (Camerer, 1999). This approach to
economics was widely acclaimed and has been successfully applied in numerous
empirical studies. Perhaps this might be the reason economics was once termed by some
as imperialism (Frey and Benz, 2002).
Since 1940s, George Katona in the U.S. introduced economic psychology, and
began to use psychological theories and methods to solve economic problems (Wameryd,
1988). Later, Allais (1953) and Ellsberg (1961) proposed famous Allais paradox and
Ellsberg paradox which document the inconsistency with the predictions of expected
utility and subjective expected utility. Although these studies attracted more attention,
they did not change most economists attitudes for adopting psychological concepts in
economics (Camerer and Loewenstein, 2004).
Over the years, researchers, such as Amos Tversky, Daniel Kahneman, Richard
Thaler, Matthew Rabin, Colin Camerer, George Loewenstein and others have criticized
some axioms in classical economic models as psychologically unrealistic (Rabin, 2001).
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Particularly, these scholars began to use economic models as a benchmark against which
to contrast their psychological models (Camerer and Loewenstein, 2004). Their famous
works on Heuristics and Biases (Kahneman and Tversky, 1974), Prospect theory
(Kahneman and Tversky, 1979), Framing Effect (Kahneman and Tversky, 1981), and
Mental Accounting (Thaler, 1980) cause surprising impacts on economics. These authors
provide strong evidences against classical economics and add psychological concepts to
economic theories to strengthen the realism of economic theory. Furthermore, it is worth
noting that two Nobel Prizes in economics were awarded to two psychologists: Herbert
Simon in 1978 and Daniel Kahneman in 2002. This indicates that the importance of
psychology in economics has been acknowledged by mainstream economists.
Now, the applications of psychological concepts to economic research have been
widely noted and accepted. The synthesis of economics and psychology is referred to
psychological economics or economic psychology (behavioural economics).
Wameryd (1988) noted that, at first, Katona vacillated between the concepts of
economic psychology and psychological economics. He tended to use these two terms
interchangeably, but he named his book Psychological Economics published in 1975.
Later, Katona used Behavioural Economics as the title of another book of his. He
thought behavioural economics is the most appropriate heading for the field of study.
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Earl (2005) discusses the above question in detail. Between two names: economic
psychology and psychological economics, many scholars would choose the former or use
both interchangeably. But Earl thought economists and psychologists may have quite
different attitudes for such a synthesis. They define it depending on which discipline
plays the main role in their relationship. In what follows, there are three different
definitions:
Firstly, from economists perspectives, they may prefer the term of economic
psychology. They do not regard psychology as an integral part of economic theory.
Therefore, economists would like to use psychological factors as a condition of
constrained optimization or in game theoretic terms. In psychologists opinions, they may
also choose the title economic psychology but its interpretation is different from the
same term which economists define. Psychologists think that economic elements are
designed to be the incentive systems for changing the behaviour of children or explaining
human responses in experiments in behavioural psychology.
Secondly, unlike economic psychology, behavioural economics or psychological
economics challenge the assumptions of classical economics which exclude ideas from
psychology. Furthermore, it borrows ideas from psychology to describe the real economic
behaviours which can not be easily explained by classical economic theories. By adding
psychological concepts to economic study, behavioural economics can predict economic
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behaviours more accurately. The emergence of behavioural economics narrows the gap
between economic theories and real economic life.
Thirdly, some scholars thought the relationship between psychology and economics
is reinforcing each other. In Raaij, van Veldhoven and Wameryds opinions, scholars
ought not to over emphasize the differences between the two terms. Generally,
psychologists are inclined to economic psychology because it is closer to psychology,
while economists favor behavioural economics since it seems closer to economics. In
addition, economic psychology is more widely accepted in Europe, whereas the
behavioural economics is more widely spread in the U.S (Van Raaij, Van Veldhoven and
Wameryd, 1989).
Presently, more scholars prefer behavioural economics over psychological
economics as the definition of this field. Overall, in the history of behavioural economics,
behavioural economics as a new field has been developing at a rapid speed due to these
scholars hard work. More economists acknowledged the importance of psychology in
economic theories, for example, Robin (2002) pointed out that George Akerlof (1970)
and Robert Locus (1972) have simultaneously been innovators in classical economics.
Their works on asymmetrical information and rational expectations modify classical
economic theories to become more accurate and realistic. Papers which refer to
behavioural economics or integrating psychology into economics have been published in
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top economic journals. Recently, some economic textbooks also have covered this field
(see Varian, 2006 and Frank, 2007).
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CHAPTER 3
Psychological Foundations for Behavioural Economics
The assumption of homo economicus states that individuals are completely
rational and self-interested agents. This assumption of rationality implies: individuals can
maximize their utility by selecting the best alternative from all possible choices according
to their preferences. This assumption is criticized by scholars from psychological
perspectives.
The field of psychology is used to explore human judgment, behaviour, and
well-being (Rabin, 1998). From psychologists perspective, human beings do not act
according to some assumptions of classical economics. As Hayers (1950) suggests, the
assumption of rationality ignores the necessity of studying human psychology. Better
understanding the psychological foundations is useful for doing research in behavioural
economics. This chapter will introduce the psychological determinants of behavioural
economics and criticize the assumptions of classical economics by applying modem
psychological approaches.
3.1 Psychological Determinants of Behavioural Economics
Individuals different characteristics separate us from one and other. For example,
both persons A and B are excellent employees in the same company. They both were
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given a chance to get a higher position and higher salary offered by another company.
According to the assumption of homo economicus, both of them should choose to quit
from the current company and accept the new offer which can provide the best benefits
for them. However, in reality, persons A and B may have different reasons used for their
decisions. Person A may give up the opportunity to stay at the present company, because
person A is satisfied with the current position and understands that the higher position
means higher responsibility and challenges. Even with the offer of a slightly higher salary,
he prefers friendly relations with colleagues, comfortable and happy work environment
with a lighter pressure. Conversely, person B is ambitious, who always strives for a better
opportunity and wants to accept new challenge. The reward in the opportunity is indeed
appealing to him or her. In the end, person B decides to accept the offer. Why do they
make different choices and decisions? Does the decision of person A violate the
assumption of rationality?
Their behaviours are caused by different thinking, experiences, and life goals. In
other words, they have different motivations. Similarly, Coke and Pepsi are so similar in
flavor and price. The preference between the two drinks can be indifferent. Why do some
customers prefer Coke to Pepsi, and vice versa? The answer could be that some
consumers are used to drinking a specific brand of beverage. Namely, consumers insist
on buying one brand of drink because they have formed the habit. Habit is a
psychological factor that affects consumer behaviour.
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As indicated above, economics and psychology both study human behaviour.
Human behaviours are influenced by culture, attitudes, emotions, and other factors. That
is, psychology is one of the most influential determinants of human behaviour. Economic
behaviours are always restricted by specific psychological determinants. Before
discussing those basic themes of behavioural economics, an analysis of such
psychological determinants would be of help.
Generally, scholars argue that human behaviours are dominated by cognition and
emotion which interplay with decision making (Schwarz, 2000). However, more scholars
would like to classify psychological determinants in more details. Van Veldhoven (1988)
defined a new area called behavioural dynamics which deals with human behaviour
that is caused and ruled by processes that originate from motivational states, personality
and learning characteristics. It merges and combines several psychological approaches to
study the dynamics of human behaviour. That is, personality refers to the total of an
individuals characteristics which are stable over different situations and over time. It can
be stated that the motivation approach of behaviour stresses the direction of behaviour
towards certain goals or states and the intensity of this behavioural orientation; learning
refers to the way in which past experiences are integrated within the behaviour of an
individual. In his opinion, personality, motivation and learning are the psychological
basis of economic behaviour (Van Veldhoven, 1988).
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Antonides (1991)s approach is more concrete. He classifies psychological
determinants into motivation and personality, perception, learning, attitude, limited
information processing, economic expectations, emotions and well-being. Frey and Benz
(2002) list five elements of the economic model of human behaviour: individuals act,
incentives determine behaviour, incentives are produced by preferences and constraints
which are strictly distinguished, and individuals pursue their own interests and generally
behave in a selfish way.
Bayton (1958) notes motivation, cognition and learning which are basic factors for
consumer behaviour. The analysis of consumer behaviour is a comprehensive application
of psychology and economics. These opinions represent a broad range of views used in
analyzing general economic behaviour. Corresponding to the analysis of consumer
behaviour in marketing, I subscribe to Baytons view.
Motivation refers to the drives, urges, wishes, or desires which initiate the sequence
of events known as behaviour . For example, when a firm plans to produce a new
product, marketers must consider which group of people will like it and need to buy it.
Consumers decide to buy it or not to buy it based on their own different motivations. That
is, motivation influences consumer attitude toward goods and services, and consumer
attitude eventually leads to consumer behaviour. The opinion or belief regarding the
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attributes of a product is associated with the extrinsic motivation to behaviour (e.g.
supermarkets use discount activities (extrinsic motivation) to make consumers buy their
goods (behaviour)), whereas the attributed evaluation or importance is associated with the
intrinsic motivation (e.g. consumer satisfaction).
Cognition is the area in which all of the mental phenomena (perception, memory,
judging, thinking, etc.) are grouped (Bayton, 1958). A well-know example is about Coke
and Pepsi, different brands of products with almost the same utility, what psychological
factors underlie consumer choice? The first step in peoples mentality is to differentiate
attributes of products. The brand name, package, design are differentiating attributes that
can be called signs or cues. Moreover, the signs are associated with expectancies. For
example, how do we select one specific mango from a group of mango? The critical signs
are thickness of skin, color of skin, and firmness of mango. That is, package can carry the
expectancy of quality; thin-skin and color reflect the expectancy of juice and firmness
which stands for fresh (Bayton, 1958).
Learning refers to those changes in behaviour which occur through time relative to
external stimulus conditions...starting with need-arousal, continuing under the influence
of cognitive processes, and engaging in the necessary action, the individual arrives at
consumption or utilization of a goal-object(Bayton, 1958). When consumption or
utilization of the goal-object leads to satisfaction of the initial motivation, this satisfaction
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can leave a reinforcement impression upon consumers. If consumers have the same
needs aroused later, it is probable that they will repeat the process of selecting and getting
to the same goal-object. By repeating the process, they will form a habit. For example,
suppose I went to a new Chinese restaurant to have dinner, and I found that the food was
very delicious and prices were reasonable. The next time, when I want to eat Chinese
food, I will have an increased tendency to select this restaurant over others, because I had
a high degree of satisfaction about this restaurant the first time.
These psychological concepts provide a comprehensive explanation for human
behaviour, and can be applied to the analysis of consumer behaviour. Psychology governs
how people make judgment and choice. Because of limitations of psychological factors,
people cannot make rational decisions all the time. It leads to a series of theories that
criticize the assumption of rationality. Section 3.2 will state the challenges for classical
economic assumptions.
3.2 Bounded Rationality
In his textbook Microeconomic Theory, Whinston (1995) discussed two related
approaches to modeling decision. One is the preference-based approach, assumes that
the decision maker has a preference relation over her set of possible choices that satisfies
certain rationality axioms. The other is the choice-based approach, focuses directly on
the decision makers choice behaviour, imposing consistency restrictions that parallel the
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rationality axioms of the preference-based approach.
