consumer judgment and decision making professor charles hofacker [email protected] spring 2005

Consumer Judgment and Decision Making

Professor Charles [email protected]

Spring 2005

Spring 2005JDM Slide: 2Dr. Charles Hofacker

2

The Persistence of Illusion


3

The Persistence of Illusion


4

Consumer Decision Making Solving

Problem recognition

Problem recognition SearchSearch Alternative

evaluation

Alternative evaluation

Purchase decision

Purchase decision

Purchase behavior

Purchase behavior

Post purchase evaluation

Post purchase evaluation


5

Standard Economic Theory of Consumer Choice

x = [x1 x2 ··· xn] vector of goods available

c = [c1 c2 ··· cn] prices for those goods

u(x) consumer’s utility function

I consumer’s income

u(x) s. t. ci xi Ii

xMax

According to rational decision theory, the consumer picks the optimal bundle of goods from x.


6

The Theory of Bounded Rationality

Theory attributed to Herbert Simon as a critique of rational decision theory. The optimization process should take into account

cognitive limitations

finite time availability

Ratchford, Brian T. (1982), "Cost-Benefit Models for Explaining Consumer Choice and Information Seeking Behavior,"

Management Science, 28 (2), 197-212.


7

Bottlenecks in the Flow of Information through the Human Mind

Short Term Storage

Long Term Storage

Attention Learning

Perception

Sensory Storage

See alsoBettman, James R. (1979), "Memory Factors in Consumer

Choice: A Review," Journal of Marketing, 43, 37-53.


8

Satisficing

Simon coined this term which means acting just rational enough

It is a special case of bounded rationality applied to sequential decision w/ no objectively optimal stopping point

A consumer might pick the first option that exceeds some key threshold cutoffs


9

Choosing How to Choose

A consumer must tradeoff the quality of the decision against the opportunity costs of the time and the effort

Johnson, Eric J. and John W. Payne (1985), "Effort and Accuracy in Choice," Management Science, 31 (4), 395-414.

Payne, John W., James R. Bettman, and Eric J. Johnson (1988), "Adaptive Strategy Selection in Decision Making," Journal of Experimental Psychology: Learning, Memory and Cognition, 14 (3), 534-52.

Shugan, Steven M. (1980), "The Cost of Thinking," Journal of Consumer Research, 7 (2), 99-111.


10

Thinking about the Utility Function

$

u($)

?


11

Uncertainty Reveals Interesting Aspects about Choice - Lotteries

Would you rather have a sure $10,000 or a 50% shot at $20,250?


12

The Utility Function Is Nonlinear

Would you rather have a sure $10,000 or a 50% shot at $20,250?

EV = .5($20,250) = $10,125

We have to replace Expected Value with Expected Utility

The function u is concave (u'' < 0) Consumers tend to be risk averse


13

Risk Aversion Is a By Product of Concavity

Objective Dollars

SubjectiveValue


14

Uncertainty Reveals Interesting Aspects about Choice – the St. Petersburg Paradox

How much would you pay to play a game in which a coin is tossed n times

the coin is tossed until there is a Head you win $2n

The Expected Value of the game is infinite


15

Using Lotteries to Establish the Utility of Money

With probability p you win $50,000 with probability 1-p you lose $50,000

EV(lottery) = p($50k) + (1-p)(-$50k)

Note that this lottery would be worth more than $30,000 if p > .8


16

The Price of a Lottery

Would you rather have $30,000 or .8 probability of winning $50,000 and a .2 probability of losing $50,000?

For most people, p must be closer to .9.

We look for a p which creates the indifference point


17

Creating the Utility Scale

Arbitrarily set U(-$50,000) = 0U($50,000) = 10

If the indifference point between the $30,000 and the lottery is .95, we have

U(30,000) U(30,000) = p · U($50,000) + (1-p) · U(-$50,000)= p · U($50,000) + (1-p) · U(-$50,000)= .95(10) + .05(0) = 9.5= .95(10) + .05(0) = 9.5

We can vary the lottery buy-in price and use this method to establish the relationship between $ and U($).


18

Prospect Theory: Gains and Losses

Dollars

Value


19

Prospect Theory

The disutility from a loss exceeds the utility from a comparatively sized gain

Differences, contrast or changes are more salient than absolute values (more on this later)

Kahneman, Daniel and Amos Tversky (1979), "Prospect Theory: An Analysis of Decision under Risk,"

Econometrica, 47 (2), 263-91.


