behavioural economic ananlysis of decision making

8/12/2019 Behavioural Economic Ananlysis of Decision Making

1/107

BEHAVIOURAL ECONOMIC ANALYSIS OF DECISION MAKING:

A CASE OF MARKETING

by

Zhang Yu

Submitted in partial fulfillment of the requirements

for the degree of Master of Arts

at

Dalhousie University

Halifax, Nova Scotia

April 2007

Copyright by Zhang Yu, 2007

roduced with permission of the copyright owner. Further reproduction prohibited without permission.


2/107

1*1Library and

Archives Canada

Published HeritageBranch

Bibliotheque etArchives Canada

Direction duPatrimoine de I'edition

395 Wellington StreetOttawa ON K1A0N4Canada

395, rue WellingtonOttawa ON K1A 0N4Canada

Your file Votre reference

ISBN: 978-0-494-26887-2

Our file Notre reference

ISBN: 978-0-494-26887-2

NOTICE:

The author has granted a non-

exclusive license allowing Library

and Archives Canada to reproduce,publish, archive, preserve, conserve,

communicate to the public by

telecommunication or on the Internet,

loan, distribute and sell theses

worldwide, for commercial or non-

commercial purposes, in microform,

paper, electronic and/or any other

formats.

AVIS:

L'auteur a accorde une licence non exclusive

permettant a la Bibliotheque et Archives

Canada de reproduire, publier, archiver,sauvegarder, conserver, transmettre au public

par telecommunication ou par I'lnternet, preter,

distribuer et vendre des theses partout dans

le monde, a des fins commerciales ou autres,

sur support microforme, papier, electronique

et/ou autres formats.

The author retains copyrightownership and moral rights in

this thesis. Neither the thesis

nor substantial extracts from it

may be printed or otherwise

reproduced without the author's

permission.

L'auteur conserve la propriete du droit d'auteuret des droits moraux qui protege cette these.

Ni la these ni des extraits substantiels de

celleci ne doivent etre imprimes ou autrement

reproduits sans son autorisation.

In compliance with the Canadian

Privacy Act some supportingforms may have been removed

from this thesis.

While these forms may be included

in the document page count,

their removal does not represent

any loss of content from the

thesis.

Conformement a la loi canadienne

sur la protection de la vie privee,quelques formulaires secondaires

ont ete enleves de cette these.

Bien que ces formulaires

aient inclus dans la pagination,

il n'y aura aucun contenu manquant.

i * i

Canadaroduced with permission of the copyright owner. Further reproduction prohibited without permission.


3/107

DALHOUSIE UNIVERSITY

To comply with the Canadian Privacy Act the National Library of Canada has requested

that the following pages be removed from this copy of the thesis:

Preliminary Pages

Examiners Signature Page (pii)

Dalhousie Library Copyright Agreement (piii)

Appendices

Copyright Releases (if applicable)



4/107


5/107

4.1.3 Anchoring and Adjustment.................................................................................46

4.2 Prospect Theory...........................................................................................................51

4.3 Reference Dependence and Loss Aversion...............................................................

58

4.3.1 Framing Effect.....................................................................................................58

4.3.2 Endowment Effect...............................................................................................60

4.3.3 Mental Accounting..............................................................................................63

Chapter 5: Prospect Theory and Extensions: Evidence from Marketing..........................

68

5.1 Asymmetric Price Elasticities of Consumer Goods ..................................................70

5.2 Exclusion versus Inclusion Option-Framing for Consumer Choice....................... 73

5.3 The Endowment Effect of Retail Purchase and Direct Marketing ......................... 76

5.4 Mental Accounting, Preferences States and Framing Effect in Price Changes 78

Chapter 6: Conclusion.............................................................

References..............................................................................................................................87

v



6/107

LIST OF TABLES

Table 4.1: Preferences between Positive and Negative Gambles........................................

54

Table 5.1: The Field Phenomena Consistent with Prospect Theory...................................69

Table 5.2: Design Summary..................................................................................................80

vi



7/107

LIST OF FIGURES

Figure 4.1: The Value Function.............................................................................................

56

Figure 4.2: The Weighting Function......................................................................................57

produced with permission of the copyright owner. Further reproduction p rohibited without permission.


8/107

ACKNOWLEDGEMENTS

First of all, I would like to thank my supervisor, Professor Kuan Xu, for his patientand knowledgeable guidance. Without his support and encouragement, this thesis would

not be finished. I also would like to thank Professors Melvin Cross and Yulia Kotlyarova

for their insightful suggestions and valuable corrections. In addition, thank you to my

friends for their help and encouragement. Finally, I would mostly thank my parents for

their enduring love and strong support during my graduate studies in Canada.

viii



9/107

ABSTRACT

Economics and psychology are both sciences that have the common goal of

studying human behaviour. These two disciplines have a close relationship. However, the

concept that psychology is an integral part of economics was not considered by

mainstream economists in the first half of the twentieth century. However, many scholars

found that some anomalies that occur in economic life cannot be explained by

conventional economic theories. Because of this, the emergence of behavioural

economics provides realistic psychological foundations to enhance the explanatory power

of economics. Behavioural economics is a growing discipline that combines economics

with psychology. This discipline has been successfully applied to many areas, such as

macroeconomics, labor economics, finance and marketing in the recent past.

