1. How Framing Affects Mental Accounting and “The Compromise Effect” Shivani Patel May 2, 2007

2. ► The compromise effect is a economic phenomenon which states that the market share of a product is increased when it is the intermediate choice option in a choice set and diminished when it is an extreme option—extremeness aversion (Kivietz et al, 2004). ► Mental Accounting is the way in which people tend to evaluate, categorize, and code economic outcomes. In particular, the manner in which people label and group resources often leads to the violation of the economic principle of fungibility. What is it?

3. Why is it useful? ► The compromise effect has been studied extensively by behavioral researchers and market analysts in order to predict consumer demand and to construct strategic options sets, thereby increasing the market share and probable purchase of certain products. ► The way people “frame” outcomes can have direct consequences on consumer markets. In this example, we try to determine the effect of lottery winnings on consumer choice.

4. What are the theories which underlie this phenomenon ? ► Contextual concavity and loss aversion underlie the compromise effect. ► The idea of contextual concavity assumes that concavity for the part- worth gain of each attribute by the weight of the attribute. This streamlines the effect of compromise on choice (Kivietz et al. 2004). ► More formally the contextual concavity model (CCM) implies that, ► Mij^S=∑k (Pijk-P^Si, min, k)^ck ► Where:  Mij^S=the deterministic component of utility of alternative j in choice set S for consumer i.  Pijk=the part-worth (utility) of the level of attribute k of alternative j for consumer i.  Pi, min, k^S=the partworth of attribute k of the alternative with the lowest partworth on this attribute in choice set S for consumer i.  Ck=the concavity parameter of attribute k.

5. Loss Aversion ► The concept of loss aversion states that most people prefer to avoid losses than make gains (Kahneman and Tversky, 1991). ► Most behavioral scientists view this concept as irrational behavior. For example, suppose an item cost $500. Would you rather have a savings of 5% or avoid paying a 5% surcharge? ► For the 5% savings: total cost is now $475. ► For avoiding the 5% surcharge: $498.75 ► Thus, people would rather pay $498.75 in order to avoid perceived loss than pay $475!

6. In this experiment… ► In order to demonstrate the compromise effect, cellular plans which differed on only two attributes, namely, price and number of anytime minutes were chosen. This will hopefully

7. Experiment 1 ► This experiment asked people to choose between Plan A (525 anytime minutes, $29.99) and Plan B (575 anytime minutes, $39.99) ► 57.1% of participants chose Plan A over Plan B. (n=5)

8. Experiment 2 ► This experiment asked people to choose between Plan B (575 anytime minutes, $39.99) and Plan C (650 anytime minutes, $49.99). 57.1% of the participants preferred Plan C over Plan B.

9. Experiment 3 In this experiment, participants were asked to choose between Plan A (525 mins., $29.99), Plan B (575 mins., $39.99), and Plan C (650 mins., $49.99). Plan B (the compromise option) was chosen 71.4% of the time.

10. Implications of study… ► The data from these experiments seems to suggest that the compromise effect may have been demonstrated. The market share of Plan B was lower when compared separately to Plans A & C, but when presented in a ternary choice set, the market share of Plan B increased.

11. Further Implications… ► The compromise effect implies the presence of a context effect. ► In the preceding experiments, cell phone plan options were used as the option choices. All the characteristics of the cell phone plans were the same (ex: unlimited nights & weekends) but they differed on price and number of anytime minutes. Thus, the concept of contextual concavity has been demonstrated, as well as the economic phenomenon of the compromise effect!

12. Cont’d… ► Plan B had the highest market share when presented as a compromise option in the set. ► The principle of the compromise effect has implications for consumer choice models within the realm of product positioning and branding. For example, in order to increase sales of a mid-priced product, companies often introduce a more expensive alternative. ► This strategy was followed by retailer Williams & Sonoma when trying to boost sales of their $275 bread machines. They simply introduced a $400 bread machine, and voila! Market share of the $275 (mid-priced) option increased as predicted by the Compromise Effect.

13. The confounding effect of mental Accounting! ► Mental accounting and reason based consumer choice have a very volatile relationship! ► For example, did you ever think of a product as too expensive, but out of nowhere received money (lottery, gift, found, etc.) which made you suddenly reconsider the utility of that product? ► Therefore, the product is no longer considered a hedonistic purchase. ► In this example, resource “framing” has a direct effect on consumer choice. By framing the option choice set with winning $1000, participants were predicted to choose the most expensive plan (Plan C).

14. Experiment 1A ► This experiment was identical to Exp. 1, but participants were told to pretend that they had just won $1000 in the lottery. As such, an 71.4% of participants choose the more expensive cell phone plan. This may demonstrate the effect of mental accounting, and more specifically, placing less monetary value on “windfall” money than earned money. The proportion of participants choosing the more expensive cell phone plan increased by 28.6%

15. Experiment 2A ► In this experiment, Plan B was picked by 71.4% of the time when there were told they had won $1000, versus 42.9% of the time when participants assumed status quo.

16. Experiment 3A ► In this experiment, participants were told they had just won $1000, and Plan B (compromise option) was favored by 28.6% of the time. This may be due to gaining assessing the gain of $1000 as “extra” unexpected income, there fore, Plan C, the most expensive option was chosen 42.9% of the time.

17. Mental Accounting? Or Reason Based Choice? ► The idea that people choose options according to the Value Maximization is inconsistent with the demonstrations of the compromise effect and mental accounting behaviors. ► For example, per unit cost of the cell phone plans: ► Plan A: 525mins/$29.99=17.51mins/$1 ► Plan B: 575mins/$39.99=14.39mins/$1 ► Plan C: 650mins/$49.99=13.00mins/$1

18. Implications of Study… ► Product manufacturers and distributors use product framing in order to increase/decrease market share of products. ► It is often possible to increase the market share of a mid-priced product by merely offering an even more expensive option in the choice set.

19. References ► Kivietz, R., Oded, N., and Srinivasan, V. (2004) Alternative Models for Capturing the Compromise Effect, Journal of Marketing Research, Vol. XLI, pp. 237-257. ► Tversky, A., and Kahneman, D. (1991), “Loss Aversion in Riskless Choice: A Reference Dependent Model,” Quarterly Journal of Economics, 106, (November), 1039-1061.