Mental accounting and consumer choice

1. Mental accounting and consumer choice Richard Thaler Cornell University Presented by Scott Savage

2. Introduction • Standard Economic Theory • Goal of consumer is to maximize Utility • Should purchase set of goods (z) at prices (p) such that utility is maximized given Income constraints max U(z) s.t. Σ p1z1 ≤ I where z = goods, p = price, and I = Income

3. Introduction • Mental Accounting Theory • Utility function U(x) is replaced by Value function v(*) from Prospect Theory developed by Kahneman and Tversky • Prospect theory aimed at describing or predicting behavior • Utility theory aimed at characterizing optimal behavior • Value function uses perceived gains and losses relative to a reference point instead of wealth or income as in traditional model

4. Value Function v(∗)

5. Coding Gains and Losses Integrated Segregated Outcomes are valued jointly v(x + y) Outcomes are valued separately v(x) + v(y)

6. Possible Outcomes • Multiple Gains → x > 0 and y > 0 • v(x) + v(y) > v(x + y) • Segregation is preferred • Multiple Losses → - x and –y where x and y still positive • v(-x) + v(-y) < v(-(x + y)) • Integration is preferred • Mixed Gain → x > y • v(x) + v(-y) < v(x – y) • Integration is preferred - cancellation • Mixed Loss → x < y • v(x) + v(-y) ? v(x – y) • Segregation is preferred if v(x) > v(x – y) – v(-y) : “silver lining” • Integration is preferred otherwise – almost cancellation

7. Compounding Rules • Segregate Gains • Integrate Losses • Cancel Losses against Larger Gains • Segregate “silver linings”

8. Total Purchase Utility = Acquisition utility + Transaction utility • Value of the good compared to the outlay • Direct result of the trade of something to receive something else • Perceived merits of the “deal”. • Will depend on the price paid as compared to some reference price

9. Transaction Utility Theory • Fairness determines the reference price • Fairness is dependent on the cost to the seller • Individuals will have a different reference price when expectations are different

10. Budget Constraints Theory • Consumers typically use month to month time horizon instead of present value of lifetime wealth • Individuals or families will make purchasing decisions based on explicit or implicit budget constraints (k) for a category (i) given a specific timeframe (t) • High category k’s are typically goods that require more self-control from the consumer • Low category k’s are typically goods that are advantageous in the long run http://www.youtube.com/watch?v=sSSg3RkW8MI

11. Marketing Implications • Compounding Rule • http://www.dell.com • Transaction Utility • http://www.amazon.com • Budgeting Constraints • http://www.thecoronabeach.com/