This thesis first introduces the development of behavioural economics and reviews

three basic themes: Heuristics and Biases, Prospect Theory, Reference Dependence and

Loss Aversion, and then explores how these three basic ideas of behavioural economics,

especially prospect theory, can be applied to the firms decisions in marketing. The

purpose of the thesis is to draw the attention of economists to this new field and

encourage scholars and marketers to better understand behavioural economics and apply

its tools in research.

ix



10/107

CHAPTER 1

Introduction

Behavioural economics is a new field of economics that combines economics and

psychology (Mullainathan and Thaler, 2000). Economics and psychology are both

sciences that study human behaviour. Although they have a common theme, classical

economics has not incorporated many psychological factors into the analysis of human

behaviour. In classical economics, the individual is regarded as homo economicus or

economic man. Homo economicus is completely rational and selfish when he or she

makes decisions and his or her tastes do not change. The assumption of homo

economicus is too ideal. As Kahneman said in 2003, no one ever seriously believed that

all people have rational beliefs and make rational decisions all the time (Kahneman,

2003). Many scholars questioned this assumption and many empirical studies found that

their results are inconsistent with economic predictions. Consequently, the assumption of

homo economicus has been increasingly criticized and the belief of economics as Queen

of the Social Science has been challenged. These questions and critiques lead to the

emergence of a new field Behavioural Economics (Frey and Benz, 2002). Unlike

classical economics, behavioural economics applies psychological insights to economic

analysis so that it could increase the explanatory power of economics (Camerer and

Loewenstein, 2004).

1



11/107

Behavioural economics modifies the assumptions of classical economics, such as

rationality and selfishness, in various economic theories, such as the expected utility

theory, social utility, revealed preference theory and so forth. Theories in behavioural

economics have successfully solved many anomalies (e.g. asymmetric price elasticity

(Hardie, Johnson, Fader, 1993) and equity premium puzzle (Benartzi and Thaler, 1995))

which cannot be explained by assumptions of classical economic theories. Although

behavioural economics has not yet been widely accepted by mainstream economists, so

far it has also been fruitfully applied to finance1, macroeconomics, labor economics and

law.

The definition of marketing is a controversial topic. But different definitions

represent a common belief that marketing is a discipline of studying how individuals and

firms facilitate and expedite exchanges in markets (Pride and Ferrell, 1977). In other

words, marketing is an applied science that studies consumer and firm behaviour in

markets. It has the same goal as behavioural economics. In addition, economics and

psychology are the two most influential foundations for marketing (Ho, Lim and Camerer,

2006). Unfortunately, the relevant works that studied how the opinions from behavioural

economics can be used in marketing practices are relatively few.

1 When I finished this thesis, the book Behavioural Economics and Its Applications written by Peter

Diamond and Hannu Vartiainen will be published in April 2007. In this book, Diamond and Vartiainen

think behavioural economics was successfully applied to only one field of applied economics finance.

However, this thesis found a different opinion that behavioural economics has not merely been applied to

finance, but also has been used to analyze marketing.

2



12/107

This thesis has two purposes. One is to review this new field by introducing the

development of behavioural economics and its basic themes. Behavioural economics and

its applications have been a growing literature. This thesis focuses only on three main

themes: Heuristics and Biases, Prospect Theory and Reference Dependence and Loss

Aversion.

Another purpose of this thesis is to apply behavioural economic analysis to firms

decision, in particular the decision making in marketing. Marketing is an action of firms

to increase the awareness of the public about the goods and services so that this action

can affect client behaviour and the sales of goods and services. Behavioural economics

studies decision making of individual firms and consumers. As a result, how behavioural

economics can be used to analyze marketing is an interesting and meaningful issue. This

issue has not attracted too much attention from scholars.

The rest of the thesis is organized as following. Chapter 2 will briefly introduce the

history of behavioural economics and the relationship between economics and

psychology. Chapter 3 will discuss the psychological foundations for behavioural

economics and state the challenges for the assumptions of classical economics so that it

provides the reader with an overview of psychological underpinnings of economic

behaviour. Chapter 4 will illustrate three basic themes of behavioural economics:

3



13/107

Heuristics and Biases; Prospect Theory; and, Reference Dependence and Loss Aversion.

Chapter 4 will also discuss some applications of Heuristics and Biases in marketing

practices. Because Reference Dependence and Loss Aversion is considered an extension

theory of Prospect Theory, Chapter 5 will focus on prospect theory and its applications in

marketing practices. Chapter 6 will provide some conclusions including the limitations of

this thesis and future research.

4



14/107

CHAPTER 2

A Brief History of Economics and Psychology

In a history that spans more than one century, behavioural economics has

significantly contributed to progress in economic research. In fact, the relationship

between economics and psychology is close. Some scholars thought that most of the

ideas in behavioural economics are not new (Camerer, 1999; Camerer and Loewenstein,

2004). But its course of unification of economics and psychology has been arduous. This

chapter is intended to provide readers with a brief history of psychology and economics.

