Wednesday, 20 June 2012

Behavioural economics and consumer issues- (Reference-Peter Winsley)

Behavioural economics and consumer issues- (Reference-Peter Winsley)

 Anomalies and cognitive biases relevant to consumer issues  Evolution has left us with a host of psychological characteristics that are inconsistent with rational modern world assumptions.
Unstable preferences
 Preferences are unstable – what is observed at one point in time changes with time. People value gains and losses differently. Gains and losses display diminishing sensitivity, so the difference between $10 and $20 seems bigger than the difference between $1000 and $1010. People go to more trouble to save a small sum (e.g. $5) over a small purchase (e.g. $20) than saving a larger sum on a larger purchase, such as several hundred dollars on a house purchase (Camerer et al 2004 p 79).
 People assign value to gains and losses against reference points rather than final assets. So, someone may buy a share at $5, see it drop to $3, and stay there for long enough for the $3 to become the new reference point. They then feel a profit has been made at $4 because the reference point is now $3.
Thinking often anchors on an irrelevant reference point such as the spin of a wheel, a random number, unrelated fact, or a credit card minimum repayment rate lower than what is optimal for the consumer. Salespeople may offer consumers an expensive product which they do not expect to sell, since this creates an anchor against which consumers judge a lower cost product to be reasonably priced.
 Importance of framing Framing can alter perceptions of gain or loss. A “discount” is seen as a gain and a “surcharge” is seen as a loss even when they are financially neutral. For example when tested, the credit card industry has insisted that the difference between paying in cash or through a credit card be framed as a cash discount not a credit card surcharge. Were the wording the other way round the economic behaviours and outcomes would possibly be different. Framing influences how risk and uncertainty are perceived and managed. People will more often decline a medical operation framed as having a 10% failure rate than one with a 90% success rate, even though the risk is equivalent. Consumers will perceive differently foods advertised as “95% fat free” compared to “5% fat”.
Loss aversion, endowment effect and status quo bias
Individuals are loss averse (Kahneman et al 1991; Kahneman & Tversky 1984). This may explain why consumers are more responsive to price increases than price cuts. They place higher valuation on what they have, compared to what they may aspire to obtain (“a bird in the hand is worth two in the bush”). Experimentally, people reject 50:50 bets to lose $100 or gain $105.
People have a bias in favour of the status quo and current endowments (Thaler 1980). People use heuristic short-cuts, that is, simple rules of thumb enabling decisions to be made without going through complex, optimality-based analysis. “Hassles” matter, and people avoid them through short cuts. Some of these short cuts may be efficient, though non-optimal, however others may be maladaptive in the modern world.
People respond to cues or primes, many of which trigger “rule of thumb” heuristics. It is easier to draw on and apply familiar associations than to imagine counter-factuals. An availability heuristic can be employed to estimate frequency or probability by the ease with which familiar associations are brought to mind. The availability heuristic creates a bias favouring what is more memorable, vivid or emotionally charged. The “availability cascade” sees a collective belief become more plausible through its repetition in public discourse: “repeat something long enough and it will become true”. These heuristics are in turn related to the recognition heuristic, where if people have heard of something it must be for a reason, and so they favour this “something”.
Information and choice overload
People are vulnerable to information overload, and too many options reduce the likelihood that people will make a choice (see Schwartz, 2004). Iyengar et al (2004) show that employees’ participation in retirement savings plans drops as the number of fund options proposed by the employer increases. The number of options offered will influence the one chosen.
People tend to overestimate their abilities and this has consequences for individuals and whole economies. Associated with this, projection bias or false consensus bias refers to people over-estimating the likelihood of people acting in the same way as an individual. Bubbles arise partly because cognitive biases such as excessive self-confidence at the individual level aggregate into herding behaviour and major distortions. Over-confidence by investors, lenders and borrowers was one of many factors that caused the recent global financial crisis.
The confirmation bias means we privilege information that supports a pre-ordained theory. This bias can reinforce individual overconfidence. It is associated with hindsight bias where people exaggerate the prior predictability of an event after it has happened. Money illusion
Money illusion includes confusion over nominal versus real values, the illusion of free goods when costs are hidden and shifted to others, People may not notice a real wage decrease (e.g. due to inflation) so long as nominal wages don’t fall.
Consideration of sunk costs
People’s reluctance to accept they have made past bad decisions means they overvalue sunk costs, leading to “throwing good money after bad” problems.
Misunderstanding of probabilities and of risk
People overweight small probabilities, for example when they buy raffle tickets Assessment of probabilities may be distorted by false or irrelevant cues or associations. The “base rate fallacy” describes people focusing on particular data only rather than on all data bearing on a problem. An example is the roulette wheel in a casino. Some tables have displays which show the recent numbers the ball has landed on in the wheel. Some punters use this as a guide to predict what number or colour will come up next, often using the so called ‘trend’ as an indicator when of course the result of each spin of the wheel is independent of the previous spin.
People often prefer a small probability of winning a large prize over the expected value of that prospect. There is a tendency to make risk-averse choices if the expected outcome is positive, but to make risk-seeking choices to avoid negative outcomes (Tversky & Kahneman 1981).
Different mental accounts
The orthodox economic assumption is money is fungible, that is “a dollar is a dollar” regardless of whether it is held in cash, in a superannuation fund or in a property value. People have different mental accounts (Thaler, 1990; Thaler 1985),

