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Posts Tagged ‘Behavioural Economics’

Fifteen years have passed since a Nobel Prize in economics was awarded to Daniel Kahneman to this time (Fall 2017) when another leading researcher in behavioural economics, Richard Thaler, wins this honourable prize. Thaler and Kahneman are no strangers — they have collaborated in research in this field from its early days in the late 1970s. Moreover, Kahneman together with the late Amos Tversky helped Thaler in his first steps in this field, or more generally in meeting economics with psychology. Key elements of Thaler’s theory of Mental Accounting are based on the value function in Kanheman and Tversky’s Prospect theory.

In recent years Thaler is better known for the approach he devised of choice architecture and the tools of nudging, as co-author of the book “Nudge: Improving Decisions About Health, Wealth and Happiness” with Cass Sunstein (2008-9). However, at the core of the contribution of Thaler is the theory of mental accounting where he helped to lay the foundations of behavioural economics. The applied tools of nudging are not appropriately appreciated without understanding the concepts of mental accounting and other phenomena he studied with colleagues which describe deviations in judgement and behaviour from the rational economic model.

Thaler, originally an economist, was unhappy with predictions of consumer choice arising from microeconomics — the principles of economic theory were not contested as a normative theory (e.g., regarding optimization) but claims by economists that the theory is able to describe actual consumer behaviour and predict it were put into question. Furthermore, Thaler and others early on argued that deviations from rational judgement and choice behaviour are predictable.  In his ‘maverick’ paper “Toward a Positive Theory of Consumer Choice” from 1980, Thaler described and explained deviations and anomalies in consumer choice that stand in disagreement with the economic theory. He referred to concepts such as framing of gains and losses, the endowment effect, sunk costs, search for information on prices, regret, and self-control (1).

The theory of mental accounting developed by Thaler thereafter is already an integrated framework that describes how consumers perform value judgements and make choice decisions of products and services to purchase while recognising psychological effects in making economic decisions (2).  The theory is built around three prominent concepts (described here only briefly):

Dividing a budget into categories of expenses: Consumers metaphorically (but sometimes physically) allocate the money of their budget into buckets or envelopes according to type or purpose of expenses. It means that they do not transfer money freely between categories (e.g., food, entertainment). This concept contradicts the economic principle of fungibility, thus suggesting that one dollar is not valued the same in every category. A further implication is that each category has a sub-budget allotted to it, and if expenses in the category during a period surpass its limit, a consumer will prefer to give up on the next purchase and refrain from adding money from another category. Hence, for instance,  Dan and Edna will not go out for dinner at a trendy restaurant if that requires taking money planned for buying shoes for their child. However, managing the budget according to the total limit of income in each month is more often unsatisfactory, and some purchases can still be made on credit without hurting other purchases in the same month. On the other hand, it can readily be seen how consumers get into trouble when they try to spread too many expenses across future periods with their credit cards, and lose track of the category limits for their different expenses.

Segregating gains and integrating losses: In the model of a value function by Kahneman and Tversky, value is defined upon gains and losses as one departs from a reference point (a “status quo” state). Thaler explicated in turn how properties of the gain-loss value function would be implemented in practical evaluations of outcomes. The two general “rules”, as demonstrated most clearly in “pure” cases, say: (a) if there are two or more gains, consumers prefer to segregate them (e.g., if Chris makes gains on two different shares on a given day, he will prefer to see them separately); (b) if there are two or more losses, consumers prefer to integrate them (e.g., Sarah is informed of a price for an inter-city train trip but then told there is a surcharge for travelling in the morning — she will prefer to consider the total cost for her requested journey). Thaler additionally proposed what consumers would prefer doing in more complicated cases of “mixed” gains and losses, whether to segregate between the gain and loss (e.g., if the loss is much greater than the gain) or integrate them (e.g., if the gain is larger than the loss so that one remains with a net gain).

