Prospect Theory and its Applications

in Marketing
Topic2

Instructor: IMRAN KHAN

You Will Learn
• What is prospect theory ?
• How it is relevant to Marketing concepts
• How it can be Applied and practiced in
real life
• What is the literature review in different
areas of marketing
 Prospect Theory
• A theory relating individual risk-aversion and
risk-seeking tendencies to gain And loss
situations, where it is theorized and
experimentally demonstrated that Individuals
are significantly more risk averse when facing
gains and significantly more risk seeking when
facing losses.
Who will be the real looser?

• https://www.youtube.com/watch?v=sM91
d5I36Po
 Strategic Process
According to prospect theory as developed and researched by Kahneman
and Tversky (1979), individuals facing favorable conditions tend to be
more risk averse, as opposed to risk seeking, because they feel they have
more to lose than to gain. Conversely, individuals facing unfavorable
circumstances tend to be more risk seeking, as opposed to risk averse,
because they feel they have little to lose.

The theory has received support as a result of experiments conducted by

the founders and subsequent academic researchers on individuals
confronted with gain and loss situations under a wide variety of controlled
conditions.

In order to predict people's choices, the position of the reference point

needs to be known.
 Theory Implications
The theory has implications for explaining and predicting the
tendencies of people in evaluating information. Specifically, the
theory provides an explanation for why individuals and
organizations may make decisions that vary from what might be
considered purely rational based on maximizing expected utilities.
In the context of organizational decision making, executives facing
external threats might be expected to be risk seeking, and
executives facing external opportunities might be expected to be
risk averse (Fiegenbaum and Thomas 1988; Wiseman and Gomez-
Mejia 1998; Chattopadhyay, Glick, and Huber 2001).

Executives and managers should, therefore, attempt to compensate

for the possibility of inadvertent biases in their decision making as a
result of the way a decision is framed in terms of gains and losses
 Theory Implications
In the context of influencing consumer decision making, marketers
should consider the fact that consumers are likely to make product
and service purchase decisions based on personal valuations of
gains and losses that differ significantly from a purely rational
perspective.
Specifically, whereas losing a dollar should be just as painful as the
pleasure of gaining a dollar, experiments based on prospect theory
suggest that losing a dollar is about twice as painful as the
pleasure of gaining a dollar (Kahneman and Tversky 1991).
Thus, according to the theory, consumers buying and holding
financial market instruments will tend to hold on to losing
positions in the hope of a recovery while also tending to move too
quickly to sell to secure any financial gains.

Car Selling Process Vs. Buying Process

Stock Exchange Shares
 Theory Implications
Astute marketers of a wide range of products and services (e.g.
financial instruments, disability insurance, electric utility services,
equipment warranties) should therefore recognize consumer
biases in psychologically valuing gains and losses and make
adjustments to their marketing strategies and tactics in order to
provide stronger psychological and actual tangible appeals. In
advertising and promotions, for example, marketers
may potentially increase consumer receptivity to a product or
service by emphasizing the risk of significant losses without the
product or service as opposed to the opportunity for significant
gains with the same product or service.
Yale University

• https://www.youtube.com/watch?v=myqZ
ZM9mj3g
Evaluating Company External Environment
SITUATION 1.
In addition to whatever you own, you have been given $1,000.
You are now asked to decide whether to accept a sure $500
gain or play a gamble. The gamble features a 50-50 chance of
winning $1,000 more or nothing more.

SITUATION 2:
In addition to whatever you own, you have been given
$2,000. You are now asked to decide whether to accept a sure
$500 loss or play a gamble. The gamble features a 50-50
chance of losing $1,000 or nothing.
 Evaluating Company External Environment
most people prefer winning $50 with certainty rather than taking a
risky bet in which they can toss a coin and either win $100 or
nothing.

The same people when confronted with 100% chance of losing $50 versus a 50%
chance of no loss or $100 loss – they often choose the second option.
Certainty: “This is when people tend to overweight options that are certain and risk
averse for gains.”

Isolation effect: “Refers to people’s tendency to act on information that stands out
and differs from the rest.”

Loss aversion: “When people prefer to avoid losses to

acquire equivalent gains”
Most people avoid the risk and take the $900
.
“This is when people tend to overweight options that are certain and risk
averse for gains.”
Isolation effect: “Refers to people’s tendency to act on information that
stands out and differs from the rest.”
Theory Implications
Loss aversion: “When people prefer to avoid losses to acquire
equivalent gains”
Most people avoid the risk and take the $900.
Service Industry
• Prospect theory also suggests that, in individual decision
making, resources are weighed differentially according to
their utility (Kahneman and Tversky 1979).
• In service failure/recovery encounters, customers will prefer
to receive, in exchange for the loss suffered, resources that
match the type of loss (failure) they experienced.
• Because, as we believe, economic and social resources are
classified in different mental accounts, they should be distal
(dissimilar) resources.
• Thus, if a service failure leads to loss of an economic
resource, customers will prefer to receive an economic
resource as part of the recovery effort.
• If a service failure leads to loss of a social resource, they
will prefer to receive a social resource as part of the
recovery effort.
Service Industry
• Specifically, we expect interaction effects between the type
of service failure and the recovery attributes, because
customers evaluate recovery efforts differently depending
on whether a failure occurred in the service outcome (i.e.,
the core service) or the service process (i.e., the service de
livery). When outcome failures occur (e.g., a reserved hotel
room is unavailable because of overbooking), customers ex-
perience an economic loss. Therefore, customers' percep-
tions of distributive justice will be restored by recovery at-
tributes that are economic resources, such as compensation
(money). We also expect that the impact of an apology (a
social resource) on customers' perceptions of distributive
justice will be lower (i.e., have less utility) for outcome
failures (an economic loss), because the resources are
stored in separate mental accounts. In a similar fashion,
customers' perceptions of procedural justice will be restored
by recovery attributes, such as response speed (time).
Service Industry
When process failures occur (e.g., a front-desk clerk is rude),
•customers experience a social loss. Therefore, customers'
perceptions of interactional justice will be enhanced by
recovery attributes, such as an apology or recovery initiation,
that communicate respect and empathy (social resources) to
the customer. We also expect that the impact of
compensation (an economic resource) on customers'
perceptions of interactional justice will be lower for process
failures (a social loss), because the resources are stored in
separate accounts. For example, when customers are treated
rudely by a waiter, they will assign less value to a discount
than to an apology.
Service Industry
When process failures occur (e.g., a front-desk clerk is rude),
•customers experience a social loss. Therefore, customers'
perceptions of interactional justice will be enhanced by
recovery attributes, such as an apology or recovery initiation,
that communicate respect and empathy (social resources) to
the customer. We also expect that the impact of
compensation (an economic resource) on customers'
perceptions of interactional justice will be lower for process
failures (a social loss), because the resources are stored in
separate accounts. For example, when customers are treated
rudely by a waiter, they will assign less value to a discount
than to an apology.
 Articles for Readings
Advertising:
Smith, Amy K., Bolton, Ruth N., and Wagner, Janet (1999). ‘A Model of Customer
Satisfaction with Service Encounters Involving Failure and Recovery,’ Journal of
Marketing Research, 36(3), August, 356–372
SALES
Burton, S. (1989). ‘Decision-Framing Helps Make the Sale,’ Journal
of Consumer Marketing, 6(2), Spring, 15–24.

Strategies
Chattopadhyay, Rithviraj, Glick, William H., and Huber, George P. (2001).
‘Organizational Actions in Response to Threats and Opportunities,’ Academy of
Management Journal, 44(5), October, 937–955.