Consumer Judgment and Decision Making Professor Charles Hofacker chofack @ cob.fsu

1. Consumer Judgment and Decision Making Professor Charles Hofacker chofack@cob.fsu.edu Spring 2005

2. The Persistence of Illusion

3. The Persistence of Illusion

4. Consumer Decision Making Solving Problem recognition Alternative evaluation Search Post purchase evaluation Purchase behavior Purchase decision

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  Max u(x) s. t. ci xi  I x i 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 Perception Attention Learning Long Term Storage Sensory Storage Short Term Storage See also Bettman, 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 Subjective Value Objective Dollars

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) = 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($).

18. Prospect Theory: Gains and Losses Value Dollars

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 endowmenteffect. 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 Define p(a, b) as the choice proportion for selecting a over b 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. p(a, b) = .84 p(c, d) = .13 http://www.cs.umu.se/kurser/TDBC12/HT99/Tversky.html

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. 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!

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 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. 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!

26. 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 Insurance as a Frame

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

28. 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% Framing and Fairness 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 $15 and a calculator for $125 even though you can buy that same calculator for $120, 20 minutes away .29 are willing to travel 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

31. Define a b as “a is weakly preferred to b” A Notation for Preference Define  as indifference, i. e. a b and a b Define as strict preference, i. e. a b but not a b

32. The Theory of Expected Utility Preference must follow these axioms: • Complete • Transitive • Continuous • Independent

33. The Theory of Expected Utility Preference must follow these axioms: • Complete • Transitive • Continuous • Independent Pertains to choice under uncertainty

34. If the Previous Axioms Hold If these axioms hold, preferences can be represented as below:  U(x) = pi u(xi) i 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 1 Attribute 1 a a The addition of c adds to the share of b b b c Attribute 2 Attribute 2 Dhar, Ravi and Itamar Simonson (2003), "The Effect of Forced Choice on Choice," Journal of Marketing Research, 40 (2), 146-60.

39. The Attraction Effector the Asymmetric Dominance Effect Attribute 1 Attribute 1 a a The addition of c adds to the share of a c b b Attribute 2 Attribute 2 Dhar, Ravi and Itamar Simonson (2003), "The Effect of Forced Choice on Choice," Journal of Marketing Research, 40 (2), 146-60.

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. a b c Transitivity

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 Conservatives Socialists b a c

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 Standard 100% Standard 100% Frequency that the Variable Figure is Judged Larger than the Standard Figure Similar Variable Figure Similar Variable Figure Dissimilar Variable Figure Dissimilar Variable Figure 91 96 106 109 91 96 106 109 Relative Area of Variable Figure (%) Mellers, Barbara A. and Karen Biagini (1994), "Similiarity and Choice," Psychological Review, 101 (3), 505-18.

50. 33 100 chance of winning $2,500 66 100 chance of winning $2,400 1 100 chance of winning $0 Lotteries and Independence 100 100 chance of winning $2,400 Lottery a Lottery b Most people prefer b