Whinston (1995) goes on to explain the preference-based approach and the
choice-based approach, such as utility maximization, expenditure minimization, and
expected utility theorem (including famous von Neumann-Morgenstem expected utility
function), among others. Whatever choice is under certainty or uncertainty, the whole
structure is restricted by the assumption of rationality.
The assumption of rationality has been a debating problem in behavioural
economics as well as in economics. A great number of economists have realized that this
assumption frequently deviated from realistic economic life. Since many classical
economic theories make explicit or implicit use of the assumption of rationality, many
empirical findings are always inconsistent with the predictions of these economic theories.
For example, in 1952, French economist Allais designed an experiment to test expected
utility theory, but its result was opposite to the prediction of expected utility theory. This
finding was the famous Allais Paradox2 (1952). Due to this contribution, Allais was
awarded the Nobel Prize in Economics. Later, Daniel Ellsberg (1961) conducted
additional experiments to find a paradox3 in decision making. His research also proved
that individual choice violates the expected utility theory.
2 Allais Paradox (1952) proposed by Maurice Allais shows that peoples choice does not conform to the
expected utility theory.
3 Ellsberg Paradox (1961) provided by Daniel Ellsberg implies peoples choice is inconsistent with the
predictions of the expected utility theory.
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From psychologists perspective, individuals cannot select the optimal outcome by
ordering all possible choices according to their preferences (Antonides, 1991). In 1950s,
Herbert Simon modified the assumption of rationality and first constructed the bounded
rationality model. It suggests the economic behaviour of human agents should be based
on algorithms that included cognitive principles (Camerer, 1999) and it becomes a central
theory of behavioural economics.
In his paper entitled A Behavioural Model of Rational Choice, Simon (1955) cast
doubts about the assumption of the economic man which implies that individuals make
rational decisions using their unrealistic capacity of information processing and
sophisticated calculating ability. He built a behavioural model that replaced the complete
rationality of the economic man with a limited rational agent whose information and
computation skills were constrained by psychological limitations of the biologically
defined organism. For instance, at the Olympic Games, a sprint athletes speed is
constrained by his physical capacity. Even if he may receive scientific training and have a
nutrition plan, his physical capacity still cannot go beyond his limitations. An extreme
example is that no person can run faster than 1 kilometer per second. Humans, like a
computer and a machine, have limited capacities for problem solving (Tisdell, 1966).
Under the constraints of organism, Simon indicated that the goal of human behaviour is
to get satisfaction rather than maximum utility. In the works which were published in
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1957, 1972 and 1982, Simon studied the problem solving and information processing
models based on bounded rationality. That is, individuals do not have complete
information and sophisticated calculating ability. But they have limited information and
reasonable computation skills. In short, the theory of bounded rationality assumes that
individuals make choices and decisions rationally subject to limited knowledge, resource
and time (Hoffrage and Reimer, 2004).
In 2002, Kahneman delivered his Nobel lecture entitled Maps of Bounded
Rationality: Psychology for Behavioural Economics. He stated that our research
attempted to obtain a map of bounded rationality, by exploring the systematic biases that
separate the beliefs that people have and the choices they make from the optimal beliefs
and choices assumed in rational-agent models. Unlike Simons theory that adopted a
normative and prescriptive approach, Kahneman and Tversky (1971, 1974, 1979, and
1981) used a descriptive approach from empirical evidence to criticize the assumption of
rationality. This lecture mentioned Langer et al.s (1978) well-known example of
mindless behaviour to show that people are used to simplifying complicated
information when they make choices. This is also referred to as elimination by aspects
in making choices (Tversky, 1972). These findings inspired Kahneman and Tversky to
explore the heuristics that people use availability, representativeness, and anchoring4
(Slovic et al. 2002). Since people would like to choose a shortcut to make choices instead
4 Representativeness, availability and anchoring will be discussed in Chapter 4.
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of sophisticated thinking and computing, biases and errors are inevitable.
Etzioni (1986) even asserts that rationality is not the rule in human behaviour. The
classical economic theory assumes that individuals rational choices are on the basis of
full and relevant information. However, in real life, it is impossible for people to have
complete and perfect information on which rational choices can be made. Akerlof (1970)
describes that there is asymmetric information between buyers and sellers in the market.
Because of limited information, buyers cannot make rational choices. Furthermore, in
economic models, information is generally derived from external sources which may be
too general. Decision typically requires more specific information on the attributes of all
alternatives. This line of thinking neglects information acquired from internal source that
is stored in memory and comes from prior learning and experience that may be suitable
for similar decisions (Van Rajj, 1988). Internal sources are dominated by psychological
factors of human beings, such as habits, motivation, emotion, and so on.
As indicated above, because of limited information, rationality is an ideal state
which may not be accomplished. In recent years, many economists and psychologists
become interested in studying how limited information affects consumer choices and
decisions. The limitation to information search and processing can be classified into:
information environment, situational environment, information stored in memory and
individual differences (Van Rajj, 1988).
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Information environment refers to the structure and format of the available
information. Information structure5 describes how the information is presented (Van
Raaij, 1977). Information structure pertains to structuring of information and the format6
of the information pertains to the type and unit of information and both of them are
important factors to influence information search and processing (Van Raaij, 1988).
People would like to use shortcuts to deal with complicated events. Some shortcuts
depend on the structure and format of information, such as representativeness,
availability and anchoring (Kahneman and Tversky, 1974). Framing effects (Kahneman
and Tversky, 1986) is also a sort of information environment that influences information
processing.
Information search and processing are constrained by situational environment. For
example, different store display, advertisement and commercials could provide different
product information (Van Raaij, 1988).
Information in memory is accumulated from previous knowledge or experience. It
affects the way in which people make judgment and choice. If consumers are not familiar
with a product, they will spend more time and effort to search missed information,
5 For example, information can be structured by matrix of alternatives and attributes, or be structured by a
pair comparison (Van Raaij, 1977).
6 Examples of formats are: ratio-scale numbers, such as weight and price; in ordinal numbers, such as
hotel classifications or pictorial format, such as pictures or video (Van Raaij, 1988).
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because there is no relevant information in their memory. If consumers know basic
product information and hope to know more product information, they may be interested
in exploring new information, since the old information in memory is insufficient (Van
Raaij, 1977).
Individual differences refer to that different people have different motivation
(need-arousal). Consumer motivation can be activated by advertising or the product
presentation. But different consumer may have different motivations for the same
advertising or the product presentation (Van Raaij, 1988). Individual differences limit the
information search and processing and affect consumer decision. Beatty and Smith (1987)
find that consumers would like to search more information under high involvement and
search little information or stop searching more information under low involvement.
In addition to theoretical reasoning, empirical evidence has been acquired from
consumer behaviours and it indicates that decision is made by the limited information
processing. Ferber (1973) reports that around 87% of households do not have a financial
plan. And many consumers do not have any purchasing plans when going shopping; but
purchase behaviour is often impulse. Moreover, people often rely entirely upon the
salesmans recommendation to decide what to buy. It is common for consumers to buy
health products depending largely on the information provided by the nutritional labeling
(Baltas, 2001). Even though some of these information is not useful for consumers or
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some consumers cannot fully understand what these information means, more
information can make consumers more confident (Oskamp, 1965). All above examples
imply that decision making is significantly affected by limited information.
In marketing practices, advertising is a fact of modem economic life. However, as
Borden (1942) said, advertising has never been very well digested into the body of
economic analysis. Advertising has been greatly influencing and changing human life.
On one hand, advertising provides information to consumers to satisfy their needs; on the
other hand, advertising helps firms persuade consumers to buy their goods and create
brand loyalty. Apparently, advertising plays an important role in markets, but its role is
not fully explored in economics. Indeed, under the traditional assumptions that
consumers have fixed preferences over products and perfect information, there is no
reason for consumers to respond to firms advertising efforts (Bagwell, 2001).
Advertising utilizes bounded rationality of individuals to promote their products and
build brand loyalty. As we known, the objective of advertising is to influence consumers
to buy their products. Sometimes, consumers may be influenced by advertising and they
may buy some goods at impulse without knowing that they are exploited by advertising.
Marketers often cannot make rational decisions in resource allocation. For example,
advertising and sales promotion are two different methods used to achieve the same
marketing objective. It is difficult for brand managers to consider how to allocate the
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budget between advertising and sales promotion. Low and Mohr (2000) investigate
outcomes of brand managers advertising and sales promotion budget allocations by
using a bounded rationality perspective. They find that brands with higher budget
allocations to advertising would have stronger effects on consumer attitudes, brand equity,
and market share.
3.3 Bounded Self-Interest
The economic theory typically assumes that everyone has self-interest in
maximizing his or her own utility and disregarding others. At first glance, the
assumption appears to conform to human nature. But evidence suggests that many people
are willing to help others, even though their behaviour will not maximize and may even
reduce their utility. Most people are willing to cooperate, help each other, and put
themselves into others shoes.
Altruism refers to the belief that an individual should take into account the utility of
others when evaluating his or her utility (Becker, 1981). Sawyer (1965) also examined
the idea of reciprocal altruism in a simple economic model to better understand the nature
of cooperation and altruism. However, altruism is different from reciprocity. It is
unconditional kindness (Antonides, 1991).
Fairness means that people want to achieve an equitable distribution of resources
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between the parties involved in an exchange relationship (Frey and Benz, 2002). Guth
(1982) designed a well-known game the Ultimatum Game which has been seen as the
standard experiment in economics to reveal the human nature is not exclusively selfish.
In this game, two players bargain anonymously over a fixed amount of money between
them. Person A, the proposer, offers a plan of how to divide the amount. On the other
hand, Person B, the responder, just has the right to accept or reject, but no right to
bargaining with the proposer. If the responder accepts the plan, both of them can get
money, respectively; if the responder rejects the plan, neither of them can get money.
According to the classical economic assumption, the economic man who is a selfish actor
desires to obtain maximum profits. The proposer can make an offer that gives the
responder the least money, while the responder has to accept the proposal to get money. It
is better for the responder to accept rather than to reject due to his or her self-interest.
However, the game was played in many countries such as Western nations, China and
Japan among individuals of various backgrounds (Sigmund, Fehr and Nowak, 2002). The
results are opposite to the prediction under the classical assumption. Most proposers
made a relatively fair offer that gives responders a half to two third of money. On the
other hand, most responders would reject small money offer to punish the unfair
behaviour of proposers. The ultimatum game leads to a lot of relevant experiments and
studies that were designed to state the rules of fairness.
Kahneman, Knetsch, and Thaler (1986) find that consumers consider it is unfair if
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firms raise product prices to take advantage of natural disasters; while consumers think
that it is fair that firms raise product prices when the cost of inputs increases. This finding
explain well why companies, even monopolies do not raise price arbitrarily to avoid a
reputation of being unfair (Kahneman et al., 1986), even if this behaviour can bring
substantive profits for them in short run. When consumers find that they suffered unfair
prices, they are more likely to choose to boycott products. Actually, there is a commonly
used approach for marketers to utilize consumer psychology bidding up original prices
and then selling products at regular price by so called discount. In fact, the products do
not become cheaper and consumers do not save money. But these marketing practices
easily induce consumers misconception that prices are lower than actual prices. This
leads consumers to buy more products.