Adding-up acquisition value with transaction value to evaluate product offers: A product or service offer generally exhibits in it benefits and costs to the consumer (e.g., the example of a train ticket above overlooked the benefit of the travel to Sarah). But value may arise from the offering or deal itself beyond the product per se. Thaler recognised that consumers may look at two sources of value, and composing or adding them together would yield the overall worth of a product purchase offer: (1) Acquisition utility is the value of a difference between the [monetary] value equivalent of a product to the consumer and its actual price; (2) Transaction utility is the value of a difference between the actual price and a reference price. In the calculus of value, hides the play of gains and losses. This value concept was quite quickly adopted by consumer and marketing researchers in academia and implemented in means-end models that depict chains of value underlying the purchase decision process of consumers (mostly in the mid-1980s to mid-1990s). Thaler’s approach to ‘analysing’ value is getting more widely acknowledged and applied also in practice, as expressions of value as such in consumer response to offerings can be found in so many domains of marketing and retailing.

A reference price may receive different representations, for instance: the price last paid; price recalled from a previous period; average or median price in the same product class; a ‘normal’ or list price; a ‘fair’ or ‘just’ price (which is not so easy to specify). The transaction value may vary quite a lot depending on the form of reference price a consumer uses, ceteris paribus, and hence affect how the transaction value is represented (i.e., as a gain or a loss and its magnitude). Yet, it also suggests that marketers may hint to consumers a price to be used as a reference price (e.g., an advertised price anchor) and thus influence consumers’ value judgements.

We often observe and think of discounts as a difference between an actual price (‘only this week’) and a higher normal price — in this case we may construe the acquisition value and transaction value as two ways to perceive gain on the actual price concurrently. But the model of Thaler is more general because it recognizes a range of prices that may be employed as a reference by consumers. In addition, a list price may be suspected to be set higher to invoke in purpose the perception of a gain vis-à-vis the actual discounted price which in practice is more regular than the list price. A list price or an advertised price may also serve primarily as a cue for the quality of the product (and perhaps also influence the equivalent value of the product for less knowledgeable consumers), while an actual selling price provides a transaction value or utility. In the era of e-commerce, consumers also appear to use the price quoted on a retailer’s online store as a reference; then they may visit one of its brick-and-mortar stores, where they hope to obtain their desired product faster, and complain if they discover that the price for the same product in-store is much higher. Where customers are increasingly grudging over delivery fees and speed, a viable solution to secure customers is to offer a scheme of ‘click-and-collect at a store near you’. Moreover, when more consumers shop with a smartphone in their hands, the use of competitors’ prices or even the same retailer’s online prices as references is likely to be even more frequent and ubiquitous.


  • The next example may help further to illustrate the potentially compound task of evaluating offerings: Jonathan arrives to the agency of a car dealer where he intends to buy his next new car of favour, but there he finds out that the price on offer for that model is $1,500 higher than a price he saw two months earlier in ads. The sales representative claims prices by the carmaker have risen lately. However, when proposing a digital display system (e.g., entertainment, navigation, technical car info) as an add-on to the car, the seller proposes also to give Jonathan a discount of $150 on its original price tag.
  • Jonathan appreciates this offer and is inclined to segregate this saving apart from the additional pay for the car itself (i.e., ‘silver-lining’). The transaction value may be expanded to include two components (separating the evaluations of the car offer and add-on offer completely is less sensible because the add-on system is still contingent on the car).

Richard Thaler contributed to the revelation, understanding and assessment of implications of additional cognitive and behavioural phenomena that do not stand in line with rationality in the economic sense. At least some of those phenomena have direct implications in the context of mental accounting.

One of the greater acknowledged phenomena by now is the endowment effect. It is the recognition that people value an object (product item) already in their possession more than when having the option of acquiring the same object. In other words, the monetary compensation David would be willing to accept to give up on a good he holds is higher than the amount he would agree to pay to acquire it —  people principally have a difficulty to give up on something they own or endowed with (no matter how they originally obtained it). This effect has been most famously demonstrated with mugs, but to generalise it was also tested with other items like pens. This effect may well squeeze into consumers’ considerations when trying to sell much more expensive properties like their car or apartment, beyond an aim to make a financial gain. In his latest book on behavioural economics, ‘Misbehaving’, Thaler provides a friendly explanation with graphic illustration as to why fewer transactions of exchange occur between individuals who obtain a mug and those who do not, due to the endowment effect vis-à-vis a prediction by economic theory (3).