The roots of behavioural economics can be traced back to three centuries ago.

Adam Smith, the founder of modem economics, mentioned psychology in his book

entitled The Theory o f Moral Sentiments. This book refers to psychology of human

behaviour, some of which signifies current developments in behavioural economics

(Camerer and Loewenstein, 2004). For example, Adam Smith commented (1759/1892,

311) that we suffer more.. .when we fall from a better to a worse situation, than we ever

enjoy when we rise from a worse to a better.(Camerer and Loewenstein,2004). Smiths

view implicitly reflects the nature of Loss Aversion that is a basic theme in behavioural

economics. In 1776, Adam Smith wrote the second of his famous books, The Wealth o f

Nations. But in this book, the content of psychology receives much less attention.

5



15/107

French social psychologist Gabriel Tarde wrote Za Psychologie Economique in

1881 which was published in 1902. In this work, he claimed that he was the person who

first applied psychology to economic theories. In Tardes opinion, it was regrettable that

Adam Smith described psychology of human beings in Theory o f Moral Sentiments

(1759) but did not utilize psychological insights in his book The Wealth o f Nations

(Wameryd, 1988). However, Reynaud (1964) disagrees with Tardes claim, and believes

that there were some attempts to combine economics and psychology long before Tarde

(Wameryd, 1988).

Jeremy Bentham (1789), an early advocate of Utilitarianism, argued that utility

could be measured by means of a persons happiness. The greatest happiness principle

which he advocated is regarded as the core of the utilitarian moral theory for determining

individuals level o f utility. In addition, Benthams utility concept is considered important

in forming the foundation of classical economics (Loewenstein 1999). Edgeworths

Theory o f Mathematical Psychics (1881) introduced a simple social utility model in

which one individuals utility is influenced by another persons payoff (Camerer and

Loewenstein, 2004). Edgeworth also wanted to measure utility in terms of cardinal

numbers. But the concept of measurable cardinal utility was questioned by Robbins

(1932). Later, the cardinal utility was replaced with a preference index of ordinal utility

which can be represented by the indifference curves. From then on, the content of

psychology in economics was gradually neglected by economists.

6



16/107

Why did classical economics ignore psychology? The answer is that most

economists thought psychology provided an unsteady foundation for economic reasoning

(Camerer and Loewenstein, 2004). To make economics more general and accurate,

economists, like Samuelson, Arrow, and Debreu, strived for presenting and interpreting

economic problems in the form of mathematics (Camerer, 1999). This approach to

economics was widely acclaimed and has been successfully applied in numerous

empirical studies. Perhaps this might be the reason economics was once termed by some

as imperialism (Frey and Benz, 2002).

Since 1940s, George Katona in the U.S. introduced economic psychology, and

began to use psychological theories and methods to solve economic problems (Wameryd,

1988). Later, Allais (1953) and Ellsberg (1961) proposed famous Allais paradox and

Ellsberg paradox which document the inconsistency with the predictions of expected

utility and subjective expected utility. Although these studies attracted more attention,

they did not change most economists attitudes for adopting psychological concepts in

economics (Camerer and Loewenstein, 2004).

Over the years, researchers, such as Amos Tversky, Daniel Kahneman, Richard

Thaler, Matthew Rabin, Colin Camerer, George Loewenstein and others have criticized

some axioms in classical economic models as psychologically unrealistic (Rabin, 2001).

7



17/107

Particularly, these scholars began to use economic models as a benchmark against which

to contrast their psychological models (Camerer and Loewenstein, 2004). Their famous

works on Heuristics and Biases (Kahneman and Tversky, 1974), Prospect theory

(Kahneman and Tversky, 1979), Framing Effect (Kahneman and Tversky, 1981), and

Mental Accounting (Thaler, 1980) cause surprising impacts on economics. These authors

provide strong evidences against classical economics and add psychological concepts to

economic theories to strengthen the realism of economic theory. Furthermore, it is worth

noting that two Nobel Prizes in economics were awarded to two psychologists: Herbert

Simon in 1978 and Daniel Kahneman in 2002. This indicates that the importance of

psychology in economics has been acknowledged by mainstream economists.

Now, the applications of psychological concepts to economic research have been

widely noted and accepted. The synthesis of economics and psychology is referred to

psychological economics or economic psychology (behavioural economics).

Wameryd (1988) noted that, at first, Katona vacillated between the concepts of

economic psychology and psychological economics. He tended to use these two terms

interchangeably, but he named his book Psychological Economics published in 1975.

Later, Katona used Behavioural Economics as the title of another book of his. He

thought behavioural economics is the most appropriate heading for the field of study.

8



18/107

Earl (2005) discusses the above question in detail. Between two names: economic

psychology and psychological economics, many scholars would choose the former or use

both interchangeably. But Earl thought economists and psychologists may have quite

different attitudes for such a synthesis. They define it depending on which discipline

plays the main role in their relationship. In what follows, there are three different

definitions:

Firstly, from economists perspectives, they may prefer the term of economic

psychology. They do not regard psychology as an integral part of economic theory.