Kanfmann, Ortmeyer and Smith (1991) examined fairness in consumer pricing by
two legal cases. One is about May Company which was charged with deceptive
advertising. It was suspected of using high-low pricing policy to deceive consumers. The
retailer raised its so-called original or regular reference prices artificially first, and
then earned extra profits from promoting discounts from these prices. Another case is
about the General Development Corporation (GDC) which was charged of deceiving
almost 10,000 consumers to buy their houses at inflating prices. Although the two
companies used different types of deception, both companies used deception and
unfairness in pricing. But whether consumers are skeptical or being deceived becomes a
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debated issue. Shapiro (1990) concluded consumers know different retailers approaches
to advertising and promotion and doubt retailer pricing policies which contain substantial
puffery in advertisements. However, even though consumers cast doubt on retailer
pricing policies, they are still willing to compare May Companys sale prices with other
retailers and then buy the cheapest product. In Shapiros opinion, consumers are not
deceived by sale advertisements since they know that these advertisements are retailers
approaches to increase sales. While Urbany (1990) provides a different view, he thought
sale advertisements involving a reference price significantly stimulated the consumers
perception of the savings and the consumers intention to purchase. Therefore, consumers
are deceived by these deception advertisements. To avoid the reputation of unfairness in
pricing, Kaufmann et al. (1991) suggested companies and policymakers should provide
more information on how they determine prices and what market prices are. Furthermore,
they should keep stable pricing to avoid generating unrealistic consumer expectations.
In the paper Fairness as a Constraint on Profit Seeking: Entitlements in the Market
written by Kahneman, Knetsch and Thaler (1986), the authors mention a case of fairness
in customer markets to support their conclusion that even profit maximizing firms have
an incentive to act in a manner that is perceived as fair if the individuals with whom they
deal are willing to resist unfair transactions and punish unfair firms at some cost to
themselves. During the spring and summer of 1920, although Standard Oil of California
(SOCal) had the opportunities to raise the oil price legally, when there was a severe
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gasoline shortage in the U.S. West Coast, SOCal did not raise the price but maintained it
at the existing level. Economically, SOCal lost a large amount of profits in short run. But
according to confidential SOCal documents, it said that SOCal officers were clearly
concerned with their public image and tried to maintain the appearance of being fair.
From the three cases, it is not hard to find that fairness is important for profits of
firms in the long run and that firms can be punished due to unfair behaviour in the long
run. Akerlof (1980, 1982) suggests that firms should emphasize their reputation to create
good impression among their customers.
Fehr and Gachter (2000) defined reciprocity as follows: Reciprocity means that in
response to friendly actions, people are frequently much nicer and much more
cooperative then predicted by the self-interest model; conversely in response to hostile
actions they are frequently much more nasty and even brutal. Furthermore, people may
choose to punish others who misbehaved, even at some costs for themselves, and reward
those who have helped, or to make outcomes fairer (Camerer and Loewenstein, 2004).
The ultimatum game can be used to illustrate negative reciprocity. There is a reciprocity
relationship between consumer and firm. When we have dinner in restaurant, the smiling
waitresses have larger probabilities to get more tips than the less smiling ones (Tidd and
Lochard, 1978). Reciprocity has been employed as an effective promotion technique. By
doing three laboratory experiments Morales (2005) shows that consumers reward firms
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by increasing their willingness to pay, store choice and overall evaluations, even though
the actual quality of the products is not enhanced, when firms exerts extra effort in
displaying their products. If firms provide good quality of good and services for
consumers, customers would like to keep good customer relations with these firms.
However, if firms provide poor quality of good and services, customers will terminate
such relations with these firms (Huck and Tyran, 2004). These evidences suggest that
firms should emphasize reciprocity and apply it into marketing.
3.4 Measurement of Happiness
In Victorian days, philosophers and economists talked blithely of utility as an
indicator of a persons overall well-being. Utility was thought of as a numeric measure of
a persons happiness. Given this idea, it was natural to think of consumers making
choices so as to maximize their utility, that is, to make themselves as happy as possible
(Varian, 2006). It is the concept of cardinal utility theory. Jeremy Bentham and John
Stuart Mill were the early advocates who proposed Utilitarianism. This theory forms
the foundation of cardinal utility.
Cardinal utility was gradually replaced by ordinal utility, because economists
thought cardinal utility cannot exactly describe how to measure utility. Conversely,
ordinal utility indicates that utility cannot be measured and it is just a way to describe
consumer preference by indifference curves. Ordinal utility has been used in economic
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research since 1940s. Frey and Stutzer (2003) state that standard economic theory
employs an objectivist position based on observable choices made by individuals. His
or her utility only depends on tangible factors (goods and services), is inferred from
revealed behaviour (or preferences), and is in turn used to explain the choices made. This
modem view of utility has been influenced by the positivistic movement in philosophy.
Subjectivist experience (e.g. captured by surveys) is rejected as being unscientific,
because it is not objectively observable and is not necessary for economic theory.
However, in recent years, there has been an increasing critique for ordinal utility and
a strong advocating that utility should be measured in terms of happiness. Kahneman,
Wakker and Sarin (1997) suggested that utility theory should be back to Bentham.s
experienced utility. Experienced utility can be measured by pleasure and displeasure so
that it provides an approximately realistic explanation for situations that ordinal utility
fails to illustrate. In other words, the economic concept the richer, the happier can not
be supported. Instead, measurement of happiness is reconsidered. Happiness also is
termed as subjective well-being. The common approach to measure happiness is by
means of surveying on persons happiness or life satisfaction. This concept of happiness
can offer new insights of well-being which have been totally ignored by classical
economics (Frey and Benz, 2002). But what on earth does happiness mean? Does it mean
that people feel happier when they get more income?
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Ng (1997) studies the importance of happiness in utility theory. He points out that
happiness is more important than the more objective concepts of choice, preference and
income since happiness is the ultimate goal of human being. In fact, the purpose that
people want to have more money is to make them happier. But it is not difficult to find
that happiness cannot be measured in terms of money (Ng, 1997).
At the individual level, people do not evaluate their level of happiness by absolute
magnitude. The level of happiness is adjusting with regard to circumstances and
comparisons to other persons, past experience and expectations of the future (Frey and
Stutzer, 2003).
In the classical economics, higher income should lead to higher happiness. However,
33 years ago, Easterlin (1974) already answered the question whether rapid economic
growth improves human welfare. By analyzing time-series data, he concluded GNP and
its derivations cannot be used as a reliable and valid measurement of human welfare.
Although substantive evidence suggests that there is a positive relationship between
nation income and happiness, there is a truth that people in poor countries are happier
because they live under more natural and less stressful conditions (Frey and Stutzer,
2003). Moreover, a rapid economic growth may make people unhappier, because the cost
of the rapid economic growth may be environmental pollution, destruction of ecosystems
or decreasing in cultivated land, and others. If an economy is growing sharply, but the
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growth has mined countless trees and polluted fresh air and water, people cannot enjoy
high quality of life so as not to get the maximum happiness.
There are a variety of ways to measure well-being. Usually, scholars or marketers
are used to use objective indicators, such as GDP, unemployment figures, sales, market
share to measure well-being. The advantage of objective indicators is that they are
credible and easy to interpret. The disadvantage is that objective indicators always
evaluate well-being from the aggregate level but ignore the individual level. Unlike
objective indicators, subjective indicators are experiences of individuals. Individuals
pessimism or optimism may be treated as a measurement of well-being (Antonides, 1999).
In marketing, how marketers measure the well-being of consumers?
Usually, consumer satisfaction with reference to a particular product or brand is used
as an indicator of well-being (Poiesz and Von Grumbkow, 1988). The importance of the
consumer satisfaction issue has drawn attention of marketers and scholars. On the one
hand, consumer satisfaction is the common goal of all firms. All firms want to attract new
consumers; meanwhile, they also cannot lose consumers who have brand loyalty. Only
when consumers are satisfied with goods and services, they will generate brand loyalty.
Once a firm owns a large number of consumers with brand loyalty, it is sufficient to
prove that consumers are very satisfied with its goods and services. To grasp the degree
of consumption satisfaction, many enterprises hire professional employees to do research
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on consumer feedback. By analyzing the information, firms can improve the quality of
goods and services. Sometimes, to acquire precious and valuable feedback information,
firms would send gifts to consumers hoping that they can fill out investigation forms
which refer to the levels of satisfaction for firms goods and services. On the other hand,
scholars consider that consumer satisfaction is an important indicator which measures the
general well-being and an object which policy maker is interested in (Poiesz and Von
Grumbkow, 1988).
There are two types of consumption experience: satisfaction and dissatisfaction.
Poiesz and Von Grumbkow (1988) state: a satisfied consumer is likely to
repeat-purchase the particular good or service that produced satisfaction. Consumer
satisfaction can be measured by some objective indicators, such as time series indexes of
the quality of consumer goods, scrutiny of warranties and standard contracts, regular
content analyses of advertising and other sales promotion and so on (Olander, 1977).
However, when consumers are not satisfied with the good and services, they will
have complaints. Because of these complaints, negative communication among
consumers will take place so that it could bring huge negative impacts on firms.
Consequently, firms have to spend a lot of time and money on reducing the negative
impacts.
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Olander (1977) provides three subjective indicators to measure consumer
(dis)satisfaction: complaints, problems and reported (dis)satisfaction. Many firms set a
special agent to record and deal with consumer complaints. The records of complaints
can reflect consumer (dis)satisfaction. However, some people who are dissatisfied with
good or service do not report their complaints to these agents, because they may consider
to no longer buy this product or go to this store. It is hard to find these consumer
problems from records of consumer complaints. Olander (1977) suggest that marketers
should design more scientific interviews for consumers to find these problems. Finally,
Olander (1977) thinks that the simplest measurement which is provided by subjective
indicator is to let consumers report and rate their own (dis)satisfaction.
However, satisfaction and dissatisfaction are not unchanged. For the same good or
service, one day, consumers may feel satisfaction, but another day, they may feel
dissatisfaction, because consumers are used to comparing current situation with past
situation and then adjusting their requirement. As Cornell University economist Robert
Frank said: humans are highly adaptable animals, quickly adjusting expectations to new
realities (David, 2004). In light of this attribute, how to judge consumption satisfaction
or dissatisfaction? Poiesz and Von Grumbkow (1988) and Antonides (1991) mentioned
three theories: Comparison level theory (Thibaut and Kelley, 1959), the
assimilation-contrast theory (Anderson, 1973; Olson and Dover, 1979) and the adaptation
level theory (Helson, 1964).
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The comparison level theory (Thibaut and Kelley, 1959) has been applied to
consumer satisfaction by LaTour and Peat (1979). It implies that consumers compare
product attributes with a particular comparison level. This level relies on three
determinants: past experience, other consumer experiences, and commercial and
noncommercial product information (LaTour and Peat, 1979). Therefore, the product
performance is relative rather than absolute. That is, consumers feel satisfaction if
product performance is higher than this level and feel dissatisfaction if product
performance is lower than this level (Poiesz and Von Grumbkow, 1988).
The assimilation-contrast theory (Anderson, 1973; Olson and Dover, 1979) states
that consumers may psychologically ignore (assimilate) the slight distinction between the
perceived performance and the expected performance. Therefore, when the performance
of goods and services is just a little higher or lower than consumer expectations, it does
not lead to obvious consumer satisfaction or dissatisfaction. However, if the gap between
the perceived performance and the expectation is large, it could induce a relatively strong
effect on (dis)satisfaction results (Poiesz and Von Grumbkow, 1988).