Another important issue of interest to Thaler is fairness, such as when it is fair or acceptable to charge a higher price from consumers for an object in shortage or hard to obtain (e.g., shovels for clearing snow on the morning after a snow storm). Notably, the perception of “fairness” may be moderated depending on whether the rise in price is framed as a reduction in gain (e.g., a discount of $2o0 from list price being cancelled for a car in short supply) or an actual loss (e.g., an explicit increase of $200 above the list price) — the change in actual price is more likely to be perceived as acceptable in the former case than the latter (4). He further investigated fairness games (e.g., Dictator, Punishment and Ultimatum). Additional noteworthy topics he studied are susceptibility to sunk cost and self-control.

  • More topics studied by Thaler can be traced by browsing his long list of papers over the years since the 1970s, and perhaps more leisurely through his illuminating book: “Misbehaving: The Making of Behavioural Economics” (2015-16).

The tactics of nudging, as part of choice architecture, are based on lessons from the anomalies and biases in consumers’ procedures of judgement and decision-making studied by Thaler himself and others in behavioural economics. Thaler and Sunstein looked for ways to guide or lead consumers to make better choices for their own good — health, wealth and happiness — without attempting to reform or alter their rooted modes of thinking and behaviour, which most probably would be doomed to failure. Their clever idea was to work within the boundaries of human behaviour to modify it just enough and in a predictable way to put consumers on a better track to a choice decision. Nudging could mean diverting a consumer from his or her routine way of making a decision to arrive to a different, expectedly better, choice outcome. It often likely involves taking a consumer out of his or her ‘comfort zone’. Critically important, however, Thaler and Sunstein conditioned in their book ‘Nudge’ that: “To count as a mere nudge, the intervention must be easy and cheap to avoid. Nudges are not mandates“. Accordingly, nudging techniques should not impose on consumers the choice of any designated or recommended options (5).

Six categories of nudging techniques are proposed: (1) defaults; (2) expect errors; (3) give feedback; (4) understanding “mappings”; (5) structure complex choices; and (6) incentives. In any of these techniques, the intention is to allow policy makers to direct consumers to choices that improve the state of consumers. Yet, the approach they advocate of ‘libertarian paternalism’ is not received without contention —  while libertarian, that is without coercing a choice, a question remains what gives an agency or policy maker the wisdom and right to determine which options should be better off for consumers (e.g., health plans, saving and investment programmes). Thaler and Sunstein discuss the implementation of nudging mostly in the context of public policy (i.e., by government agencies) but these techniques are applicable just as well to plans and policies of private agencies or companies (e.g., banks, telecom service providers, retailers in their physical and online stores). Nevertheless, public agencies and even more so business companies should devise and apply any measures of nudging to help consumers to choose the better-off and fitting plans for them; it is not for manipulating the consumers or taking advantage of their human errors and biases in judgement and decision-making.

Richard Thaler reviews and explains in his book “Misbehaving” the phenomena and issues he has studied in behavioural economics through the story of his rich research career — it is an interesting, lucid and compelling story. He tells in a candid way about the stages he has gone through in his career. Most conspicuously, this story also reflects the obstacles and resistance that faced behavioural economists for at least 25-30 years.

Congratulations to Professor Richard Thaler, and to the field of behavioural economics to which he contributed wholesomely, in theory and in its application.    

Ron Ventura, Ph.D. (Marketing)

Notes:

(1) Toward a Positive Theory of Consumer Choice; Richard H. Thaler, 1980/2000; in Choices, Values and Frames (eds. Daniel Kahneman and Amos Tversky)[Ch. 15: pp. 269-287], Cambridge University Press. (Originally published in Journal of Economic Behaviour and Organization.)