Therefore, economists would like to use psychological factors as a condition of

constrained optimization or in game theoretic terms. In psychologists opinions, they may

also choose the title economic psychology but its interpretation is different from the

same term which economists define. Psychologists think that economic elements are

designed to be the incentive systems for changing the behaviour of children or explaining

human responses in experiments in behavioural psychology.

Secondly, unlike economic psychology, behavioural economics or psychological

economics challenge the assumptions of classical economics which exclude ideas from

psychology. Furthermore, it borrows ideas from psychology to describe the real economic

behaviours which can not be easily explained by classical economic theories. By adding

psychological concepts to economic study, behavioural economics can predict economic

9



19/107

behaviours more accurately. The emergence of behavioural economics narrows the gap

between economic theories and real economic life.

Thirdly, some scholars thought the relationship between psychology and economics

is reinforcing each other. In Raaij, van Veldhoven and Wameryds opinions, scholars

ought not to over emphasize the differences between the two terms. Generally,

psychologists are inclined to economic psychology because it is closer to psychology,

while economists favor behavioural economics since it seems closer to economics. In

addition, economic psychology is more widely accepted in Europe, whereas the

behavioural economics is more widely spread in the U.S (Van Raaij, Van Veldhoven and

Wameryd, 1989).

Presently, more scholars prefer behavioural economics over psychological

economics as the definition of this field. Overall, in the history of behavioural economics,

behavioural economics as a new field has been developing at a rapid speed due to these

scholars hard work. More economists acknowledged the importance of psychology in

economic theories, for example, Robin (2002) pointed out that George Akerlof (1970)

and Robert Locus (1972) have simultaneously been innovators in classical economics.

Their works on asymmetrical information and rational expectations modify classical

economic theories to become more accurate and realistic. Papers which refer to

behavioural economics or integrating psychology into economics have been published in

10



20/107

top economic journals. Recently, some economic textbooks also have covered this field

(see Varian, 2006 and Frank, 2007).

11



21/107

CHAPTER 3

Psychological Foundations for Behavioural Economics

The assumption of homo economicus states that individuals are completely

rational and self-interested agents. This assumption of rationality implies: individuals can

maximize their utility by selecting the best alternative from all possible choices according

to their preferences. This assumption is criticized by scholars from psychological

perspectives.

The field of psychology is used to explore human judgment, behaviour, and

well-being (Rabin, 1998). From psychologists perspective, human beings do not act

according to some assumptions of classical economics. As Hayers (1950) suggests, the

assumption of rationality ignores the necessity of studying human psychology. Better

understanding the psychological foundations is useful for doing research in behavioural

economics. This chapter will introduce the psychological determinants of behavioural

economics and criticize the assumptions of classical economics by applying modem

psychological approaches.

3.1 Psychological Determinants of Behavioural Economics

Individuals different characteristics separate us from one and other. For example,

both persons A and B are excellent employees in the same company. They both were

12



22/107

given a chance to get a higher position and higher salary offered by another company.

According to the assumption of homo economicus, both of them should choose to quit

from the current company and accept the new offer which can provide the best benefits

for them. However, in reality, persons A and B may have different reasons used for their

decisions. Person A may give up the opportunity to stay at the present company, because

person A is satisfied with the current position and understands that the higher position

means higher responsibility and challenges. Even with the offer of a slightly higher salary,

he prefers friendly relations with colleagues, comfortable and happy work environment

with a lighter pressure. Conversely, person B is ambitious, who always strives for a better

opportunity and wants to accept new challenge. The reward in the opportunity is indeed

appealing to him or her. In the end, person B decides to accept the offer. Why do they

make different choices and decisions? Does the decision of person A violate the

assumption of rationality?

Their behaviours are caused by different thinking, experiences, and life goals. In

other words, they have different motivations. Similarly, Coke and Pepsi are so similar in

flavor and price. The preference between the two drinks can be indifferent. Why do some

customers prefer Coke to Pepsi, and vice versa? The answer could be that some

consumers are used to drinking a specific brand of beverage. Namely, consumers insist

on buying one brand of drink because they have formed the habit. Habit is a

psychological factor that affects consumer behaviour.

13



23/107

As indicated above, economics and psychology both study human behaviour.

Human behaviours are influenced by culture, attitudes, emotions, and other factors. That

is, psychology is one of the most influential determinants of human behaviour. Economic

behaviours are always restricted by specific psychological determinants. Before

discussing those basic themes of behavioural economics, an analysis of such

psychological determinants would be o f help.

Generally, scholars argue that human behaviours are dominated by cognition and

emotion which interplay with decision making (Schwarz, 2000). However, more scholars

would like to classify psychological determinants in more details. Van Veldhoven (1988)

defined a new area called behavioural dynamics which deals with human behaviour

that is caused and ruled by processes that originate from motivational states, personality

and learning characteristics. It merges and combines several psychological approaches to

study the dynamics of human behaviour. That is, personality refers to the total of an

individuals characteristics which are stable over different situations and over time. It can

be stated that the motivation approach of behaviour stresses the direction of behaviour

towards certain goals or states and the intensity of this behavioural orientation; learning

refers to the way in which past experiences are integrated within the behaviour of an

individual. In his opinion, personality, motivation and learning are the psychological

basis of economic behaviour (Van Veldhoven, 1988).