The adaptation-level theory (Helson, 1964) as an approach which was used in
analyzing consumer (dis)satisfaction (Olander, 1977) suggests that (dis)satisfaction is
adjusted according to changes in consumer expectations. For example, a person is
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satisfied with restaurant services today, but he or she may be dissatisfied with the services
tomorrow, since he or she resets his or her expectation to a higher norm. Consumer
expectations are mainly influenced by the prior experiences with similar products and the
context of communications, e.g. content of advertisement and recommendation from
sales man (Antonides, 1991). Poiesz and Von Grumbkow (1988) note that the difference
between this theory and the other comparison theories is that the adaptation-level theory
departs from satisfaction as an additive function of both expectation and
discontinuation.
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CHAPTER 4
The Basic Themes of Behavioural Economics
Behavioural economics classifies research into main two categories: judgment and
choice (Camerer and Loewenstein, 2004). Heuristics and biases are explored in the theory
that describes how to judge the likelihood of uncertain events. Prospect theory refers to
theory that states how people make decisions under risk, while reference dependence and
loss aversion are extensions of prospect theory for decision under risky or certain
conditions.
This chapter focuses only on three basic themes of behavioural economics which
describe how people make actual judgment and choice in economic life: heuristics and
biases, prospect theory and reference-dependence and loss aversion (framing effect,
endowment effect and mental accounting).
4.1 Heuristics and Biases
Will the jacket be on sale during Christmas day? Will the central bank raise the
interest rate? Will this person achieve success in his or her career? Nobody can answer
these questions in a certain manner, since these events are uncertain. As Hal Varian (2006)
said, uncertainty is a fact of life. In classical economics, judgments of the likelihood of
uncertain events depend on the principles of probability theory. However, many scholars
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found that people do not obey the principles of probability theory in real life since many
of these principles are neither intuitive nor simple to use (Kahneman, Slovic and Tversky,
1982).
In real life, how do people evaluate the likelihood of uncertain events, what would
methods they like to use to judge probabilities, and do these methods obey the principles
of the probability theory? Kahneman and Tversky (1974) focused on the judgment of
uncertain events and published a series of pathbreaking papers. The most well-known one
of these papers is Judgment under Uncertainty: Heuristics and Biases (1974) which
shows that people rely on a limited number of heuristic principles which reduce the
complex tasks of assessing probabilities and predicting values to simpler judgmental
*7
operations (Kahneman and Tversky, 1974). Kahneman and Tversky (1974)
concentrated on three heuristics8: Representativeness, Availability and Anchoring which
violate either sampling principles or Bayess rule (Kahneman and Frederick, 2002).
Although heuristic is a shortcut for decision making that can save people a lot of time and
effort, sometimes it causes severe and systematic biases (Kahneman and Tversky, 1974).
4.1.1 Representativeness
Representativeness is a heuristic which is employed to assess the probability by the
7 Gerd Gigerenzer criticized that scholars should not over emphasize how to generate cognitive biases
rather center on how to make precise judgments by heuristics.
8 The three heuristics are the most famous heuristics. There are still many less famous heuristics, such as,
affect heuristic, contagion heuristic, simulation heuristic and others.
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degree of resemblance between objects. For example, if event A is similar to event B, it
leads to high probability that A belongs to B; if A is not similar to B, it leads to low
probability that A belongs to B (Tversky and Kahneman, 1974).
Tversky and Kahneman (1974) did an experiment and its result showed that people
will neglect the prior probability if they evaluate the probability by representativeness.
One group consists of 70 engineers and 30 lawyers. Another group consists of 30
engineers and 70 lawyers. A person named Dick is a 30 year old man, He is married
with no children. A man of high ability and high motivation, he promises to be quite
successful in his field. He is well liked by his colleagues (Tversky and Kahneman, 1974).
The subjects were asked to evaluate the probability that Dick is an engineer not a lawyer
according to the description of each group. According to the probability theory, the
probability of Dick in the first group should be equal to 0.7, while the probability of Dick
in the other group should be equal to 0.3. However, the result of experiment is 0.5.
Obviously, subjects are largely influenced by the personality description of Dick and their
results indicate that subjects do not take account of prior probabilities. Consequently,
Tversky and Kahneman concluded that common people are insensitive to the prior
probability of an outcome.
In the probability theory, the law of large numbers states that as the number of
samples increases, the average of these samples converges towards the mean of the whole
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population. Contrary to the law of large numbers, Tversky and Kahneman (1971) first
provided a psychological definition the law of small numbers that argues most people
do not notice the sample size so that it could lead to biases in probability judgment. For
example, one day, in a small hospital about 15 babies are bom, and in a large hospital
about 50 babies are bom. In the small hospital, 60 percent of 15 babies are boys. When
people know this information, they are used to thinking that the distribution of boy birth
in the small hospital is the same as the probability in the large hospital. However, they do
not realize that the sample of the large hospital is larger than the sample of the small
hospital. According to the law of large numbers, a large sample is less likely to deviate
from 50 percent.
Misconceptions of chances are beliefs in the law of small numbers (Tversky, 1974).
It means that people expect that a sequence of events generated by a random process can
represent the essential characteristics of that process even when the sequence is short.
For example, when tossing a coin for heads or tails five times, one often regards the
situation (H-T-H-T-H or T-H-T-H-T) is more likely than the situation (H-H-H-T-T). But
in fact, because a coin tossing is random, the chances of any situation are in fact equal.
That is, the probability of any outcome from tossing a coin is 1/2. Nevertheless, people
cannot understand this fact. They are likely to think that the essential characteristics of
the process will be represented, not only globally in the entire sequence, but also locally
in each of its parts (Kahneman and Tversky, 1974). Another example is the well-known
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gamblers fallacy in which people have misconceptions of chances by using
representativeness. Many people who gamble have the belief that they will have a big
chance to win money next time after losing money previously. Actually, this probability
of a win is independent of prior outcomes (win or loss).
People always predict future events by making use of representativeness. Suppose
people want to buy stocks, they are used to predicting the future profits of companies
according to the subjective descriptions of these companies. If the subjective description
of one company is good, people would like to buy its stock. Conversely, if the description
of one company is not decent, people would doubt whether its stock will bring them
attractive returns in the future (Tversky and Kahneman, 1974). It looks like that these
predictions mainly depend on partial information which people are familiar with,
regardless of other more important information, such as the company's revenues, earnings,
cash flow, shareholder's equity and so on. However, the predictions are not affected by
this reliable and accurate information. Some unfavorable or inessential information (e.g.
the description of a company) may affect peoples judgments. That is, people are
insensitive to predictability.
When making predictions in the future uncertain world, some people appear to be
very confident by using the most representative information in their memories. The
confidence depends on the quality of the match between the input information (for
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example, salary levels) and the predicted outcome (for example, a job position). The
better fit between the input information and the predicted outcome is, the more
confidently people predict. This confidence is called the illusion of validity. Moreover,
the internal consistency of a pattern of inputs plays an important role in peoples
confidence in making predictions. It is easier for people to confidently predict the average
of 5 identical numbers than to access the average of 5 different numbers. For example,
people can immediately speak out the average of (2,2,2,2,2) is 2, while seldom people
can confidently figure out the average of (1,2,3,4,5) at once.
Misconceptions of regression means that people cannot be aware of the principle of
regression towards the mean. The failure to understand this principle often leads to biases
in judgments. For example, a flight training instructor found that trainee had a good
performance after a punishment and a poor performance after a reward (Kahneman and
Tversky, 1974). However, he cannot realize the phenomenon of regression towards the
mean, so he could overestimate the effect of a punishment and underestimate the effect of
a reward (Kahneman and Tversky, 1974).
4.1.2 Availability
The availability heuristic is that people evaluate the probability of an event by the
ease with which instances or occurrences can be brought to mind (Kahneman and
Tversky, 1974). It is easier for people to recall familiar events. An event that happened
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many times may leave more impressive memory for people than the one that happened
only once. For example, it is easier for students to remember an important axiom that a
professor repeats many times in class than a theory that the professor just mentions once.
To promote sales, some companies play their advertisements again and again in mass
media or post their logos in many places to reinforce customers impression about their
products. These actions make the information of their products easily available in
customers memory.
Besides familiarity, salience and recent events are factors that affect the
retrievability of instances. These factors are easy to be recalled. However, they inevitably
cause biases (Kahneman and Tversky, 1974).
Familiarity, salience and recent events are in the searchable set in peoples memory.
When people search for relevant information from their memories, they rely on the
effectiveness of the search set. Suppose you are required to list all words starting with r,
you may think a lot. Nonetheless, if you are required to list all words that r is the third
letter, you have to take a long time to think. Why? Because it is much easier to remember
words with reference to their first letter, few people memorize words from the third letter.
In addition, to make use of information available in memory, people would like to
access the frequency of a class whose instances are not stored in memory but can be
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generated according to a given rule (Kahneman and Tversky, 1974). For instance, a
person is not familiar with C city. One day, he or she reads a paper and learns that a
visitors precious jewelry was stolen in C city. From then on, he or she may think the
public security of C city is of concern. Actually, this city has been peaceful and quiet all
the time. This is a rare incident in the city. Because of this incident, the individual may
think that similar cases have occurred many times in this city. In a similar manner, many
people are afraid to take airplane because there are many reports about plane accidents.
So people think that the airplane is not a safe way to travel (Kahneman and Tversky,
1974). But according to the real and scientific data, flying is the safest way to travel in
the world.
Furthermore, people always imagine that there is a correlation among some separate
events that have no relationship. Chapman and Chapman (1967) noted that although
projective testing is not helpful in the diagnosis of mental disorders, some psychologists
continue to use such tests because of a perceived, illusory, correlation between test results
and certain attributes. Availability can take a natural account for the illusory-correlation
effect. The strength of the association between two events is the base for the judgment of
how frequently two events co-occur. If the association is strong, subjects are likely to
conclude that the events have co-occurred frequently and vice versa. Therefore, subjects
might overestimate the frequency of co-occurrence of natural association.
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4.1.3 Anchoring and Adjustment
In many situations, people make estimates by starting from an initial value that is
adjusted to yield the final answer....That is, different starting points yield different
estimates, which are biased toward the initial value (Tversky and Kahneman, 1974).
This phenomenon is called anchoring.
In real life, people often are affected by anchoring effects. For example, one day, a
lady found a very nice jacket which was on sale from a flyer. The price of this jacket was
reduced from $38 to $20. But she was too busy to go shopping. She decided to buy this
jacket after two weeks. Unfortunately, when she went to the store to buy this jacket, she
found that the price went up from $20 to $38. The promotion activities were finished a
week ago. In the end, she did not buy it, because she felt it too expensive. But if the price
of this jacket was $38 all the time, the probability that this lady bought the jacket is very
high. However, at first, she anchored on $20. As a consumer, the cheaper the jacket is, the
happier she is. Once the price was higher than she expected, she would feel very
disappointed, because she felt it became a large loss for her.
Although it is simple for people to make estimates by starting from an initial value,
the adjustment of their estimation is often not sufficient. Kahneman and Tversky (1974)
did a very interesting experiment. They asked two groups of high school students to
estimate a numerical value of the following two numerical expressions within 5 seconds.
