Consumer Judgment and Decision Making Professor Charles Hofacker Spring 2005

JDM Slide: 1 Dr. Charles Hofacker 1 The Persistence of Illusion

Spring 2005 JDM Slide: 2 Dr. Charles Hofacker 2 The Persistence of Illusion

Spring 2005 JDM Slide: 3 Dr. Charles Hofacker 3 Consumer Decision Making Solving Problem recognition Search Alternative evaluation Purchase decision Purchase behavior Post purchase evaluation

Spring 2005 JDM Slide: 4 Dr. Charles Hofacker 4 Standard Economic Theory of Consumer Choice x = [x 1 x 2 ··· x n ] vector of goods available c = [c 1 c 2 ··· c n ] prices for those goods u(x) consumer’s utility function I consumer’s income u(x) s. t. c i x i  I  i x Max According to rational decision theory, the consumer picks the optimal bundle of goods from x.

Spring 2005 JDM Slide: 5 Dr. Charles Hofacker 5 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),

Spring 2005 JDM Slide: 6 Dr. Charles Hofacker 6 Bottlenecks in the Flow of Information through the Human Mind Short Term Storage Long Term Storage AttentionLearning Perception Sensory Storage See also Bettman, James R. (1979), "Memory Factors in Consumer Choice: A Review," Journal of Marketing, 43,

Spring 2005 JDM Slide: 7 Dr. Charles Hofacker 7 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

Spring 2005 JDM Slide: 8 Dr. Charles Hofacker 8 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), 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), Shugan, Steven M. (1980), "The Cost of Thinking," Journal of Consumer Research, 7 (2),

Spring 2005 JDM Slide: 9 Dr. Charles Hofacker 9 Thinking about the Utility Function $ u($) ?

Spring 2005 JDM Slide: 10 Dr. Charles Hofacker 10 Uncertainty Reveals Interesting Aspects about Choice - Lotteries Would you rather have a sure $10,000 or a 50% shot at $20,250?

Spring 2005 JDM Slide: 11 Dr. Charles Hofacker 11 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

Spring 2005 JDM Slide: 12 Dr. Charles Hofacker 12 Risk Aversion Is a By Product of Concavity Objective Dollars Subjective Value

Spring 2005 JDM Slide: 13 Dr. Charles Hofacker 13 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 $2 n The Expected Value of the game is infinite

Spring 2005 JDM Slide: 14 Dr. Charles Hofacker 14 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

Spring 2005 JDM Slide: 15 Dr. Charles Hofacker 15 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

Spring 2005 JDM Slide: 16 Dr. Charles Hofacker 16 Creating the Utility Scale Arbitrarily set U(-$50,000) = 0 U($50,000) = 10 If the indifference point between the $30,000 and the lottery is.95, we have U(30,000) = p · U($50,000) + (1-p) · U(-$50,000) =.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($).

Spring 2005 JDM Slide: 17 Dr. Charles Hofacker 17 Prospect Theory: Gains and Losses Dollars Value

Spring 2005 JDM Slide: 18 Dr. Charles Hofacker 18 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),

Spring 2005 JDM Slide: 19 Dr. Charles Hofacker 19 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

Spring 2005 JDM Slide: 20 Dr. Charles Hofacker 20 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 p(a, b) =.84 p(c, d) =.13

Spring 2005 JDM Slide: 21 Dr. Charles Hofacker 21 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…

Spring 2005 JDM Slide: 22 Dr. Charles Hofacker 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… 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!

Spring 2005 JDM Slide: 23 Dr. Charles Hofacker 23 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… 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

Spring 2005 JDM Slide: 24 Dr. Charles Hofacker 24 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… 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!