14



24/107

Antonides (1991)s approach is more concrete. He classifies psychological

determinants into motivation and personality, perception, learning, attitude, limited

information processing, economic expectations, emotions and well-being. Frey and Benz

(2002) list five elements of the economic model of human behaviour: individuals act,

incentives determine behaviour, incentives are produced by preferences and constraints

which are strictly distinguished, and individuals pursue their own interests and generally

behave in a selfish way.

Bayton (1958) notes motivation, cognition and learning which are basic factors for

consumer behaviour. The analysis of consumer behaviour is a comprehensive application

of psychology and economics. These opinions represent a broad range of views used in

analyzing general economic behaviour. Corresponding to the analysis of consumer

behaviour in marketing, I subscribe to Baytons view.

Motivation refers to the drives, urges, wishes, or desires which initiate the sequence

of events known as behaviour . For example, when a firm plans to produce a new

product, marketers must consider which group of people will like it and need to buy it.

Consumers decide to buy it or not to buy it based on their own different motivations. That

is, motivation influences consumer attitude toward goods and services, and consumer

attitude eventually leads to consumer behaviour. The opinion or belief regarding the

15



25/107

attributes of a product is associated with the extrinsic motivation to behaviour (e.g.

supermarkets use discount activities (extrinsic motivation) to make consumers buy their

goods (behaviour)), whereas the attributed evaluation or importance is associated with the

intrinsic motivation (e.g. consumer satisfaction).

Cognition is the area in which all of the mental phenomena (perception, memory,

judging, thinking, etc.) are grouped (Bayton, 1958). A well-know example is about Coke

and Pepsi, different brands of products with almost the same utility, what psychological

factors underlie consumer choice? The first step in peoples mentality is to differentiate

attributes of products. The brand name, package, design are differentiating attributes that

can be called signs or cues. Moreover, the signs are associated with expectancies. For

example, how do we select one specific mango from a group of mango? The critical signs

are thickness of skin, color of skin, and firmness of mango. That is, package can carry the

expectancy o f quality; thin-skin and color reflect the expectancy of juice and firmness

which stands for fresh (Bayton, 1958).

Learning refers to those changes in behaviour which occur through time relative to

external stimulus conditions...starting with need-arousal, continuing under the influence

of cognitive processes, and engaging in the necessary action, the individual arrives at

consumption or utilization of a goal-object(Bayton, 1958). When consumption or

utilization of the goal-object leads to satisfaction of the initial motivation, this satisfaction

16



26/107

can leave a reinforcement impression upon consumers. If consumers have the same

needs aroused later, it is probable that they will repeat the process of selecting and getting

to the same goal-object. By repeating the process, they will form a habit. For example,

suppose I went to a new Chinese restaurant to have dinner, and I found that the food was

very delicious and prices were reasonable. The next time, when I want to eat Chinese

food, I will have an increased tendency to select this restaurant over others, because I had

a high degree o f satisfaction about this restaurant the first time.

These psychological concepts provide a comprehensive explanation for human

behaviour, and can be applied to the analysis of consumer behaviour. Psychology governs

how people make judgment and choice. Because of limitations of psychological factors,

people cannot make rational decisions all the time. It leads to a series of theories that

criticize the assumption of rationality. Section 3.2 will state the challenges for classical

economic assumptions.

3.2 Bounded Rationality

In his textbook Microeconomic Theory, Whinston (1995) discussed two related

approaches to modeling decision. One is the preference-based approach, assumes that

the decision maker has a preference relation over her set of possible choices that satisfies

certain rationality axioms. The other is the choice-based approach, focuses directly on

the decision makers choice behaviour, imposing consistency restrictions that parallel the

17



27/107

rationality axioms of the preference-based approach.

Whinston (1995) goes on to explain the preference-based approach and the

choice-based approach, such as utility maximization, expenditure minimization, and

expected utility theorem (including famous von Neumann-Morgenstem expected utility

function), among others. Whatever choice is under certainty or uncertainty, the whole

structure is restricted by the assumption o f rationality.

The assumption of rationality has been a debating problem in behavioural

economics as well as in economics. A great number of economists have realized that this

assumption frequently deviated from realistic economic life. Since many classical

economic theories make explicit or implicit use of the assumption of rationality, many

empirical findings are always inconsistent with the predictions of these economic theories.

For example, in 1952, French economist Allais designed an experiment to test expected

utility theory, but its result was opposite to the prediction of expected utility theory. This

finding was the famous Allais Paradox2 (1952). Due to this contribution, Allais was

awarded the Nobel Prize in Economics. Later, Daniel Ellsberg (1961) conducted

additional experiments to find a paradox3 in decision making. His research also proved

that individual choice violates the expected utility theory.