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One group estimated the product
8 X7 X6 X5 X4 X3 X2 X1
While another group estimated the product
1 X2 X3 X4 X5 X6 X7 X8
Note: From Kahneman and Tversky (1974, p. 1128)
Obviously, 5 seconds is not sufficient time to estimate the numerical value. Generally,
students performed some simple computations and got an approximate outcome. The first
expression is a descending sequence; students were affected by the large figure 8 and 7.
As a result, their estimation is larger than the estimation of an ascending sequence. Since
people are not completely rational, they cannot adjust the product sufficiently.
Moreover, Kahneman and Tversky (1974) studied the Bar-Hillels (1973)
experiment in which subjects were asked to estimate the probability of simple events,
conjunctive events and disjunctive events and then they concluded that people were used
to overestimating the probability of conjunctive events and to underestimate the
probability of disjunctive events. Biases are produced in the evaluation of conjunctive
and disjunctive events.
Anchoring in the assessment of subjective probability distributions indicates that
subjects estimate narrower confidence intervals of probability distributions than actual
probability distributions. This bias is common to naive and expert respondents.
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Many phenomena in judgment and decision making can be explained by the
operation of these heuristics. Comparatively speaking, anchoring and adjustment models
are more used in analysis of marketing practices. For example, when we want to buy
products, we always consider three questions: Should I buy the category on this
shopping trip? Which brand should I buy? and How much should I buy?
(Chintagunta, 1993 and Wansink, Kent and Hoch, 1997). In marketing research, scholars
should be familiar with the three questions. However, previous researchers merely
focused on purchase incidence and brand choice (Bucklin and Lattin 1991; Krishna 1994
and Hardie and Barwise, 1996).
Wansink, Kent and Hoch (1997) proposed anchoring and adjustment model to
illustrate the above three questions. They described how consumers make purchase and
quantity decisions and suggested that marketers can influence quantity decisions through
anchors provided at the point of purchase9 (POP). They made three experiments about
multiple-unit pricing (e.g., on sale 4 cans for $2), quantity limits (e.g. As Lemon
Soda sale 25 cents/can, Limit of 5 cans per person), and suggestive selling anchors
(e.g. Buy a package of ice-cream for your freezer), respectively, to explain the effect of
various POP anchors on quantity decisions. In study 1, authors examined whether a
9 Point of purchase (POP) refers to outside signs, window displays, counter prices, and so on (Pride and
Ferrell, 1977)
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multiple-unit price promotion could stimulate consumers to purchase more than their
normal purchase. By using econometric methods and analyzing econometric results, they
suggested that marketers should use multiple-unit prices instead of single-unit prices (e.g.
On sale-4 cans for $2 versus On sale-50 cent per can). When consumers make their
quantity decisions, the number of product units presented at the POP served as an anchor.
That is, although both expressions of multiple-unit prices and single-unit prices imply the
same discount, consumers quantity decision will be affected by presenting the number of
product units which is the starting point of the anchoring effect. Study 2 examined the
impact of high purchase quantity limits on sales. Prior researches mainly studied the
impact of low purchase quantity (four units or less). Lessne and Notarantonio (1988)
suggested that low purchase limits can increase purchase incidence because consumers
will buy more price-promoted products to remedy their loss of freedom that the purchase
quantity is limited. Inman, Peter and Raghubie (1997) found that single-unit purchase
limits can have stronger effects on purchase incidence. Unlike prior researches, Wansink,
Kent and Hoch (1997) studied anchor values in the form of high purchase quantity limits
and show that high purchase quantity limits can increase the number of units a buyer
purchases. Unlike low purchase quantity limits, they suggested high purchase quantity
limits must be set high enough, otherwise, it may reduce the quantity of other purchases.
In short, low or single-units limits may increase purchase incidence, while high quantity
limits may increase the number of units in each purchase (Wansink et al., 1997). Study 3
found that purchase quantity will go up by setting product quantity anchors which are
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presented in a suggestive selling slogan, even if products are not on sale. In this study, all
participants were given suggestive selling claims that did not contain any product
quantity anchor, unlike Snickers bars-buy 18 for your freezer. The results implied that
purchase intentions may be influenced by such anchors with no price discount (Tversky
and Kahneman, 1974).
Typically, these heuristics often influence consumer purchasing decisions. More
generally, few consumers know the real product quality. Most consumers judge product
quality by perception and predictions. Oxoby and Finnigan (2005) studied attention
blocking as an outcome of heuristics to imply that consumer judgment of quality may be
heavily dependent on first impressions which develop into brand and price heuristics.
There are works employing heuristics research on consumer behaviour and firm
behaviour, such as Jordan and Kaas (2002) who used advertising in the mutual fund
business to state the role of representativeness and anchoring heuristic in private
investors evaluation of risk and return. Simonson and Drolet (2004) examined arbitrary
anchoring effects on the susceptibility of consumers willingness-to-pay (WTP) and
willingness-to-accept (WTA). Their research found that in different conditions, both WTP
and WTA for goods are largely influenced by irrelevant anchors and are most susceptible
to anchoring effects under uncertainty about the desire to trade (Simonson and Drolet,
2004). They did not suggest that marketers use arbitrary anchors to enhance consumers
WTP. Instead, marketers should adopt a more positive approach to assess the value of a
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product to target consumers and set the price.
4.2 Prospect Theory
Some decisions are made under certain and riskless conditions, while others are
made under uncertainty and risky conditions. Under uncertainty and risky conditions,
expected utility theory (EU) is the standard theory of individual decision making.
Expected utility theory was first proposed by Daniel Bernoulli (1738) who sought to
solve the St. Petersburg paradox10 (Starmer, 2000). Bernoulli assumed that decision
makers are risk averse and used a cardinal utility function to explain the St. Petersburg
paradox (Starmer, 2000). This theory was developed by John von Neumann and Oskar
Morgenstem (1947). They extended the expected utility hypothesis according to those
three axioms: ordering, continuity and independence (Starmer, 2000).
However, since 1950s numerous studies have revealed that many decision making
behaviours are inconsistent with EU (Harless and Camerer, 1994). The most well-known
theory of these studies was the publication of prospect theory by Daniel Kahneman and
Amos Tversky in 1974.
Prospect theory shows how to modify the expected utility theory as a descriptive
10 St. Petersburg paradox (1738) proposed by Daniel Bernoulli is an important issue which is used by
rational agents to make decisions based on expected utility, rather than expected value.
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model of choice under risk (Kahneman and Tversky, 1979). Kahneman and Tversky
(1979) incorporated psychological ideas into prospect theory, which is psychologically
more realistic than expected utility theory.
Kahneman and Tversky (1979) discussed certainty effect and reflection effect which
play central roles in prospect theory. Certainty effect shows that people overweight
outcomes that are considered certain, relative to outcomes which are merely probable.
For example, there are two gambles A and B. The payoffs for each gamble and its
probability are listed as follows:
A: $2,500 with probability 0.33, B: $2,400 with certainty
$2,400 with probability 0.66,
$0 with probability 0.01;
Note: From Kahneman and Tversky (1979, p.266)
72 subjects were asked to choose between gambles A and B. 18 percent of subjects
chose A, while 82 percent of subject chose B. Then, these subjects were given another
two gambles C and D and asked to choose between these two gambles.
C: $2,500 with probability 0.33, D: $2,400 with probability 0.34,
$0 with probability 0.67; $0 with probability 0.66
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Note: From Kahneman and Tversky (1979, p.266)
In this case, 83 percent of subjects chose C while 17 percent of subjects chose D.
Obviously, subjects actual choices between gambles violate the axioms of expected
utility theory. Note that 100 percent chance of winning $2,400 from gamble B is reduced
to 0.66 chance of winning $2,400 from gamble D. This change generates a greater effect
than the reduction of probability of uncertain gambles A and C. Moreover, the certainty
effect does work in a number of non-monetary outcomes.
The certainty effect describes that people make choices between positive prospects
(i.e. prospects which do not bring losses to people), while reflection effect describes
preferences between negative prospects (i.e. prospects which do not bring gains to
people). Kahneman and Tversky (1979) compared the preferences between positive and
negative prospects and summarized their outcomes in Table 4.1.
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Table 4.1
Preferences between Positive and Negative Gambles
Positive Gambles Negative Gambles
Gamble Answers Gamble Answers
l.($4,000, 0.80) 20% 1' (-$4,000, 0.80) 92%
($3000, 1.00) 80% (-$3000, 1.00) 8%
2. ($4,000, 0.20) 65% 2' (-$4,000, 0.20) 42%
($3,000, 0.25) 35% (-$3,000, 0.25) 58%
3. ($3,000, 0.90) 86% 3' (-$3,000, 0.90) 8%
($6,000, 0.45) 14% (-$6,000, 0.45) 92%
4. ($3,000, 0.002) 27% 4' (-$3,000, 0.002) 70%
($6,000, 0.001) 73% (-$6,000, 0.001) 30%
Note: The left-hand column of Table 4.1 displays four positive gambles with their
respective probabilities of winning and the right-left hand column displays four negative
gambles with their respective probabilities of losing. The percentage who choose each
gamble is given below Answers (Kahneman and Tversky, 1979, p.268).
Table 4.1 showed that the preference between negative prospects is the mirror
image of the preference between positive prospects (Kahneman and Tversky, 1979).
Comparing certainty effect with reflection effect, people are risk averse in facing gains
but they could become risk seeking in facing losses. For example, in Gamble 1, 92
percent of subjects would rather choose the gamble which has 0.8 probabilities to lose
$4,000 than choose the sure loss of $3,000.
Certainty effect and reflection effect show how people make choices among risky
prospects and indicate that actual choices violate the expected utility. These anomalies
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lead Kahneman and Tversky to explore prospect theory which modifies expected utility
theory.
In expected utility theory, suppose a prospect is(X]5p i ' , x2P 2 - ' XnP ) *ts
utility can be evaluated as the sum of the product, in which each possible state is
multiplied by corresponding objective probability. The general expected utility function
is:
u (x, -PlX2-P1----X-P,') = P , u( x) + P 1U<.X2>+ - + P . u (xJ-
Unlike expected utility theory, prospect theory evaluates a prospect with a value function
and a probability weighting function. The formula proposed by Kahneman and Tversky
in 1979 is:
U(Xi> P{>Xv P 2 -XnP ) = w ( p ) < x ) + w ( p 2) v( x2) + - + w ( p ) v ( Xn)
where X v X i potential outcomes and p , p 2, . . . , p are their respective
probabilities.
v ( x ) (i1, 2... n) is the value function which assigns a value to an outcome. It has
three essential characteristics. First, the value function weights gains and losses relative
to some reference point. It evaluates the utility of an outcome relative to a reference point,
but expected utility theory is the evaluation of outcomes as final states. Second,
according to certainty and reflection effects, people are risk averse in gains but risk
seeking in losses. More importantly, Kahneman and Tversky (1979) noted that the
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psychological response is a concave function of the magnitude of physical change. For
example, people may think that they get more money from $10 to $20 than from $1,000
to $1,010. Similarly, they may feel that they lose more money from $20 to $10 than from
$1,010 to $1,000. It implies that people have diminishing sensitivity to gains and losses.
These characteristics can be reflected in the shape of value function which is concave for
gains and convex for losses (see Figure 4.1). Third, people have asymmetric responses to
the equivalent changes in gains and losses. That is, given the same changes, losses
generate greater impacts than gains. For example, the displeasure of a loss of $100 is
larger than the pleasure of a gain of $100. This characteristic is called loss aversion. Thus,
the value function is S-shaped, passes through the reference point and is steeper for losses
than for gains.
