Cognitive Limitations and Consumer Behavior 8-1

Drawing on Chapter 8 8-2 Graphics copyright © 2010 The McGraw-Hill Companies, Inc. All rights reserved.

Overview Choice Under Uncertainty Bounded Rationality Reasons for Non-Utility-Maximizing Behavior Loss Aversion Acting on Sunk Costs Explicit vs. Implicit Opportunity Costs Affective Forecasting Errors Judgmental Heuristics And Biases The Psychophysics Of Perception The Difficulty Of Actually Deciding The Self-control Pitfall 8-3

Choice Under Uncertainty (Experimental results) Problem 1: choose between A: A sure gain of $240 (84%) B: A 25% chance of getting $1000 and a 75% chance of getting $0. (16%) 8-4

Figure 8.5: A Risk-Averse Person Will Usually Prefer a Sure Gain to a Lottery with Slightly Higher Expected Value 8-5

Choice Under Uncertainty Problem 2: choose between C: A sure loss of $750 (13%) D: A 75% chance of losing $1000 and a 25% chance of losing $0. (87%) 8-6

Choice Under Uncertainty Problem 3: choose between E: A 25% chance of getting $240 and a 75% chance of losing $760 (0%) F: A 25% chance of getting $250 and a 75% chance of losing $750. (100%) 8-7

Figure 8.1: Utility of a Pair of Events that Increases Total Wealth 8-8

Figure 8.2: The Kahneman-Tversky Value Function 8-9

Figure 8.3: Rejection of a Dominant Insurance Plan 8-10

Sunk Costs Thought Experiment: you bought a used car for $2,000, but found out it was a lemon, and have no warranty coverage. You will have to continue paying for repairs that cost more than you would be willing to pay for another car to drive. Do you continue operating and repairing it, or junk it and get another? Would your response be any different if you had not bought the car, but instead had been given it as a gift? 8-11

Judgmental Heuristics And Biases Three simple heuristics that people use to make judgments and inferences about the environment: Availability - much easier to recall events that are more “available” in memory. Representativeness – estimate likelihood that an event belongs in a class by its “representativeness” of the class. Anchoring and Adjustment - first choose a preliminary estimate and then adjust it in accordance with whatever additional information that appears relevant. 8-12

The Psychophysics Of Perception Weber-Fechner law: the property of perception whereby the just noticeable difference in a stimulus tends to be proportioned to the value of the stimulus. 8-13

The Difficulty Of Actually Deciding For many pairs of alternatives utility functions just don’t seem to assign clear, unambiguous preference rankings. Difficulty is most pronounced when the alternatives differ along dimensions that are hard to compare. 8-14

Figure 8.7: Choosing between Two Apartments 8-15

Figure 8.8: Adding an Irrelevant Alternative 8-16

The Self-control Pitfall People often have difficulty carrying out plans they believe to be in their own interests. Examples of commitment devices: “Christmas clubs” - special accounts that prohibit withdrawals until late autumn Whole-life insurance policies . 8-17