2 Allais Paradox (1952) proposed by Maurice Allais shows that peo ples choice does not conform to the

expected utility theory.

3 Ellsberg Paradox (1961) provided by Daniel Ellsberg implies peoples choice is inconsistent with the

predictions o f the expected utility theory.

18



28/107

From psychologists perspective, individuals cannot select the optimal outcome by

ordering all possible choices according to their preferences (Antonides, 1991). In 1950s,

Herbert Simon modified the assumption of rationality and first constructed the bounded

rationality model. It suggests the economic behaviour of human agents should be based

on algorithms that included cognitive principles (Camerer, 1999) and it becomes a central

theory of behavioural economics.

In his paper entitled A Behavioural Model of Rational Choice, Simon (1955) cast

doubts about the assumption of the economic man which implies that individuals make

rational decisions using their unrealistic capacity of information processing and

sophisticated calculating ability. He built a behavioural model that replaced the complete

rationality of the economic man with a limited rational agent whose information and

computation skills were constrained by psychological limitations of the biologically

defined organism. For instance, at the Olympic Games, a sprint athletes speed is

constrained by his physical capacity. Even if he may receive scientific training and have a

nutrition plan, his physical capacity still cannot go beyond his limitations. An extreme

example is that no person can run faster than 1 kilometer per second. Humans, like a

computer and a machine, have limited capacities for problem solving (Tisdell, 1966).

Under the constraints of organism, Simon indicated that the goal of human behaviour is

to get satisfaction rather than maximum utility. In the works which were published in

19



29/107

1957, 1972 and 1982, Simon studied the problem solving and information processing

models based on bounded rationality. That is, individuals do not have complete

information and sophisticated calculating ability. But they have limited information and

reasonable computation skills. In short, the theory of bounded rationality assumes that

individuals make choices and decisions rationally subject to limited knowledge, resource

and time (Hoffrage and Reimer, 2004).

In 2002, Kahneman delivered his Nobel lecture entitled Maps of Bounded

Rationality: Psychology for Behavioural Economics. He stated that our research

attempted to obtain a map of bounded rationality, by exploring the systematic biases that

separate the beliefs that people have and the choices they make from the optimal beliefs

and choices assumed in rational-agent models. Unlike Simons theory that adopted a

normative and prescriptive approach, Kahneman and Tversky (1971, 1974, 1979, and

1981) used a descriptive approach from empirical evidence to criticize the assumption of

rationality. This lecture mentioned Langer et al.s (1978) well-known example of

mindless behaviour to show that people are used to simplifying complicated

information when they make choices. This is also referred to as elimination by aspects

in making choices (Tversky, 1972). These findings inspired Kahneman and Tversky to

explore the heuristics that people use availability, representativeness, and anchoring4

(Slovic et al. 2002). Since people would like to choose a shortcut to make choices instead

4 Representativeness, availability and anchoring will be discussed in Chapter 4.

20



30/107

of sophisticated thinking and computing, biases and errors are inevitable.

Etzioni (1986) even asserts that rationality is not the rule in human behaviour. The

classical economic theory assumes that individuals rational choices are on the basis of

full and relevant information. However, in real life, it is impossible for people to have

complete and perfect information on which rational choices can be made. Akerlof (1970)

describes that there is asymmetric information between buyers and sellers in the market.

Because of limited information, buyers cannot make rational choices. Furthermore, in

economic models, information is generally derived from external sources which may be

too general. Decision typically requires more specific information on the attributes of all

alternatives. This line of thinking neglects information acquired from internal source that

is stored in memory and comes from prior learning and experience that may be suitable

for similar decisions (Van Rajj, 1988). Internal sources are dominated by psychological

factors of human beings, such as habits, motivation, emotion, and so on.

As indicated above, because of limited information, rationality is an ideal state

which may not be accomplished. In recent years, many economists and psychologists

become interested in studying how limited information affects consumer choices and

decisions. The limitation to information search and processing can be classified into:

information environment, situational environment, information stored in memory and

individual differences (Van Rajj, 1988).

21



31/107

Information environment refers to the structure and format of the available

information. Information structure5 describes how the information is presented (Van

Raaij, 1977). Information structure pertains to structuring of information and the format6

of the information pertains to the type and unit of information and both of them are

important factors to influence information search and processing (Van Raaij, 1988).

People would like to use shortcuts to deal with complicated events. Some shortcuts

depend on the structure and format of information, such as representativeness,

availability and anchoring (Kahneman and Tversky, 1974). Framing effects (Kahneman

and Tversky, 1986) is also a sort of information environment that influences information

processing.

Information search and processing are constrained by situational environment. For

example, different store display, advertisement and commercials could provide different

product information (Van Raaij, 1988).

Information in memory is accumulated from previous knowledge or experience. It

affects the way in which people make judgment and choice. If consumers are not familiar

with a product, they will spend more time and effort to search missed information,

5 For example, information can be structured by matrix of alternatives and attributes, or be structured by a

pair comparison (Van Raaij, 1977).