Figure 4.1
The Value Function
LOSSES
Note: From Kahneman and Tversky (1979, p.279)
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w ( p ) ( i=l, 2...n) is called decision weights. Decision weights are derived from
subjective probabilities but they are neither probabilities nor obey the probability axioms.
Decision weights measure the impact of events on the desirability of prospects, and not
merely the perceived likelihood of these events (Tversky and Kahneman, 1979). The
weighting function w is an increasing function ofp . It also reflects the diminishing
sensitivity of people to differences in probability. Generally, decision weights are smaller
than their corresponding probabilities near medium and large probabilities. But the
weights for probabilities near zero are larger than their corresponding probabilities. That
is, people tend to underweight high probabilities but overweight low probabilities. In
short, the weighting function is an increasing function with stated probabilities p , with
w(0) = 0 and w(l) = 1 (see Figure 2).
Figure 4.2
The Weighting Function
25
T
E - <
o

m
8
w
a
1.0
0.5
0
STATED PROBABILITY: p
Note: From Kahneman and Tversky (1979, p. 283)
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4.3 Reference Dependence and Loss Aversion
Theoretically, according to prospect theory (Kahneman and Tversky), loss aversion
implies that the impact of a difference on a dimension is generally greater when that
difference is evaluated as a loss than when the same difference is evaluated as a gain.
Reference-dependence preference alters the evaluation between risk aversion and risk
seeking when the reference point changes. Diminishing sensitivity implies that the impact
of a difference between two options that are remote from the reference point is smaller
than the impact of a distinction between both options which are close from the reference
point.
Loss aversion, reference dependence and diminishing sensitivity have been
widely used in analysis of human choice. Framing effects, endowment effect and mental
accounting are extensions of prospect theory which adopt these three essential concepts.
4.3.1 Framing Effect
Facing the same objective alternatives, decision makers will have different
evaluations in relation to different reference points. The reference point is dominated by
descriptions of the choice problem and by norms, habits, and expectancies of the decision
maker. This effect is called framing effect. Human choice is influenced by the change in
frame (Ho et al., 2006). A classic example of the framing effect is the Asian disease
problem described by Tversky and Kahneman (1981) as follows:
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Imagine that the United States is preparing for the outbreak of an unusual Asian
disease, which is expected to kill 600 people. Two alternative programs to combat
the disease have been proposed. Assume that the exact scientific estimates of the
consequences of the programs are as follows:
Gain Frame:
If Program A is adopted, 200 people will be saved.
If Program B is adopted, there is 1/3 probability that 600 people will be saved, and
2/3 probability that no people will be saved.
Loss Frame:
If Program C is adopted 400 people will die.
If Program D is adopted there is 1/3 probability that nobody will die, and 2/3
probability that 600 people will die.
Note: From Kahneman and Tversky (1981, pp.254-255)
In the gain frame, 152 subjects were asked to choose between Programs A and B. 72
percent of subjects selected Program A and 22 percent of subjects selected Program B. In
the loss frame, 155 subjects were asked to choose between Programs C and D. 22 percent
of subjects chose Program C and 78 percent of subjects chose Program D. Actually,
Programs A and C have the same final outcomes (i.e. 200 people will be saved and 400
will die), and Programs B and D have the same expected final outcomes (i.e. 1/3
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probability that 600 people will be saved and 2/3 probability that 600 people will die).
But they evoke different judgment and choice. In other words, decision makers are
sensitive to the change in frame. In the gain frame, most subjects chose Program A which
seems less risky than Program B. It indicates that people are risk averse as to gains. In the
loss frame, most subjects chose more risky Program D. This outcome indicates that
people are risk seeking as to losses. Accordingly, people have a general tendency to
choose risk aversion options in facing of positive terms (gains) and choose risk seeking
options when they confront with negative terms (loss). In real life, choices between life
and death are relatively rare. However, people are often affected by framing effects. For
example, consumers often have different attitudes to the same product sold at different
stores. If a skirt was sold at a common store, people may feel that it is not special; but if
the same one was sold at an exclusive store, people may feel that it is especially beautiful.
4.3.2 Endowment Effect
Endowment effects describe the phenomena that people make the value of a good
increase once they own it. It was first proposed by Thaler (1980). The endowment effect
has been examined many times with a variety of goods: mugs, chocolate, pension plans
and so on (Kahneman, Knetsch and Thaler, 1990; Kahneman and Tversky, 1991 and
Samuelson and Zeckhauser, 1988).
Kahneman and Tversky (1991) stated that the endowment effect is evidence which
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strongly supports loss aversion and status quo bias. Note that Kahneman and Tversky
(1991) argued that the endowment effect may be called an instant endowment effect11.
Instant endowment effect means that people assign a higher value to an object which they
want to own than the value to an object they do not want to own.
Kahneman, Knetsch and Thaler (1990) did a classical experiment to test the
endowment effect. That is, one group of subjects (the sellers) were given a coffee mug
and were asked to choose a price for which they were willing to sell their goods; the price
range was from $0.50 to $9.50. Another group of subjects (the choosers) were not
given a coffee mug, but they were told that they can choose between a mug and a sum of
money later. Sellers have to decide whether they should keep the mug or give up the mug
in exchange for money; while choosers have to make a choice between a mug and a sum
of money. Although it seems that sellers and choosers have to make the same decision,
the value of the mug is different for them (Kahneman and Tversky, 1991). When sellers
decided to give up the mug, the mug was regarded as a loss for the sellers. But the mug
was evaluated as a gain for the choosers since they were not given the mug initially.
According to loss aversion, the utility of the good which people give up is greater than
the utility of the good which people own. Actually, the results of Kahneman et al.s
experiment support this concept. The median price of the mug which sellers chose is
11 In this thesis, endowment effect refers to instant endowment effect. The long-term endowment effect is
not considered.
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$7.12 and the median price suggested by choosers is $3.12. The difference in the two
prices reflects the endowment effect and supports loss aversion.
Endowment effect also illustrates status quo bias (Samuelson and Zeckhauser, 1988)
which reflects that people prefer to retain the current situation over changes. Keeping the
status quo is an option in many decision problems. As illustrated by the analysis of the
sellers problem in the example of the mugs, loss aversion induces a bias, so sellers
would rather keep their mugs than choose other options (Kahneman and Tversky, 1991).
Knetsch (1989) did an experiment to demonstrate the status quo bias. In this
experiment, students are divided into two groups. One group of students were given a
decorated mug each; another group of students were given a large bar of Swiss chocolate
each. The two groups of students were allowed to trade the two objects by raising a card
with the word Trade. The result showed that approximately 90 percent of the students
were not willing to exchange their own object for the other object.
Endowment effect is often reflected in promotion policies of some companies. For
example, some film processing companies operate photography business. They
implement a policy that customers can ask for refunds for any pictures they do not want
to have, no matter how badly exposed they are. At first glance, the policy is not
reasonable and companies have to entail certain risks, because customers can ask for
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refunds for any pictures they do not want to have. If some customers do not like all of
their pictures and ask for refunds, it will cause a large financial loss. Of course, this
policy guarantees the customer benefits so that it could accomplish the goal of sale
promotion. However, it accompanies some risks for companies. Why did these companies
implement this policy?
According to endowment effect, as consumers get their pictures, these pictures are
seen as gains for consumers. From consumer psychology, the value of pictures is higher
than the value of refunds. It is no doubt that it is a loss for consumers, if they refund
pictures for money. Companies entail slight risks, but guarantee consumers benefits. As a
result, the objective to attract more consumers is accomplished. Another policy in retail is
the case of a two week trial period with a money back guarantee. Customers can buy the
new product first and use it for two weeks. If they are not satisfied with the product, they
can return it and get refunds. However, two weeks later, endowment effect has been at
work. Most customers do not choose to return it and get refunds (Antonides, 1991).
4.3.3 Mental Accounting
Mental accounting is first discussed by Thaler (1980). It describes that people code,
categorize, evaluate economic outcomes, and eventually, classify their assets into
corresponding non-fungible mental accounts. According to loss aversion, people are
sensitive to gains and losses from reference points and have different attitudes for gains
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and losses. For example, a person may deposit $100 of salary into checking account but
may spend $100 which he or she got from gambling games. For the same amount of
money, why did this person have different attitudes? This is because people grouped the
money into different mental accounts. Mental accounting states that individuals,
households and firms have explicitly and implicitly a number of non-fungible mental
accounting systems which people group their assets into and separate from each other.
People set up mental accounts for outcomes that are psychologically separate, as much
as financial accountants lump expenses and revenues into separated accounts to guide
managerial attention (Camerer, 2000). Mental accounting includes four principles: 1)
segregate gains, 2) integrate losses, 3) cancel losses against large gains and 4) segregate
silver linings (Thaler, 1985). Thaler (1985) designed four experiments to examine these
principles. 87 students participated in these experiments as follows:
1) Mr. A was given tickets to lotteries involving the World Series. He won $50 in
one lottery and $ 25 in the other.
Mr. B was given a ticket to a single, larger World Series. He won $ 75.
Who was happier?
Note: From Thaler (1985, p.203)
56 students selected A, 16 students selected B and others think there is indifference
between the two options. The two different outcomes are assumed to be x and y,
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respectively. They are both positive. Since the value function for gains is concave, v(x)
+v(y)>v(x+y). In this case, segregation is preferred. According to this principle, people
are happier when they receive segregated presents than all presents wrapped together
(Antonides, 1991).
2) Mr. A received a letter from the IRS saying that he made a minor arithmetical
mistake on his tax return and owed $100. He received a similar letter the same day
from his state income tax authority saying he owed $50. There were no other
repercussions from either mistake.
Mr. B received a letter from the IRS saying that he made a minor arithmetical
mistake on his tax return and owed $150. There were no other repercussions from
his mistake.
Who was more upset?
Note: From Thaler (1985, p.203)
There are 66 students thought Mr. A was more upset than Mr. B. Here, x and y are
both negative outcomes. Since the value function for losses is convex, v (-x) +v (-y) < v
(-x-y). Apparently, people would like to choose the integration of losses rather than the
segregation of losses. In marketing, sellers should be aware of the integration effect on
sales promotions. When the sale price of a car or a house contains the prices of additional
options, it is easier to sell these items together than sell them separately. Traveling
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agencies and hotels make use of the integration effect by charging the total costs of their
services, rather than charging each nights stay and each meal separately (Antonides,
1991).
3) Mr. A bought his first New York State lottery ticket and won $100. Also, in a
freak accident, he damaged the rug in his apartment and had to pay the landlord
$80.
Mr. B bought his first New York State lottery ticket and won $20.
Note: From Thaler (1985, p.204)
Finally, both persons obtained $20. However, most students (61) thought Mr. B was
happier than Mr. A. In this case, x is positive, while y is negative. Note that the absolute
value of y is less than x. So the outcome is positive. According to the value function, v(x)
+v (-y) < v(x-y), people would rather choose integration than segregation.
4) Mr. As car was damaged in a parking lot. He had to spend $200 to repair the
damage. The same day the car was damaged, he won $25 in the office football pool.
Mr. Bs car was damaged in a parking lot. He had to spend $175 to repair the
damage.
Who was more upset?