(2) Mental Accounting and Consumer Choice; Richard H. Thaler, 1985; Marketing Science, 4 (3), pp. 199-214.

(3) Misbehaving: The Making of Behavioural Economics; Richard H. Thaler, 2016; UK: Penguin Books (paperback).

(4) Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias; Daniel Kahneman, Jack L. Knetsch, & Richard H. Thaler, 1991/2000; in Choices, Values and Frames (eds. Daniel Kahneman and Amos Tversky)[Ch. 8: pp. 159-170], Cambridge University Press. (Originally published in Journal of Economic Perspectives).

(5) Nudge: Improving Decisions About Health, Wealth, and Happiness; Richard H. Thaler and Cass R. Sunstein, 2009; UK: Penguin Books (updated edition).

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From a consumer viewpoint, choice situations should be presented in a clear and comprehensible manner that facilitates consumers’ correct understanding of what is at stake and helps them to choose an alternative that fits most closely their needs or preferences. But policy makers may go farther and design choices to direct the decision-making consumers to a desirable or recommended alternative in their judgement.

It is very likely for Humans (unlike economic persons, or Econs) to be influenced in their decisions by the way a choice problem is presented; even if unintentional — it is almost unavoidable. Sometimes, however, an intervention to influence a decision-maker is done intentionally. Choice architecture relates to how choice problems are presented: the way the problem is organised and structured, and how alternatives are described, including tools or techniques that may be used to guide a decision-maker to a particular choice alternative. Richard Thaler and Cass Sunstein have called such tools ‘nudges’, and the designer of the choice problem is referred to as a ‘choice architect’. In their book, “Nudge: Improving Decisions About Health, Wealth and Happiness” (2009), the researchers were very specific, nonetheless, about the kinds of nudging they support and advocate (1). A nudge may be likened to a light push of a consumer out of his or her ‘comfort zone’ towards a particular choice alternative (e.g., action, product), but it should be harmless and left optional to consumers whether to accept or reject.

Thaler and Sunstein argue that in some cases more action is needed to ‘nudge’ consumers in a right direction. That is because consumers, as Humans, often do not consider carefully enough the choice situation and alternatives, they tend to err, and may not do what would actually be in their own best interest. It may be added that consumers’ preferences may not be well-established, and when these are unstable it could make it furthermore difficult for consumers to find an alternative that fits their preferences more closely. Hence, the authors recommend acting in a careful corrective manner that guides consumers towards an alternative that a policy maker assesses will serve them better (e.g., health-care, savings). Yet they insist that any intervention of nudging should not be imposed on the consumer. They call their approach ‘libertarian paternalism’ — a policy maker may tell consumers what alternative would be right for them but the consumer is eventually left with the freedom of choice how to act. They state that:

To count as a mere nudge, the intervention must be easy and cheap to avoid. Nudges are not mandates. Putting the fruit at eye level counts as a nudge. Banning junk food does not.

Thaler and Sunstein suggest six key principles, or types, of nudges: (a) Defaults; (b) Expect error (i.e., nudges designed to accommodate human error); (c) Give feedback (nudges reliant on social influence may be included here); (d) Understanding ‘mappings’ (i.e., a match between a choice made and its welfare outcome, such as consumption experience); (e) Structure complex choices; (f) Incentives. The authors discuss and propose how to use those tools in dealing with choice issues such as complexity and a status quo bias (inertia) (e.g., applied to student loans, retirement pensions and savings, medication plans).

Let’s look at some examples of how choice architecture may influence consumer choice:

A default may be set-up to determine what happens if a consumer makes no active choice (e.g., ‘too difficult to choose’, ‘too many options’) or to induce the consumer to take a certain action. Defaults can change the significance of opt-in and opt-out choice methods. A basic opt-in could ask a consumer to tick a box if she agrees to participate in a given programme. Now consider a slight change by pre-ticking the box as default — if the consumer does not like to join, she can uncheck the box (opt-out). A more explicit default and opt-out combination could state up-start (e.g., in a heading) that the consumer is automatically enrolled in the programme and if she declines she should send an e-mail to the organiser. If inclusion in a programme is the default, and consumers have to opt-out of the programme, many more will end-up enrolled than if they had to actively approve their participation. Yet the effect may vary depending on the ease of opting-out (just unchecking the box vs. sending a separate e-mail). Defaults of this type may be used for benign purposes such as subscription to a e-newsletter versus sensitive purposes like organ donation (2).