6 Examples o f formats are: ratio-scale numbers, such as weight and price; in ordinal numbers, such as

hotel classifications or pictorial format, such as pictures or video (Van Raaij, 1988).

22



32/107

because there is no relevant information in their memory. If consumers know basic

product information and hope to know more product information, they may be interested

in exploring new information, since the old information in memory is insufficient (Van

Raaij, 1977).

Individual differences refer to that different people have different motivation

(need-arousal). Consumer motivation can be activated by advertising or the product

presentation. But different consumer may have different motivations for the same

advertising or the product presentation (Van Raaij, 1988). Individual differences limit the

information search and processing and affect consumer decision. Beatty and Smith (1987)

find that consumers would like to search more information under high involvement and

search little information or stop searching more information under low involvement.

In addition to theoretical reasoning, empirical evidence has been acquired from

consumer behaviours and it indicates that decision is made by the limited information

processing. Ferber (1973) reports that around 87% of households do not have a financial

plan. And many consumers do not have any purchasing plans when going shopping; but

purchase behaviour is often impulse. Moreover, people often rely entirely upon the

salesmans recommendation to decide what to buy. It is common for consumers to buy

health products depending largely on the information provided by the nutritional labeling

(Baltas, 2001). Even though some of these information is not useful for consumers or

23



33/107

some consumers cannot fully understand what these information means, more

information can make consumers more confident (Oskamp, 1965). All above examples

imply that decision making is significantly affected by limited information.

In marketing practices, advertising is a fact of modem economic life. However, as

Borden (1942) said, advertising has never been very well digested into the body of

economic analysis. Advertising has been greatly influencing and changing human life.

On one hand, advertising provides information to consumers to satisfy their needs; on the

other hand, advertising helps firms persuade consumers to buy their goods and create

brand loyalty. Apparently, advertising plays an important role in markets, but its role is

not fully explored in economics. Indeed, under the traditional assumptions that

consumers have fixed preferences over products and perfect information, there is no

reason for consumers to respond to firms advertising efforts (Bagwell, 2001).

Advertising utilizes bounded rationality of individuals to promote their products and

build brand loyalty. As we known, the objective of advertising is to influence consumers

to buy their products. Sometimes, consumers may be influenced by advertising and they

may buy some goods at impulse without knowing that they are exploited by advertising.

Marketers often cannot make rational decisions in resource allocation. For example,

advertising and sales promotion are two different methods used to achieve the same

marketing objective. It is difficult for brand managers to consider how to allocate the

24



34/107

budget between advertising and sales promotion. Low and Mohr (2000) investigate

outcomes of brand managers advertising and sales promotion budget allocations by

using a bounded rationality perspective. They find that brands with higher budget

allocations to advertising would have stronger effects on consumer attitudes, brand equity,

and market share.

3.3 Bounded Self-Interest

The economic theory typically assumes that everyone has self-interest in

maximizing his or her own utility and disregarding others. At first glance, the

assumption appears to conform to human nature. But evidence suggests that many people

are willing to help others, even though their behaviour will not maximize and may even

reduce their utility. Most people are willing to cooperate, help each other, and put

themselves into others shoes.

Altruism refers to the belief that an individual should take into account the utility of

others when evaluating his or her utility (Becker, 1981). Sawyer (1965) also examined

the idea of reciprocal altruism in a simple economic model to better understand the nature

of cooperation and altruism. However, altruism is different from reciprocity. It is

unconditional kindness (Antonides, 1991).

Fairness means that people want to achieve an equitable distribution of resources

25



35/107

between the parties involved in an exchange relationship (Frey and Benz, 2002). Guth

(1982) designed a well-known game the Ultimatum Game which has been seen as the

standard experiment in economics to reveal the human nature is not exclusively selfish.

In this game, two players bargain anonymously over a fixed amount of money between

them. Person A, the proposer, offers a plan of how to divide the amount. On the other

hand, Person B, the responder, just has the right to accept or reject, but no right to

bargaining with the proposer. If the responder accepts the plan, both of them can get

money, respectively; if the responder rejects the plan, neither of them can get money.

According to the classical economic assumption, the economic man who is a selfish actor

desires to obtain maximum profits. The proposer can make an offer that gives the

responder the least money, while the responder has to accept the proposal to get money. It

is better for the responder to accept rather than to reject due to his or her self-interest.

However, the game was played in many countries such as Western nations, China and

Japan among individuals of various backgrounds (Sigmund, Fehr and Nowak, 2002). The

results are opposite to the prediction under the classical assumption. Most proposers

made a relatively fair offer that gives responders a half to two third of money. On the

other hand, most responders would reject small money offer to punish the unfair

behaviour of proposers. The ultimatum game leads to a lot of relevant experiments and

studies that were designed to state the rules of fairness.