Note: From Thaler (1985, p.204)
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Although Mr. A was not so lucky that day, he finally won $25 that would ease his
pain to some degree. This situation is also called silver lining principle. It indicates that
the pain caused by bad news is attenuated by a little pleasure from good news. Silver
lining principle is always used in rebates as a form of price promotion. Generally, rebates
just reduce a very small price from the total purchase price. However, consumers feel
happier because they save a small portion of the purchase price. Particularly, when
consumers make a decision to buy expensive or luxury goods, such as car, house, jewelry,
a rebate can generate the silver lining effect so that it could make consumers happier.
Finally, consumers may feel gratitude for sellers, although the magnitude of the rebate is
very small.
Mental accounting is an important theory in analyzing consumer behaviour and firm
behaviour in everyday life. If marketers can understand these regularities and apply them
to marketing campaign, it may create positive effects on sales promotion.
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CHAPTER 5
Prospect Theory and Extensions:
Evidence from Marketing
Prospect theory is one of core and well-known theories in behavioural economics. It
has been widely used in several fields. Recently, prospect theory has been mainly used in
macroeconomics, labor economics, and finance. Camerer (2000) describes ten patterns of
anomalies in finance, macroeconomics, labor and marketing. The studies of these
anomalies show that their outcomes are inconsistent with the predictions of expected
utility theory. Some scholars found that these ten anomalies can be explained by prospect
theory, according to its three key characteristics loss aversion, reflection effects and
weight function. Camerer summarized the ten patterns of phenomena into a table format
(see Table 5.1) to show: how much successfully prospect theory has already been
applied to field data and hope to inspire economists and psychologists to spend more time
in the wild (Camerer 2000).
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Table 5.1
The Field Phenomena Consistent with Prospect Theory
Domain Phenomenon Description
Type of
Data
Isolated
Decision
Ingredients References
Stock market Equity premium
Stock
returns are
too high
relative to
bond returns
NYSE
stock,
bond
returns
Single
yearly
return
(not
long-run)
Loss-aversion
Benartzi
and Thaler
(1995)
Stock market Disposition effect
Hold losing
stocks too
long, sell
winners too
early
Individual
investor
trades
Single
stock
(not
portfolio)
Reflection
effect
Odean (in
press),
Genesove
and Mayer
(in press)
Labor
economics
Downward-sloping
labor supply
NYC
cabdrivers
quit around
daily
income
target
Cabdriver
hours,
earnings
Single
day (not
week or
month)
Loss-aversion
Camerer et
al. (1997)
Consumer goods
Asymmetric price
elasticities
Purchases
more
sensitive to
price
increases
than to cuts
Product
purchases
(scanner
data)
Single
product
(not
shopping
cart)
Loss-aversion
Hardie,
Johnson,
Fader
(1993)
Macroeconomics
Insensitivity to bad
income news
Consumers
do not cut
consumption
after bad
income
news
Teachers
earnings,
savings
Single
year
Loss-aversion,
reflection
effect
Shea
(1995);
Bowman,
Minehar,
and Rabin
(1999)
Consumer
choice
Status quo bias,
Default bias
Consumers
do not
switch
health plans,
choose
default
insurance
Health
plan,
insurance
choices
Single
choice
Loss-aversion
Samuelson
and
Zeckhauser
(1988),
Johnson et
al. (1993)
Horse race
betting
Favorite-longshot
bias
Favorites
are
underbet,
longshots
overbet
Track
odds
Single
race (not
day)
Overweight
low p (loss)
Jullien and
Salanie
(1997)
Horse race
betting
End-of-the-day
effect
Shift to
longshots at
the end of
the day
Track
odds
Single
day
Reflection
effect
McGlothlin
(1956)
Insurance
Buying phone wire
insurance
Consumers
buy
overpriced
insurance
Phone
wire
insurance
purchases
Single
wire risk
(not
portfolio)
Overweight
low p (loss)
Cicchetti
and Dubin
(1994)
Lottery betting Demand for Lotto
More tickets
sold as top
prize rises
State
lottery
sales
Single
lottery
Overweight
low p (win)
Cook and
Clotfelter
(1993)
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Note: From Camerer (2000, p. 149)
Camerers review is comparatively comprehensive. This chapter focuses only on
applications of prospect theory and its extensions framing effect, endowment effect
and mental accounting in the field of marketing.
5.1 Asymmetric Price Elasticities of Consumer Goods
The price elasticity of a good is the ratio of a percentage change in quantity
demanded to a percentage change in its price. It measures how quantity demanded
changes with respect to a change in price. In classical economics, price elasticity of
demand is stated as an absolute value. However, according to loss aversion, given the
same variation in absolute value, consumers have different response to losses and gains.
Consumer reaction to losses due to increases in prices should be stronger than the
reaction to gains because of decreasing prices. Therefore, the magnitude by which
consumers reduce purchases when price increases is greater than the magnitude by which
they increase purchases when price decreases. Many studies estimated the price elasticity
by observing changes in consumer purchases after prices change. These studies found
that price elasticity effects will be larger for consumers after price increases than after
price decreases (Camerer, 2000). As a result, scholars conclude that the price elasticities
of consumer goods are asymmetric.
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Consumers weight loss and gains relative to a reference point. But the reference
point is not fixed and it is influenced by many factors. For example, the reference point of
consumer choice is often changed because consumers have different moods. During
holidays, because of good mood, consumers would like to accept a slight increase in
prices and do not think that this is a loss for them. For instance, on Valentines Day, rose
prices go up. However, a lot of people still would like to pay high prices for it. They are
very happy if they bought it, but they may be very disappointed if roses were out-of-stock.
Because of this, consumer response to changes in prices is also asymmetric. Marketers
can use reference dependence and loss aversion to make corresponding marketing
campaigns.
A number of scholars used prospect theory in analysis of marketing to investigate
whether the consumer response to gains and loss from reference prices is symmetric.
Winer (1986) developed a consumer model which shows how reference prices in
price-related promotions affect consumer brand choices. His study found that the
prediction of brand choice model which uses estimated reference prices and observed
prices is better than the classical demand model which only contains observed prices.
Putler (1992) developed a theoretical economic model of consumer choice that
incorporates reference price effects and uses retail eggs data to examine consumer
response. He noted that there is an asymmetry in price elasticities of consumer purchases
of eggs. Furthermore, Lattin and Bucklin (1989) and Kalwani et al. (1992) designed
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experiments to test the reference effects of promotion besides reference effects of price.
They all concluded that promotional activities have significant reference effects on
consumer expectations.
However, these previous papers paid particular attention to one of product attributes
price, disregarding other attributes. Hardie, Johnson, and Fader (1993) found this
problem and developed a theoretical brand choice model involving multiple attributes
based on cumulative prospect theory12, which is developed by Tversky and Kahneman
(1992). Hardie, Johnson and Fader (1993) first discussed two attributes of products: price
and quality in their model and then extended the outcomes to all attributes. They applied
the ideas to orange juice purchases. For price, their finding was consistent with outcomes
of prior studies. Furthermore, they studied how consumers respond to different quality
brands when price changes are equivalent. In the case of price and quality, Citrus Hill
(CH) is the reference brand for orange juice purchase. Minute Maid (MM) stands for a
higher price, higher quality brand, while Tropicana Regular (TR) represents a lower
quality, lower price brand of orange juice. When the prices of MM and TR brands of
orange juice are reduced by 12 cents, which brand consumer will choose? If quality is not
considered, consumers would choose TR brand since its price is the lowest. When price
and quality are considered, the result is that loss aversion coefficient for quality is much
12 Cumulative prospect theory is an advanced version of prospect theory. The main difference from the
original version of prospect theory is that cumulative prospect theory employs cumulative weights rather
than separable ones.
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greater than that for price. Although the price of TR is the lowest, its quality is lower than
the quality of CH and MM. Consequently, most consumers would rather chose MM or
CH brands than TR brand. Their findings imply that consumers tend to be considerably
more loss averse for quality than for price and that consumer brand choice is influenced
by multiattribute reference points, besides price.
This result reminds marketers that reducing price is not the most effective promotion.
If higher price, higher quality brands of goods are promoted by cutting prices, they may
increase their market share from lower prices, lower quality brands. But, if the lower
price, lower quality brands of goods are promoted by using price-related promotions, they
may not obtain the same effects (Blaaberg and Wisniewski, 1989).
5.2 Exclusion versus Inclusion Option-Framing for Customer Choice
Exclusion option-framing presents consumers with a fully loaded product and asks
them to delete options they do not want (Park et al., 2000). For example, when people
buy a computer, the salesman will provide 3 different sets of software service packages.
Usually, the salesman will first recommend a global list of software services to
consumers, such as antivirus software, DVD software, Microsoft office software, and so
on. He will then tell consumers if they think this plan is expensive or some software is
not useful for you, they can select some options which they do not want. Inclusion
option-framing presents consumers with a base model and asks them to add the options
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they do want (Park, et al., 2000). For example, when consumers buy a mobile phone
plan, the company will provide a basic price plan which covers basic services. Usually,
the salesman will ask consumers whether they need to use message service. If consumers
need to use message service, they would pay additional fee. In other words, exclusion
occurs when people are given a full box and then have to select things to take out of the
box while inclusion occurs when people are given an empty box and then are asked to
choose things to put in (Park et al. 2000). The theoretical background of these phenomena
refers to reference-dependence, loss aversion, endowment effect and framing effects. The
common outcome is that the number of options that subjects keep according to an
exclusion strategy is more than for those according to an inclusion strategy (Levin et al.,
2000, Levin et al., 2001).
An experiment designed by Levin et al. (2001) can prove the above conclusion.
Subjects were given a list of job applicants, and they were asked to take out some
applicants who will not be hired from the list. Then, subjects were given the same
number of applicants and were asked to select some applicants who will be hired from
the list and wrote their names on a note. The result showed that the number of applicants
who will be hired under the exclusion condition is more than the number of applicants
who will be hired under the inclusion condition (Levin et al., 2001).
Park et al. (2000) noted framing effects in analyzing consumer choices. They named
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the two options as subtractive option-framing and additive option-framing. One group of
subjects were given a fully-loaded product and was asked to delete options they do not
want. Another group of subjects were given a base model and was asked to add options
that they do want. Automobiles were included in each of three experiments, and
computers and treadmills were also included in one of the experiments. The outcome
indicated that the subjects tend to choose more options under subtractive option-framing
than those under additive option-framing. Park et al. (2000) used expensive durable
products to examine the framing effects on consumer choices. Levin et al. (2002) noted
that expensive durable products have long-term product performance and endurance
attributes and questioned whether Park et al.s results could be suitable for cheap
nondurable products.
Levin et al. (2002) explored this question by using an empirical study of nondurable
consumptions (pizzas and salads). In their experiments, half of the subjects were offered
a basic cheese pizza with no extra ingredients at a cost of $ 5.00 and were asked to
select additional ingredients such as mushrooms, peppers, pineapple, pepperoni and
sausage at a cost of 50 cents per ingredient. The other half subjects were provided a
deluxe pizza with all 12 ingredients at a cost of $ 11.00 and were told that the price would
be reduced by 50 cents for each ingredient they deleted. The results supported the
hypothesis that consumers kept more ingredients for a larger price when they were
provided with a deluxe pizza than when they were offered a basic cheese pizza with the
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opportunity to add ones. It also indicated that product selection is affected by the status
quo bias. Like the results obtained by Park et al. (2000) who used expensive durable
products, Levin et al. (2002) used cheap nondurable products to get the similar
conclusion with highlighting a hedonic rather than a utilitarian consumption experience.
