Laraine Spector

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When it comes to decision making, consumers generally like to think of themselves as totally rational beings.  Yet, as a growing body of research demonstrates, they are anything but.

How far would you travel to save $10 on a purchase?  Does it matter if you’re saving $10 on a $20 dollar purchase or $10 on a $1000 purchase?  How much time would you spend to do so?  Have you ever denied yourself an expensive personal good but then welcomed it when your spouse bought it for you, using your joint account to do so?  Though explanations of consumers’ choices have traditionally assumed human rationality, why are there so many situations in which people make decisions that seem irrational, inconsistent, or downright contrary to their best financial interests? 

 Classical economic theory says a rational person will allocate his time or money optimally but, in reality, people often violate that rule.  For example, they exhibit a greater desire to save money—and expend time—for relatively smaller purchases than larger ones.  They often buy things they don’t need just because they’re a “good deal.”  And, though standard economic theory says people are happier if they have more rather than fewer choices, they frequently act to limit their own choices—removing food from their pantries to control consumption or willingly paying more per egg to purchase half a dozen eggs instead of a full dozen. Why, indeed, are consumers willing to pay more for less? 

 Increasingly, these and other obvious violations of classical economic theory have led some economists and decision scientists to reject the standard theory as too narrow and deterministic.  Rather, they contend that human decision-making is often irrational, inconsistent, and emotionally-driven.  To make sense of all this, we explore the drivers of consumer choice behavior and reflect on their implications for marketers. 

 Framing:  Losing Feels Worse than Winning Feels Good

At a minimum, rational choice should satisfy two basic requirements: consistency and coherence.  Consumers, however, regularly violate these in their everyday decision making.  Why?  One reason is framing.  According to pioneering decision theorists Tversky and Kahneman, framing positions choices in ways that bias the outcome.  Otherwise stated, consumers’ choices depend as much on the way a problem is posed—i.e., framed--as on the objective features of the problem.  But rational choice — at least, according to standard economic theory -- requires that the preference between essentially identical options remains constant despite changes of frame.  Yet, when choices involving gains or losses are involved, respondents’ preferences for essentially identical outcomes may be contradictory.  When given a choice between a sure gain of, say, $50 versus a smaller chance to gain, say, $100, the majority choice decision is often risk averse, preferring the sure gain over the possible gain.  But when this problem is posed in terms of losses, the majority is often risk-seeking—that is, rejecting the choice of a sure loss while preferring the possibility, even if very small, of the chance to lose less or to lose nothing.  Why the inconsistent responses? 

 For Tversky and Kahneman, such inconsistencies arise from the impact of a framing effect combined with contradictory attitudes towards risks involving gains versus losses.  This leads us to the authors’ most original contribution to decision theory:  prospect theory.  As an alternative to the prevailing theory of consumer choice, prospect theory focuses on individual choice under conditions of uncertainty.  Two aspects of prospect theory are particularly noteworthy:  First, it stresses people’s concerns with changes in wealth rather than absolute levels of wealth.  Second, it emphasizes that people’s response to losses is generally more extreme than their response to gains.  Indeed, for most people, losing a sum of money brings greater displeasure than the pleasure associated with winning the same amount. In other words, for most people, losses loom larger than gains. 

 Mental Accounting & Happiness Maximization

 Tversky and Kahneman’s framing concept broke important ground in describing how decisions are made, but it was Richard Thaler who essentially completed the edifice.  Thaler, a B-school  professor at the University of Chicago Graduate School of Business, shook up the world of neo-classical economics with his concept of “mental accounting,” which he defines as “the way people perceive, code, and evaluate events.”  Like Tversky and Kahneman, Thaler showed how consumer behavior habitually violates standard microeconomic principles.  But, for him, it was consumers’ mental accounting systems—similar to the financial accounting systems used by organizations--that induced them to breach neoclassical behavior theory.  

 Focusing on combinations of outcomes instead of separate events -- which is the way he believes people process events --Thaler uses mental accounting to explain some of the irrational ways people behave with their money.  For him, the way people code combinations of events reflects their desire to make themselves as happy as possible.  Extending Tversky and Kahneman’s framing principles, Thaler contends that people not only draw their own frames but that where they place the boundaries—both categorically and temporally --also influences their decisions. For example, one of the discretionary aspects of an accounting system concerns when to open and close accounts; because closing a stock account at a loss is painful, mental accounting predicts—and research confirms-- that people will be reluctant to sell stocks that have lost value. Indeed, he argues that though mental accounting favors the sale of a winning stock, a rational analysis favors selling a losing stock. 

Given that people use mental accounting to maximize their happiness, what combination of outcomes is optimal?  To respond to this, Thaler posits his “hedonic” framing principles, which reflect the way “most people would prefer to have things organized.”  Accordingly, he maintains they want to have:  gains segregated —i.e., two separate gains are better than one large one; losses integrated—i.e., one big loss is preferable to several smaller ones; smaller losses integrated with larger gains—to offset loss aversion; small gains segregated from larger losses – i.e., the silver lining effect.  He argues, for example, people would prefer to win two lotteries rather than one; numerous companies—in particular, credit card companies-- operate using payment decoupling — separating purchase from consumption -- in order to integrate losses.  Rather than a series of small expenditures, a single larger one separated from consumption seems to reduce the perceived cost — pain deferred is almost pain denied. 