  • A default option is particularly attractive when the ‘alternative’ action is actually choosing from a long list of other alternatives (e.g., mutual and equity funds for investment).

Making a sequence of choice decisions is a recurring purchase activity. As a simple example, suppose you have to construct a list of items that you want to purchase (e.g., songs to compile, books to order) by choosing one item from each of a series of choice sets.  Presenting choice-sets in an increasing order of choice-set size is likely to encourage the chooser to enter a maximising mind-set — starting with a small set, it is easier to examine more closely all options in the set before choosing, and while the set size increases the chooser will continue trying to examine options more exhaustively. When starting with a large choice-set and decreasing the size thereon, the opposite happens where the chooser enters a simplifying or satisficing mind-set. Thus, over choice-sets, the chooser in an increasing order condition is likely to perform a deeper search and examine overall more options. As described by Levav, Reinholtz and Lin, consumers are “sticky adapters” (3). When constructing an investment portfolio, for instance, a financial policy maker may nudge investors to examine more of the funds, bonds and equities available by dividing them into classes to be presented as choice-sets in an increasing order of size (up to a reasonable limit).

Multiple aspects of choice design or architecture arise in the context of mass customization. Taking the case of price, a question arises whether to specify the cost of each level of a customized attribute (actually the price premium for upgraded levels vs. a baseline level) or the total price of the final product designed. A proponent opinion argues that providing detailed price information for levels of quality attributes allows consumers to consider the monetary implications of choosing an upgraded level on each attribute. It is not as difficult as trying to extract the marginal cost of a level chosen on each quality attribute from the total price. Including prices for levels of quality attributes leads consumers to choose more frequently intermediate attribute levels (compared with a by-alternative choice-set)(4). A counter opinion posits that carefully weighing price information on each attribute is not so easy (consumers report higher subjective difficulty), actually causing consumers to be too cautious and configure products that are less expensive but also of lower quality. Hence, providing a total price for the outcome product could be sufficient and more useful for the customers (5). It is hard to give any conclusive design suggestion in this case.

In a last example, the form in which calorie information is provided on restaurant menus matters no less than posting it. As a recent research by Parker and Lehmann shows, it is practically possible to be over-doing it (6). Consistent with other studies, the researchers find that when posting calorie figures next to food dishes, consumers choose from the calorie-posted menu items with lower calorie content on average than from a similar traditional menu but with no calorie figures. Separating low-calorie items from their original categories of food type (e.g., salads, burgers) into a new group, as some restaurants do, may eliminate, however, the advantage of calorie-posting. While the logic of a separate group is that it would make the group more conspicuous and easier for diners to attend to it, it could make it easier for them instead to exclude those items from consideration. Nevertheless, some qualification is needed as the title given to the group also matters.

Parker and Lehmann show that organising the low-calorie items in a separate group explicitly titled as such (e.g., “Low Calories”, “Under 600 Calories”) attenuates the posting effect, thus eliminating the advantage of inducing consumers to order lower-calorie items. The title is important because it is easier this way for consumers to screen out this category from consideration (e.g., as unappealing on face of it). It is demonstrated that giving a positive name unrelated to calories (e.g., “Eddie’s Favourites”, “Fresh and Fit”) would generate less rejection and make it no more likely to be screened out as a group than other categories. In a menu that is just calorie-posted, consumers are more likely to trade-off the calories with other information on a food item such as its composition and price. But if the consumers are helped to screen the low-calorie group as a measure of simplifying their decision process in an early stage, it means they would also ignore their calorie details.