More importantly, their research was not limited to one country America but extended
to Italy. The results of experiments in Italy were similar to the results in America.
5.3 The Endowment Effect of Retail Purchase and Direct Marketing
With the rapid development of high technology, marketing channels become more
diversified. Consumers do not need to go shopping in store. They can select any product
by looking through magazine, advertising or website and then purchasing it by mail
delivery. Comparatively speaking, direct marketing seems more convenient for
consumers, because consumers can receive products at home. At first, this way of
shopping is fresh and unfamiliar to consumers. Because of curiosity, many consumers,
especially, younger consumers prefer to buy products in this way. To some extent, direct
marketing has become rapidly accepted by more people.
The retail and direct marketing channels lead to different impacts of possession on
the endowment effect. Tom, Lopez and Demir (2006) compared the endowment effect
which is generated by the retail channel with the endowment effect which is generated by
the direct marketing channel. When consumers buy a product from a retail store, they can
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select a product which they are most satisfied with, possess the product immediately, and
have a chance to examine the tangible object. If consumers buy via direct marketing, they
are limited to pictures and verbal descriptions of the product. In addition, they cannot
possess the product immediately because it has to be delivered. The delivery time may be
hours to weeks. It depends upon the shipping methods and distances.
Moreover, Tom et al. study demonstrated that people who obtained their products at
the point of purchase would be more satisfied with the products than people who had to
wait for the delivery of their products. Relative to the direct marketing, the retail purchase
can better meet consumer needs for immediate possession of the purchased product.
However, as faced with an out-of-stock condition, consumers cannot possess the product
immediately and they have to wait. In this situation, even though a consumer buys a
product by the retail purchase, their valuation of the product is significantly less than the
valuation of immediate possession for the product. This lower valuation of the product
may cause consumers to decide against the purchase. Corresponding to the consumer
psychology, some retailers suggested some policies. One of these is to allow the sales
representative to give consumers who cannot get products immediately due to
out-of-stock a slight discount to make up their potential losses. This study also found the
delivery times in direct marketing purchases did not influence consumer valuation or
satisfaction for products. However, consumer valuation or satisfaction degree for
products may be reduced if the delivery time is longer than expected. So the authors
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suggested one- and two-week delivery time may be the reasonable range which
consumers can accept.
5.4 Mental Accounting, References States and Framing Effect in Price
Changes
As shown in section 4.3, mental accounting has four principles: 1) segregate gains, 2)
integrate losses, 3) cancel losses against large gains and 4) segregate silver linings
(Thaler, 1985). Mental accounting has been applied to analysis of consumer choice.
However, Heath, Chatterjee and France (1995) noted that many studies of mental
accounting in price changes ignored the explicit reference states. However, reference
states play an important role in consumer choice, since they can affect consumer price
perceptions. For example, consumers overvalue a $50 discount whose reference price is
$100 relative to the one whose reference price is $1000. This effect of reference state on
price changes may alter the four mental accounting principles.
Pricing policy is a common method which marketers use to promote their products.
The different expressions of discount prices can create different effects. For example,
some discount prices are expressed as percentage-based, such as this sweater is reduced
by 30 percent; some discount prices are expressed as absolute value, such as this
sweater is reduced from $50 to $35. Actually, the magnitude of the discount number is
the same. However, different expressions cause different price perceptions and
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preferences. For example, Lattin and Bucklin (1989) found that price elasticities are
influenced by features and special displays of POP (point-of-purchase) advertisement.
Heath, Chatterjee and France (1995) studied how the different expressions (framing
effects) for the proportional changes (i.e. if consumers evaluate events in terms of
proportional deviations from reference states rather than raw deviations (Heath et al.,
1995)) affect consumer price perceptions and further affect mental accounting principles.
Their study emphasized the effects of price changes relative to reference states and that
price changes were expressed as the absolute, dual, and relative percentage-based frames.
Here are three scenarios designed by Heath et al. (1995) which contain different
expressions for price changes when Mr. A buys a couch and Mr. B wants to buy a couch
and a chair:
Scenario E: Mr. As couch was priced originally at $1,300 but is now reduced to
$1,250. Mr. Bs chair was priced originally at $300 and his couch was priced at
$1000. His chair is now reduced to $200 and his couch is now increased to
$1,050. (mixed gain, absolute frame)
Scenario F: Mr. As couch was priced originally at $1,300 but is now reduced by
3.8 percent to $1,250. Mr. Bs chair was priced originally at $300 and his couch
was priced at $1000. His chair is now reduced by 33 percent to $200, and his
couch is now increased by 5 percent to $1,050. (mixed gain, dual frame)
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Scenario G: Mr. As couch was priced originally at $1,300 but is now reduced by
3.8 percent. Mr. Bs chair was priced originally at $300 and his couch was priced at
$1000. His chair is now reduced by 33 percent, and his couch is now increased by
5 percent, (mixed gain, relative frame)
Which scenarios do make consumers feel happier?
Note: From Heath, Chatterjee and France (1995, pp.92)
The above scenarios are designed for mixed gains under the absolute, dual and
relative frames. The authors also designed similar scenarios for multiple gains, multiple
loss and mixed loss under absolute, dual and relative frames. They summarized the all
conditions into Table 3:
Table 5.2
Design Summary
Outcome type Change in dollar value Percentage change
1,400-1,250 10.7-G
Multiple gain: Mr. A
4.5-G 1,100-1,050
Mr. B
300-200 33.3-G
1,250-1,400 12.0-L
Multiple loss: Mr. A
1,100-1050 4.8-L
Mr. B
200-300 50.0-L
1,300-1,250 3.8-G
Mixed gain: Mr. A
1,000-1,050 5.0-L
Mr. B
300-200 33.3-G
1,250-1,300 4.0-L
Mixed gain: Mr. A
1,050-1,000 4.8-G
Mr. B
200-300 50.0-L
NOTE: G=gain; L=loss. Three versions of each situation were tested: absolute frames
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(initial and final prices), dual frames (initial prices, final prices, and percentage changes),
and relative frames (initial prices and percentage changes) (Heath et al., 1995, p.92).
In these experiments, original prices were regarded as reference states and the ways
in which price changes are represented by absolute, dual and relative frames. Besides the
experiments involving reference states and frames, Heath, Chatterjee and France (1995)
first did experiments with the same value in the similar scenarios which did not contain
reference states. They found that if the experiments were tested under the three frames
without the reference states, consumers preferred to segregate two discounts, integrate
two prices increase, segregate an increase in a price from a smaller discount (mixed loss),
and integrate a discount with a smaller increase in a price (mixed gain). These results
were consistent with the mental accounting principles (Thaler, 1985).
However, if the price promotions were expressed by absolute, dual and relative
frames involving reference states, the experiment results were opposite to two of four
mental accounting principles. Under these frames, including reference states, consumers
still preferred to segregate multiple gains and integrate multiple losses. But they preferred
to segregate mixed gains and integrate mixed losses. These results indicated that
consumers are sensitive to gains and losses relative to reference states under these three
frames.
Heath et al. study (1995) implied that both consumer perceptions and preferences
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are considerably influenced by percentage-based frames. For example, 30% off
discount on a product can induce more consumers attention than simply stating its
current price of $70 (Heath et al. 1995). To obtain the better promotion effects, marketers
may use percentage-based frames with smaller discount to alter price perception.
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CHAPTER 6
Conclusion
As Kahneman said in 2003, Much has happened in the conversation between
economics and psychology...The church of economics has admitted and even rewarded
some scholars who would have been considered heretics in earlier periods and
conventional economic analysis is now being done with assumptions that are often much
more psychologically plausible than was true in the past. More and more economists
acknowledged the important role of psychology in economics. Behavioural economics
has been widely accepted by scholars. But it does not mean that classical economics
should be discarded. Classical economics is still a foundation for development of
economic theory. Although the gap between behavioural economics and classical
economics has not yet been closed, the distance is becoming narrow.
Stigler (1965) stated that economic theories should be judged by three criteria:
congruence with reality, generality, and tractability. Camerer and Loewenstein (2004)
suggest theories of behavioural economics should also be judged by these three criteria.
Needless to say, one of goals of behavioural economics is to use realistic explanation
of economic theory to get more accurate predictions and suggest better policies.
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Behavioural economics has been theoretically and empirically applied to finance,
macroeconomics, labor economics and marketing. It has successfully solved a series of
anomalies in economic life, such as equity premium puzzle, asymmetric price elasticity
and so forth. Recently, a sub-discipline of behavioural economics behavioural finance
has been formed. Furthermore, some researchers have studied how to use behavioural
economics in law, public policy, management, and so on.
Achieving generality is an additional goal of behavioural economics (Camerer and
Loewenstein, 2004). Most scholars built models of behavioural economics by adding one
or two parameters based on classical economic models. This way will help scholars to
detect where classical economic models work well and where they fail (Ho et al, 2006).
However, Fama (1998) questioned the generality of behavioural economics. He appeared
to believe that the models of behavioural economics can only be used for specific
problems or anomalies, but it is not possible to use these models to solve all finance
problems. Antonides (1991) also indicated that adding psychological concepts into
economics would reduce its generality.
When behavioural parameters are added to the standard economic models, it makes
the model more complicated so that it becomes less tractable. However, adding more
parameters can make more accurate predictions than classical economic models.
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The conclusions of this thesis are as following:
(1) Behavioural economics has been bringing more positive impacts on classical
economics and real life. Not only does it contribute to the development of classical
economics, but also it helps in solving many anomalies which occurred in real life.
(2) The studies of how behavioural economics can be applied to marketing are not
complete. This thesis found that the researchers often limited their study to decision
making by subjects who are from the same country. There is little research referring to
the areas of comparisons among countries. But different countries have different cultures,
histories, policies and so forth. These factors would significantly affect consumer
behaviour.
(3) Behavioural economics can also provide more realistic and better suggestions for
policy making, since behavioural economics modifies the assumption of rationality and
implies that people cannot make rational decisions all the time. Under this modified
assumption, policy should be considered as to how it can help people. For example, in
section 3.2, this thesis mentioned fairness in consumer pricing. To build the reputation of
fairness in pricing, policymakers can adopt these policies: provide more information on
how they determine prices and what market prices are. Furthermore, retailers should try
to keep stable prices to avoid generating unrealistic consumer expectations. These
policies not only protect consumers from deception, but also avoid vicious competition.
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Regrettably, this survey found that policy was not included in the marketing field. Most
research is limited to a narrow definition of marketing and ignores the important policy
effectiveness.
(4) Many marketing researchers design experiments and test their hypotheses to
analyze the role of behavioural economic theories in marketing practices. Few have
explored new marketing strategies or sale promotions associated with the theory of
behavioural economics.
Overall, behavioural economics has been growing rapidly. It is difficult for this
thesis to cover all studies of behavioural economics. In addition to the basic themes of
behavioural economics which are discussed in chapter 4, there are still many theories
which are developed in behavioural economics, such as self-control problems (Thaler,
1981), hyperbolic discounting (Harris and Laibson, 1999), herd behaviour (Scharfstein
and Stein, 1990), and so on. There is still a need for scholars to explore how behavioural
economics can be applied to various areas.
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