20

Loss Aversion

The disutility of giving up a valued good is much higher than the utility gain associated with receiving the same good

The endowment effect. A good’s utility appears to change when a good is incorporated into one’s endowment

People don’t like to trade lottery tickets


21

Framing as Losses or Gains

a: $240

b: with probability .25 you win $1000, with .75 you win 0

c: -$750 d: with probability .75

you lose $1000, with .25 you lose 0.

Define p(a, b) as the choice proportion for selecting a over b

http://www.cs.umu.se/kurser/TDBC12/HT99/Tversky.html

p(a, b) = .84 p(c, d) = .13


22

Imagine that the U.S. is preparing for the outbreak of a 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…


23




If program a is adopted, 200 people will be saved. If program b is adopted, there is a one-third probability that 600 people will be saved and a two-thirds probability that no people will be saved.

p(a, b) = .72

Note the sample was comprised of medical doctors!


24




If program c is adopted, 400 people will die. If program d is adopted, there is a one-third probability that nobody will die and a two-thirds probability that 600 people will die.

p(c, d) = .22


25




If program a is adopted, 200 people will be saved. If program b is adopted, there is a one-third probability that 600 people will be saved and a two-thirds probability that no people will be saved.

p(a, b) = .72

If program c is adopted, 400 people will die. If program d is adopted, there is a one-third probability that nobody will die and a two-thirds probability that 600 people will die.

p(c, d) = .22

Note the sample was comprised of medical doctors!


26

Insurance as a Frame

Prospect a - a sure loss of $10

Prospect b is a 1% chance of a $1,000 loss

p(a, b) = .51

Option c - pay an insurance premium of $10

Option d - Remain exposed to 1% loss of $1,000

p(c, d) = .81


27

Framing and Attitudes

Levin, Irwin P. and Gary J. Gaeth (1988), "Framing of Attribute Information before and after Consuming the Product.," Journal of

Consumer Research, 15 (3), 374-7

75% Lean 25% Fat

Fat/Lean 5.15 2.83

Low/High Quality 5.33 3.66

Greasy/Greaseless 4.49 2.96

Bad/Good Taste 5.69 4.43


28

Framing and Fairness

A shortage has developed for a popular model of automobile, and customers must now wait two months for delivery. A dealer has been selling these cars at list price. Now the dealer prices this model at $200 above list price.

Judged acceptable: 29%

A shortage has developed for a popular model of automobile, and customers must now wait two months for delivery. A dealer has been selling these cars at a discount of $200 below list price. Now the dealer sells this model only at list price.

Judged acceptable: 58%

Kahneman, Daniel, Jack L. Knetsch, and Richard Thaler (1986), "Fairness as a Constraint on Profit-Seeking: Entitlements in the Market," American

Economic Review, 76 (4), 728-741.


29

Psychological Accounting

You have $10 to buy a ticket for the play. You discover that you lost $10.

.88 buy another ticket

You bought the ticket for $10. You discover that you lost the ticket.

.46 buy another ticket

Thaler, Richard (1985), "Mental Accounting and Consumer Choice," Marketing Science, 4 (3), 199-214.


30

Minimal Account or Inclusive Account

You are about to buy a jacket for $125 and a calculator for $15 even though you can buy that same calculator 20 minutes away for $5 less

.68 are willing to travel

You are about to buy a jacket for $15 and a calculator for $125 even though you can buy that same calculator for $120, 20 minutes away

.29 are willing to travel


31

Define as indifference, i. e.

A Notation for Preference

Define as strict preference, i. e.

a b and a b

a b but not a b

Define a b as “a is weakly preferred to b”


32

The Theory of Expected Utility

Preference must follow these axioms:

1. Complete

2. Transitive

3. Continuous

4. Independent


33

The Theory of Expected Utility

Preference must follow these axioms:

1. Complete

2. Transitive

3. Continuous

4. IndependentPertains to choice under uncertainty


34

If the Previous Axioms Hold

U(x) = pi u( xi)i

If these axioms hold, preferences can be represented as below:

and the person with those preferences is rational


35

Completeness

A preference relation is complete if for all a and b we have a b or a b or both. Thus

The consumer is able to form an opinion about the relative merit of any pair of bundles

The consumer has well defined preferences between any pair of bundles


36

Choice Tends Be Constructed Not Revealed

Choosing is ad hoc and done on the spot

Differences, contrast or changes are more salient than absolute values

The choice process depends on contextual and situational factors

Bettman, James R., Mary Frances Luce, and John W. Payne (1998), "Constructive Consumer Choice Processes," Journal of

Consumer Research, 25(3), 187-217.