Social norms and herding effects
Humans evolved as a social species where individuals depend on others for guidance. Social norms are created and reinforced by observations or cues signalling how society expects individuals to behave. When a transparent donation box is “primed” with $5 notes rather than coins people’s average donations will tend to follow this $5 average since a norm has been established. Negative norms shape individual behaviour: “when you live among wolves you have to be a wolf yourself.” If everyone else is littering, you might too. Negative social norms and peer pressure are difficult for individuals to escape because “to be a stranger among your own is to be alone among strangers,” and therefore excluded from wider social support. So, in deciding for example on a default provision a principle may be to align a default to a positive social norm. For example, organ donation may be a widely shared and positive social norm, and therefore this could become a default provision.
 Authority bias
People defer to authority figures, including politicians and popular celebrities. Authority figures influence social norms for good or bad: “fish go rotten from the head”. Related to this, government itself is seen as “authority”. Therefore, that something is lawful and regulated can imply that government has mandated it, thereby triggering authority bias and dissuading consumers from rigorous scrutiny of product offerings. Scarcity bias
The scarcity bias or heuristic (Brannon & Brock 2001) suggests people consider rare products to be of high value or quality.
Salience and vividness
The brain privileges first hand information over abstract symbols. People are over-responsive to rare but vivid and memorable events such as crimes, terrorism, plane crashes, and are under-responsive to less obvious, low salient events such as poor diet that erodes health over time. The cost of taking a taxi is obvious while the through-life cost of owning and running a car less so. It is common food industry practice to reduce package sizes rather than increase prices because a price rise is more obvious and more likely to reduce demand.
Lotto is popular because of the high salience of the jackpot compared to the low vividness of the minute probability of winning. Businesses may sell products/services by reducing the vividness of costs (e.g. “50 cents a day” rather than $182.50 a year, or “for the price of a cup of coffee a day”). They can also amplify vividness for marketing reasons. High pressure sales tactics exploit visceral factors and the vividness of urgency. So, “cooling off periods” are often required to allow reconsideration of purchases and to counter behavioural tendencies to make early decisions based on sellers contriving a sense of urgency. These cooling off periods may be ineffective because of such factors as the way default provisions are prescribed and procrastination.
Inferential cues
De Steno et al (2004) argue that persuasion is more successful when messages are framed with emotional overtones matching the consumer’s emotional state.
Social cues of intimacy, trust or reliability, and inferential techniques can be exploited in lawful but misleading ways. An example of an inferential technique is to associate cigarette smoking with sport, outdoors life, holidays or personal freedoms. Tobacco companies use brand names such as ‘Freedom’, ‘Holiday’ and ‘Horizon’ to trigger positive associations and distract attention from health risks.
 Present bias and discounted utility
In evolutionary times, ever-present danger and uncertainty over even short-term prospects made human psychology present-centred. It now means that people are likely to be hyperbolic discounters, in that they over-value the present.
People often procrastinate and if given a relatively longer time to complete a task will take longer to do so
Practical applications of behavioural psychology to consumer issues  Producers respond to consumer “needs” and also shape or create those needs through behavioural psychology. Retailers may reduce the perceived cost of a product by e.g. labelling it $2.99 rather than $3. They encourage purchase of excessive quantities by labelling a well stocked product as “limit of ten”. This tactic exploits several cognitive biases – the scarcity bias, a sense of urgency (“buy now before they are sold out”), and the anchoring on an upper limit as a target to aspire to (buying ten not one).

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