Summary by James R. Martin, Ph.D., CMA
Professor Emeritus, University of South Florida
Behavioral Issues and Culture Main Page |
Economics Main Page
In this paper Richard Thaler develops of a new model of consumer behavior using cognitive psychology and microeconomics. It starts with the mental coding of gains and losses using the prospect theory value function. This is followed by the evaluation of purchases using the concept of transaction utility. Finally the household budgeting process is incorporated and several implications of the model are discussed related to marketing in the area of pricing.
Introduction
The article begins with four behavioral situations where a mental accounting system causes an individual to violate the principle of fungibility. For example, a man declines to purchase an expensive cashmere sweater for himself, but accepts it as a gift from his wife who shares a joint bank account.
Research has indicated that many variables fall into the category of framing, i.e., choices depend on how a problem is presented. Prospect theory was developed to predict behavior where framing is involved. An example includes when consumers pay attention to sunk cost when they should ignore them and underweight opportunity costs as compared to out-of-pocket costs.
Mental accounting as developed in this paper includes a value function that replaces the usual utility function of economics. It also includes a reference price in the value function to form a concept of transaction utility. Finally, the principle of fungibility is relaxed and numerous marketing implications of the theory are derived.
Mental Arithmetic
The value function is defined over perceived gains and losses, and framing effects influence choices. The value function is assumed to be concave for gains and convex for losses, and the loss function is steeper than the gain function. In other words, losses loom larger than gains. This is referred to as a loss aversion in several other papers.
Coding Gains and Losses
When there are compound outcomes, the question of how to code the joint outcomes arises. For example, there could be multiple gains, multiple losses, mixed gain, or mixed loss.
Evidence on Segregation and Integration
The evidence shows the analysis can be summarized by four principles: Segregate gains, integrate losses, cancel losses against larger gains, and segregate silver linings (large loss and small gain). These four principles were tested with an experiment conducted using 87 students in an undergraduate statistics class at Cornell University. There were four pairs of scenarios for Mr. A and Mr. B and the students were to judge which man was happier with the result. For example, Mr. A was given tickets to lotteries involving the World Series. He won $50 in one lottery and $25 in the other. Mr. B was given a ticket to a single, larger World Series lottery and won $75. The results indicated that 56 students said Mr. A was happier, 16 Chose Mr. B and 15 said there was no difference. For each scenario the large majority made choices that were predicted by the theory.
Transaction Utility Theory
The next step in the analysis is to use the value function to analyze transactions. This involves a two stage process. Individuals evaluate potential proposals, and then approve or disapprove of each transaction. Two kinds of utility are relevant including acquisition utility and transaction utility.
The measure of transaction utility depends on the price the individual pays p compared to some reference or fair price, p*. The acquisition utility is the value of the compound outcome, i.e., the value of paying p when the reference price is p*. The total utility from a purchase is the sum of the acquisition utility and transaction utility.
Transaction Utility Implications
The author uses transaction utility to explain sellouts and scalping. According to economic theory, prices adjust over time until supply equals demand, but some markets fail to clear. One example is the labor market where unemployment coexist with wages that are not falling. The price (wage) is too high. In some other markets prices are too low. Tickets to the Super Bowl, World Series, and World Cup provide examples. The concept of transaction utility provides an explanation for the over and underpricing in these examples. The market clearing price is much higher or lower than a well-established normal reference or fair price. There is a great deal more in this section for those who want more explanation.
Budgeting Implications: A Theory of Gift Giving
Patterns of gift giving support the current theory. The standard economic theory implies that a gift giver should choose something that is already consumed by the recipient. But survey evidence shows that many people do the opposite and choose something that the recipient would not buy for hereself, i.e., a box of expensive candy, cut flowers, or an expensive bottle of wine. The implication is that expensive items should be marketed as potential gifts.
Conclusion
The theory developed in this paper represents a hybrid of economics and psychology. New concepts were developed in three areas: coding gains and losses, evaluating purchases (transaction theory), and budgetary rules.
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* This is a reprint of Thaler, R. H. 1985. Mental accounting and consumer choice. Marketing Science 4(3): 199-214.
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