 Capturing the Irrational Consumer

 What can marketers do to capitalize on the irrational and strange ways individuals make decisions about their purchases and other financial activities?  One place to start is to recognize that, though consumers may behave irrationally, they still have a fairly elaborate set of rules they apply to different situations and operations.  Understanding how consumers assign purchases to categories, how they combine outcomes, and how frequently they open and close accounts can enable marketers to increase the perceived attractiveness of products and programs.  Below are some suggestions for achieving this.

Marketing Implications  

·         Segregating Gains/ Showcasing for Separate Valuation

Segregating gains implies that marketers selling a multi-dimensional product/service should showcase each dimension for separate evaluation.  To increase product appeal, gains should be presented in terms of multiple dimensions and/or a “multitude” of uses.  To stimulate response, “bonus” offerings should be included as an additional gain as well as products or services offering temporal separation of gains—a number of wins/gains over time rather than a single one.

 ·         Segregating Small Gains/Silver Linings

Advertising campaigns and pricing should segregate small gains, emphasizing the silver lining(s) effect to mitigate large losses (high prices or unfavorable terms).  Rebates, rewards, and other frequent usage programs, used for price promotion, exemplify the silver lining principle by reducing the impact of high prices (large losses).  They are particularly attractive because they’re usually temporary, give the consumer a chance to adapt to the new price level and aren’t always used by consumers. 

 ·         Integrating Losses

When consumers are making a large purchase, marketers can add additional smaller items as options because the demand for these options will be temporarily inelastic.  Thus, adding the cost of a monogrammed lining to an expensive fur coat is perfectly logical as is offering options for CD players to car purchases, appliance or decorating items to house purchase prices, or meal plans/spa visits to hotel stays.  Integration lessens the pain.

 ·         Deals, Deals, Deals

Like bees to honey, consumers are highly attracted to “deals.”  For consumers, obtaining an item at a savings off its regular retail price, stirs passion and a determination to purchase regardless of appropriateness or need.  Convince consumers they’re getting a deal, and sales increase.   

 ·         Opening and Closing Accounts

Opening and closing accounts, the discretionary aspect of any accounting system, can be a stumbling block for marketers.  Examples of this abound:  many consumers refuse to close a stock account (i.e., sell) that has declined in value; most public firms’ manipulate their quarterly earnings announcements to avoid announcing, to the extent possible, earnings losses; and many consumers experience difficulty or reluctance in closing accounts based on advance purchases if they have been unable to use all of the items. The challenge for marketers:  to provide buyers with options that enable them to exchange unused tickets or other items for an alternative date or to receive other compensation so they won’t have to close their account at a loss, which may have negative impact on future sales. 

 ·         Tools to Reduce the Perceived Cost of Products

 Decoupling -- separating payment from consumption -- offers marketers an enticing tool to stimulate purchase.  It can be effected through (1) prepayment plans (currently used for insurance, auto purchases, vacations, educational programs); and (2) fixed-fee, comprehensive fee, or flat-rate service fees.  Since most consumers dislike per use fees—the so-called running meter effect—decoupling can be a powerful tool   Even Starbucks sells a pre-paid card that decouples payment from java drinking.   

 ·         Framing It Right

Almost every individual or household classifies its spending into consumption categories that serve for both budgetary allocation and self-control.  Though the budgeting process can facilitate trade-offs between competing uses for the funds, marketers can influence purchases in certain categories by the way they frame their offers.  For example, annual fees for health clubs, cultural activities, or charitable organizations can be framed in terms of pennies- or dollars-a-day to increase their appeal and ease their allocation to other than their regular use category. On the other hand, large expenditures for certain categories--charitable contributions, memberships, or even annual coffee purchase -- may encounter budgetary constraints.  Indeed, informing coffee drinkers they spend over $1500 annually at Starbucks may be a good way to convince them to purchase an espresso machine.

 ·         Creating the Luxury Category:  Paying More for Less

Most households limit their consumption of expensive luxury items –certain foods, wines, travel, and entertainment, among others—but exhibit a willingness to purchase small amounts at premium prices.  In order o control their consumption, consumers “pay more for less of what they like too much.” Though consumers may hesitate to purchase these luxury items for themselves, they exhibit no such reluctance to accept the latter as gifts. Marketers should thus focus on selling luxury products as gifts for others.

 ·         Remember Consumers are Emotional Animals, Too

Consumers aren’t the rational decision makers they were once posited to be.  By acknowledging they are both rational and irrational and by understanding their cognitive processes — especially, the role of mental accounting — marketers can both anticipate and influence consumers’ purchase decisions.  Understanding how consumers frame decisions and the role of perceived losses and gains in the choice process is vital.  Ultimately, people make decisions based on a simple objective:  they want to make themselves as happy as possible.  If marketers can gear their product and service offerings to that imperative, they can enhance their products’ appeal to consumers.   

 References

1. Leclerc, F., et al.  ‘Decision making and waiting time:  Is time like money?’,      Journal of Consumer Research, 22 (1995), 110-119.

2. Thaler, R. H.  “Mental accounting and consumer choice’, Marketing Science, 4          (1985), 199-214.

3. Thaler, R. H. “Mental Accounting Matters’, Journal of Behavioral Decision      Making, Vol. 12, (1999),183-206.

4. Tversky, A. and Kahneman, D. ‘The framing of decisions and the rationality of   choice’, Science, 211 (1981), 453-458.