Lecture unit 2: Consumer decision making

Question 1

:

What is decision making?

Answer 1

• can be defined as selecting one option from a set of possible options
• The choice made has consequence for the individual that makes the decision
• Both social and cognitive factors influence the decision

Question 2

What is risky and risk-free decision making?

Answer 2

Risky: involves a degree of uncertainty about the consequences of a decision

Risk-free:: all the consequences of the decision are known with certainty

Question 3

What does the expected utility theory state? (people choose the option that..)

Answer 3

in decision making, people choose the option that maximises the expected utility for them

–>E(u)= prob. * utility of the outcome

Question 4

When is a individual risk-averse inn context of a gamble?

Answer 4

If an individual strictly prefers a sure thing to a gamble with the same expected utility, we call this individual risk averse

Question 5

What will an expected utilitiy maximizer choose?

Answer 5

An expected utility maximizer will choose the gamble that maximizes its utility

Question 6

What are the assumption of expected utility theory?

Answer 6

assumes that…
- expected utility is linear in probabilities
- preferences are related to wealth rather than gains and losses

Question 7

What are the objective of the prospect theory?

Answer 7

• llustrate violations of expected utility theory and
• develop a set of empirical regularities that inform the development of prospect theory

Question 8

What is the difference between prospect theory and expected utility theory? (From the view of prospect theory)

Answer 8

• Replaces the notion of utility with value (in terms of gains and losses)
• Argues that two phrases are involved in the decision making process

Question 9

What are the two phases of the prospec theory decison making process?

Answer 9

1.Editing phase:
- the decision problem is represented
- Information perceived as unimportant is discarded.
- A reference point is established and
- the outcomes of the possible options are represented as possible gains and losses

2.Evaluation phase:
- The potential choices are evaluated, using
preconceived attitudes towards risk, gains and losses

Question 10

What are the features of prospect theory? (Name all 7)

Answer 10

• Certainty:
• Small Probabilities:
• Relative Positioning:
• Loss Aversion:
• Diminishing sensitivity
• reference point
• Framing effect:

Question 11

Can you explain these 3 features of prospect theory: certainty, small probabilitites and relative positioning?

Answer 11

• Certainty: Outcomes with certainty are preferred over probable ones (people underweight outcomes that are merely probable)
• Small Probabilities: Very unlikely events are given disproportionate weight (p tend to give unjustified wweight to unlikly events)
• Relative Positioning: Risk perception changes whether the outcome is as a gain or a loss (p respond differently whether it is a loss or a gain)

Question 12

Can you explain these 3 features of prospect theory:
- loss aversion,
- diminishing sensitivty
- reference point and
- framing effect?

Answer 12

• Loss Aversion:Losses impact individuals more strongly than equivalent gains
• Diminishing sensitivity as losses or gains mount ( gain from 100 to 200 greater than from 1100 to 1200)
• People think in terms of expected utility relative to a reference point (e.g. current wealth) rather than absolute outcomes
• Framing effect: risk aversion in the positive frame vs. risk seeking in the negative frame

Question 13

What is the natural of people according to prospect theory?

Answer 13

People are naturally conservative in their decision making: averse to risk and averse to loss!

Question 14

What is the intuition between the change of risk behavior when considering gains and losses?

Answer 14

• When it comes to gains: people do not want to take any risk.
• When it comes to losses people suddenly become risk takers.

Question 15

What is the shape of the lines in the two areas of the value function?

Answer 15

Gains:
- value function is concave (Bogen links)
- DM will be risk averse

Losses:
- value function is convex (Schwanger)
- DM are risk seeking

Question 16

What is meant with the framing effect in prospect theory?

Answer 16

refers to the fact that people’s decision making is often influenced by irrelevant details given in a scenario

Prefer positive framing (95% chance of surviving) over negative framing (5% chance of dying)

Question 17

Framing effect: Example with Programm A to D?

Answer 17

The only difference between the groups is how the decision is framed: Programmes A and B are positively framed whereas programmes C and D are negatively framed

These results demonstrate the asymmetry between gain and loss scenarios that is assumed by prospect theory

Question 18

What does mental accounting describe ? [ process]

Answer 18

Describes the process how individuals code, categorize and evaluate economic outcomes

(people often create mental accounts in their types for different types, might treat a 100€ gift card different from 100€ in cash)

Question 19

What does mental accounting theory say and how does Thaler define mental accounting?

Answer 19

Mental Accounting Theory developed by Thaler (1985):

• individuals hark back to “mental” accounts, on which they save and retain “gains” and “losses”
• defined “mental accounting” as the tendency to assign different values to money based on its source, where it’s stored, and how it’s spent

–>It is an extension of prospect theory

Question 20

What says the mental accounting theory about the pricing components of customers?

Answer 20

• customers integrate price components (the price components are first passed to a “mental account” before the overall assessment is derived) or
• segregate price components (the price components are first assessed before the partial assessments are aggregated to an overall assessment)

Question 21

Why did the mental accounting theory gain attention in pricing?

Answer 21

• theory allows marketers to evaluate price components and pricing strategies

Question 22

What does prospect theory say about multiple losses?

Answer 22

• convex shape of the value function in the loss area, means that multiple losses are less unpleasant, when the losses are integrated

–>diminishing marginal losses, when the losses are integrated (combined)

Question 23

What does prospect theory say about multiple Gains?

Answer 23

• concave shape of the value function in the profit area,
• means that multiple gains lead to a higher gratification (diminishing marginal gains), when the gains are segregated ->Splitted

Question 24

Important to consider the integration and segregation of losses and gains in pricing?

Example: Price 3.000, and potential discounts; what should happen with the price, discounts: Seggregate or integraate?

Answer 24

• Seggregate gains (splitt)
• Integrate losses (combine)

–>Price 3.000
- Discount: 50
- Discount on sports program: 100
= 2800 final price

The presentation of the overall price should be integrated but discounts segregated

Question 25

Prospec theory: What does hedonic editing say about mixed gains?

Answer 25

• Customer perceive positive as well as negative price experiences whereas the positive price experience dominates
• Integrate smaller losses with larger gains
• Integration is preferred to segregation

Question 26

Prospec theory: What does hedonic editing say about mixed losses?

Answer 26

• When negative price experiences dominate, it is not possible to determine explicitly whether segregation is preferred to integration or vice versa
• the individuall shape of V(x) and relative height of partial losses determines the advantageousness of integration or segregation
• segregate small gains from larger losses

Question 27

What does prospect theory: say about relevance of previous gains and losses?

Answer 27

Previous losses can lead to…
- throwing good money after bad (sunk costs)
- people taking on risks they otherwise wouldn’t (breakeven ffect)

Previous gains can lead to
- increased risk-taking (house money effect)
- increased spending/decreased saving (windfalls, funny money)