Spring 2005 JDM Slide: 25 Dr. Charles Hofacker 25 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

Spring 2005 JDM Slide: 26 Dr. Charles Hofacker 26 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), % Lean25% Fat Fat/Lean Low/High Quality Greasy/Greaseless Bad/Good Taste

Spring 2005 JDM Slide: 27 Dr. Charles Hofacker 27 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),

Spring 2005 JDM Slide: 28 Dr. Charles Hofacker 28 Psychological Accounting You have $10 to buy a ticket for the play. You discover that you lost $ 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),

Spring 2005 JDM Slide: 29 Dr. Charles Hofacker 29 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

Spring 2005 JDM Slide: 30 Dr. Charles Hofacker 30 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”

Spring 2005 JDM Slide: 31 Dr. Charles Hofacker 31 The Theory of Expected Utility Preference must follow these axioms: 1. Complete 2. Transitive 3. Continuous 4. Independent

Spring 2005 JDM Slide: 32 Dr. Charles Hofacker 32 The Theory of Expected Utility Preference must follow these axioms: 1. Complete 2. Transitive 3. Continuous 4. Independent Pertains to choice under uncertainty

Spring 2005 JDM Slide: 33 Dr. Charles Hofacker 33 If the Previous Axioms Hold U(x) = p i u( x i )  i If these axioms hold, preferences can be represented as below: and the person with those preferences is rational

Spring 2005 JDM Slide: 34 Dr. Charles Hofacker 34 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

Spring 2005 JDM Slide: 35 Dr. Charles Hofacker 35 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),

Spring 2005 JDM Slide: 36 Dr. Charles Hofacker 36 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),

Spring 2005 JDM Slide: 37 Dr. Charles Hofacker 37 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), Attribute 2 Attribute 1 a b The addition of c adds to the share of b

Spring 2005 JDM Slide: 38 Dr. Charles Hofacker 38 The Attraction Effect or 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), The addition of c adds to the share of a Attribute 2 Attribute 1 a b

Spring 2005 JDM Slide: 39 Dr. Charles Hofacker 39 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

Spring 2005 JDM Slide: 40 Dr. Charles Hofacker 40 Transitivity abc

Spring 2005 JDM Slide: 41 Dr. Charles Hofacker 41 Definition of Transitivity if a b and b c, then a c

Spring 2005 JDM Slide: 42 Dr. Charles Hofacker 42 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

Spring 2005 JDM Slide: 43 Dr. Charles Hofacker 43 The Ideal Point Model Socialists: b a c Greens:c b a Conservatives: a c b bac Socialists Conservatives

Spring 2005 JDM Slide: 44 Dr. Charles Hofacker 44 Weak Stochastic Transitivity if p(a, b) .5 and p(b, c) .5 then p(a, c) .5

Spring 2005 JDM Slide: 45 Dr. Charles Hofacker 45 Continuity For a b c, there must exist a unique p s.t. p · a + (1 – p) · c  b

Spring 2005 JDM Slide: 46 Dr. Charles Hofacker 46 Independence If a b, then p · a + (1 – p) · c p · b + (1 – p) · c

Spring 2005 JDM Slide: 47 Dr. Charles Hofacker 47 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

Spring 2005 JDM Slide: 48 Dr. Charles Hofacker 48 Similarity Effect Relative Area of Variable Figure (%) Frequency that the Variable Figure is Judged Larger than the Standard Figure Similar Variable Figure Standard 100% Similar Variable Figure Dissimilar Variable Figure Mellers, Barbara A. and Karen Biagini (1994), "Similiarity and Choice," Psychological Review, 101 (3),

Spring 2005 JDM Slide: 49 Dr. Charles Hofacker 49 Lotteries and Independence chance of winning $2, chance of winning $2, chance of winning $0 100 chance of winning $2,400 Lottery aLottery b Most people prefer b

Spring 2005 JDM Slide: 50 Dr. Charles Hofacker 50 The Next Lottery Pair chance of winning $2, chance of winning $ chance of winning $0 Lottery cLottery d chance of winning $2,400 Most people prefer c

Spring 2005 JDM Slide: 51 Dr. Charles Hofacker 51 Representing the Lotteries a Different Way Roulette Slots a$2,500$0$2,400 b c$2,500$0 d$2,400 $0 Modeled after: Kulish, Mariano (2002), "The Independence Axiom: A Survey," in Boston University Department of Economics Working Paper. Boston.

Spring 2005 JDM Slide: 52 Dr. Charles Hofacker 52 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

Spring 2005 JDM Slide: 53 Dr. Charles Hofacker 53 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),

Spring 2005 JDM Slide: 54 Dr. Charles Hofacker 54 Define C i as the selling price for bet i. Then PR Analyzed C H  H L  C L C H 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),