37

Assimilation and Contrast

Assimilation - Consumers adjust their evaluation of an unfamiliar option in the direction of a context of familiar options

Contrast – Consumers adjust their evaluation of an unfamiliar option in the direction opposite from a context of familiar options

Cooke, Alan D. J., Harish Sujan, Mita Sujan, and Barton A. Weitz (2002), "Marketing the Unfamiliar: The Role of Context and Item-Specific

Information in Electronic Agent Recommendations," Journal of Marketing Research, 39 (4), 488-97.


38

The Compromise Effect

Attribute 2

Attribute 1

a

b

c

Dhar, Ravi and Itamar Simonson (2003), "The Effect of Forced Choice on Choice," Journal of Marketing Research, 40 (2), 146-60.

Attribute 2

Attribute 1

a

bThe addition of c adds to the share

of b


39

The Attraction Effector the Asymmetric Dominance Effect

Attribute 2

Attribute 1

a

b

c

Dhar, Ravi and Itamar Simonson (2003), "The Effect of Forced Choice on Choice," Journal of Marketing Research, 40 (2), 146-60.

The addition of c adds to the share

of a

Attribute 2

Attribute 1

a

b


40

Idiosyncratic Preferences

Students who like sushi more than most students are more likely to join a loyalty program that offers a free movie ticket after

purchasing 12 sandwiches + 12 orders of sushi

than after

purchasing 12 sandwiches

Kivetz, Ran and Itamar Simonson (2003), "The Role of Effort Advantage in Consumer Response to Loyalty Programs: The Idiosyncratic Fit

Heuristic," Journal of Marketing Research, 40, 454-4


41

Transitivity

a b c


42

Definition of Transitivity

if a b and b c,

then a c


43

Intransitive Group Decisions

In the first vote, c beats b. Then b beats a. But

look what happens when c and a are pitted against each other.

Socialists: b a c

Greens: c b a

Conservatives: a c b


44

The Ideal Point Model

Socialists: b a c

Greens: c b a

Conservatives: a c b

b a c

Socialists Conservatives


45

Weak Stochastic Transitivity

if p(a, b) .5 and p(b, c) .5

then p(a, c) .5


46

Continuity

For a b c, there must exist a unique p s.t.

p · a + (1 – p) · c b


47

Independence

If a b, then

p · a + (1 – p) · c p · b + (1 – p) · c


48

Another Way to Express Independence

For four choice options a, b, c and d

p(a, b) > p(c, b) iff p(a, d) > p(c, d)

This is equivalent to Tversky & Kahneman’s (1986) cancellation


49

Similarity Effect

0

50

100

150

200

0

50

100

150

200

91 96 106 109 91 96 106 109

Relative Area of Variable Figure (%)

Frequency that the Variable Figure is Judged Larger than the Standard Figure

Similar Variable Figure

Standard 100% Standard 100%

Similar Variable Figure

Dissimilar Variable Figure

Dissimilar Variable Figure

Mellers, Barbara A. and Karen Biagini (1994), "Similiarity and Choice," Psychological Review, 101 (3), 505-18.


50

Lotteries and Independence

33100 chance of winning $2,500


1100 chance of winning $0


Lottery a Lottery b

Most people prefer b


51

The Next Lottery Pair


67100 chance of winning $0 66

100 chance of winning $0

Lottery c Lottery d


Most people prefer c


52

Representing the Lotteries a Different Way

Roulette Slots

1-33 34 35-100

a $2,500 $0 $2,400

b $2,400 $2,400 $2,400

c $2,500 $0 $0

d $2,400 $2,400 $0

Modeled after:Kulish, Mariano (2002), "The Independence Axiom: A Survey," in Boston University

Department of Economics Working Paper. Boston.


53

Procedural Invariance

Strategically equivalent methods of preference elicitation should yield the same preference order. Thus

choice between two options should be in the same order as the cash equivalence (minimum selling price) of the two options


54

Preference Reversal (PR)

H Bet: 28/36 chance to win $10 L Bet: 3/26 chance to win $100

•Most people will prefer the H bet to the L bet

•Most people will be willing to sell the H bet for a lower price than the L bet

Lichtenstein, Sarah and Paul Slovic (1971), "Reversals of Preferences between Bids and Choices in Gambling Decisions," Journal of

Experimental Psychology, 89 (1), 46-55.


55

Define Ci as the selling price for bet i. Then

PR Analyzed

CH H L CL CH

Implied by Procedural Invariance

Implied by Intransitivity

Tversky, Amos, Paul Slovic, and Daniel Kahneman (1990), "The Causes of Preference Reversal," American Economic Review, 80 (1), 204-17.

consumer judgment and decision making professor charles hofacker [email protected] spring 2005

Documents

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