  • An additional explanation can be suggested for disregarding the low-calorie items when grouped together: If those items are mixed in categories of other items similar to them in type of food, each item would stand-out as ‘low calorie’ and be perceived as different and more important. If the low-calorie items are aggregated on the other hand in a set-aside group, they are more likely to be perceived as of diminished importance or appeal collectively and be ignored together. (cf. [7]). Therefore, creating a separate group of varied items pulled out from all the other groups sends a wrong message to consumers and may nudge them in the wrong direction.

Both public and private policy makers can use nudging. But there are some limitations deserving attention especially with regard to private (business) policy makers. Companies sometimes act out of belief that in order to recruit customers they should present complex alternative plans (e.g., mobile telecoms, insurance, bank loans), which includes obscuring vital details and making comparisons between alternatives very difficult. They see nudging tools that are meant to reduce complexity of consumer choice as playing against their interest (e.g., if choice is complex it will be easier for the company to capture [trap-in] the customer). That counters the intention of Thaler and Sunstein, and they stand against this kind of practice.

In the case of helping customers to see more clearly the relation, and match, between their patterns of service usage and the cost they are required to pay, Thaler and Sunstein propose a nudge scheme called RECAP — Record, Evaluate, and Compare Alternative Prices. The scheme entails publishing in readily accessible channels (e.g., websites) full details of their service and price plans as well as provide existing customers periodic reports that show how their level of usage on each component of service contributes to total cost. These measures that increase transparency would help customers understand what they pay for, monitor and control their costs, and reconsider from time to time their current service plan vis-à-vis alternative plans of the same provider and those of competitors. The problem is that service providers are usually reluctant to hand over such detailed information from their own good will. Public regulators may have to require companies to create a RECAP scheme, or perhaps nudge them to do so.

In the lighter scenario, companies prefer to avoid nudging techniques that work in the benefit of consumers because of concern it would hurt their own interests. In the worse scenario, companies misinterpret nudging and use tools that actively manipulate consumers to choose not in their benefit (e.g., highlight a more expensive product the consumer does not really need). Thaler and Sunstein are critical of either public or private (business) policy makers who conceive and apply nudges in their own self-interest. They tend to dedicate more effort, however, to counter objections to government intervention in consumers’ affairs and popular suspicions of malpractice by branches of the government (i.e., these issues seem to be of major concern in the United States that may not be fully understood in other countries). Of course it is important not turn a blind eye to harmful usage of nudges by public as well as private choice architects.

There are many opportunities in cleverly using nudging tools to guide and assist consumers. Yet there can be a thin line between interventions of imposed choice and free choice or between obtrusive and libertarian paternalism. Designing and implementing nudging tools can therefore be a delicate craft, advisably a matter primarily for expert choice architects.

Ron Ventura, Ph.D. (Marketing)

Notes:

(1) “Nudge: Improving Decisions About Health, Wealth and Happiness”; Richard H. Thaler and Cass R. Sunstein, 2009; Penguin Books (updated edition).

(2) Ibid 1, and: “Beyond Nudges: Tools of Choice Architecture”; Eric J. Johnson and others, 2012; Marketing Letters, 23, pp. 487-504.

(3) “The Effect of Ordering Decisions by Choice-Set Size on Consumer Search”; Jonathan Levav, Nicholas Reinholtz, & Claire Lin, 2012; Journal of Consumer Research, 39 (October), pp. 585-599.

(4) “Contingent Response to Self-Customized Procedures: Implications for Decision Satisfaction and Choice”; Ana Valenzuela, Ravi Dahr, & Florian Zettelmeyer, 2009; Journal of Marketing Research, 46 (December), pp. 754-763.

(5) “Marketing Mass-Customized Products: Striking a Balance Between Utility and Complexity”; Benedict G.C. Dellaert and Stefan Stremersch, 2005; Journal of Marketing Research, 42 (May), pp. 219-227.

(6) “How and When Grouping Low-Calorie Options Reduces the Benefits of Providing Dish-Specific Calorie Information”; Jeffrey R. Parker and Donald R. Lehmann, 2014; Journal of Consumer Research, 41 (June), pp. 213-235.

(7) Johnson et al. (see #2).

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