Kahneman, Knetsch, and Thaler (1986) find that consumers consider it is unfair if

26



36/107

firms raise product prices to take advantage of natural disasters; while consumers think

that it is fair that firms raise product prices when the cost of inputs increases. This finding

explain well why companies, even monopolies do not raise price arbitrarily to avoid a

reputation of being unfair (Kahneman et al., 1986), even if this behaviour can bring

substantive profits for them in short run. When consumers find that they suffered unfair

prices, they are more likely to choose to boycott products. Actually, there is a commonly

used approach for marketers to utilize consumer psychology bidding up original prices

and then selling products at regular price by so called discount. In fact, the products do

not become cheaper and consumers do not save money. But these marketing practices

easily induce consumers misconception that prices are lower than actual prices. This

leads consumers to buy more products.

Kanfmann, Ortmeyer and Smith (1991) examined fairness in consumer pricing by

two legal cases. One is about May Company which was charged with deceptive

advertising. It was suspected of using high-low pricing policy to deceive consumers. The

retailer raised its so-called original or regular reference prices artificially first, and

then earned extra profits from promoting discounts from these prices. Another case is

about the General Development Corporation (GDC) which was charged of deceiving

almost 10,000 consumers to buy their houses at inflating prices. Although the two

companies used different types of deception, both companies used deception and

unfairness in pricing. But whether consumers are skeptical or being deceived becomes a

27



37/107

debated issue. Shapiro (1990) concluded consumers know different retailers approaches

to advertising and promotion and doubt retailer pricing policies which contain substantial

puffery in advertisements. However, even though consumers cast doubt on retailer

pricing policies, they are still willing to compare May Companys sale prices with other

retailers and then buy the cheapest product. In Shapiros opinion, consumers are not

deceived by sale advertisements since they know that these advertisements are retailers

approaches to increase sales. While Urbany (1990) provides a different view, he thought

sale advertisements involving a reference price significantly stimulated the consumers

perception of the savings and the consumers intention to purchase. Therefore, consumers

are deceived by these deception advertisements. To avoid the reputation of unfairness in

pricing, Kaufmann et al. (1991) suggested companies and policymakers should provide

more information on how they determine prices and what market prices are. Furthermore,

they should keep stable pricing to avoid generating unrealistic consumer expectations.

In the paper Fairness as a Constraint on Profit Seeking: Entitlements in the Market

written by Kahneman, Knetsch and Thaler (1986), the authors mention a case of fairness

in customer markets to support their conclusion that even profit maximizing firms have

an incentive to act in a manner that is perceived as fair if the individuals with whom they

deal are willing to resist unfair transactions and punish unfair firms at some cost to

themselves. During the spring and summer of 1920, although Standard Oil of California

(SOCal) had the opportunities to raise the oil price legally, when there was a severe

28



38/107

gasoline shortage in the U.S. West Coast, SOCal did not raise the price but maintained it

at the existing level. Economically, SOCal lost a large amount of profits in short run. But

according to confidential SOCal documents, it said that SOCal officers were clearly

concerned with their public image and tried to maintain the appearance of being fair.

From the three cases, it is not hard to find that fairness is important for profits of

firms in the long run and that firms can be punished due to unfair behaviour in the long

run. Akerlof (1980, 1982) suggests that firms should emphasize their reputation to create

good impression among their customers.

Fehr and Gachter (2000) defined reciprocity as follows: Reciprocity means that in

response to friendly actions, people are frequently much nicer and much more

cooperative then predicted by the self-interest model; conversely in response to hostile

actions they are frequently much more nasty and even brutal. Furthermore, people may

choose to punish others who misbehaved, even at some costs for themselves, and reward

those who have helped, or to make outcomes fairer (Camerer and Loewenstein, 2004).

The ultimatum game can be used to illustrate negative reciprocity. There is a reciprocity

relationship between consumer and firm. When we have dinner in restaurant, the smiling

waitresses have larger probabilities to get more tips than the less smiling ones (Tidd and

Lochard, 1978). Reciprocity has been employed as an effective promotion technique. By

doing three laboratory experiments Morales (2005) shows that consumers reward firms

29



39/107

by increasing their willingness to pay, store choice and overall evaluations, even though

the actual quality of the products is not enhanced, when firms exerts extra effort in

displaying their products. If firms provide good quality of good and services for

consumers, customers would like to keep good customer relations with these firms.

However, if firms provide poor quality of good and services, customers will terminate

such relations with these firms (Huck and Tyran, 2004). These evidences suggest that

firms should emphasize reciprocity and apply it into marketing.

3.4 Measurement of Happiness

In Victorian days, philosophers and economists talked blithely of utility as an

indicator of a persons overall well-being. Utility was thought of as a numeric measure of

a persons happiness. Given this idea, it was natural to think of consumers making

choices so as to maximize their utility, that is, to make themselves as happy as possible

(Varian, 2006). It is the concept of cardinal utility theory. Jeremy Bentham and John

Stuart Mill were the early advocates who proposed Utilitarianism. This theory forms

the foundation of cardinal utility.

Cardinal utility was gradually replaced by ordinal utility, because economists

thought cardinal utility cannot exactly describe how to measure utility. Conversely,

ordinal utility indicates that utility cannot be measured and it is just a way to describe

consumer preference by indifference curves. Ordinal utility has been used in economic

30



40/107

research since 1940s. Frey and Stutzer (2003) state that standard economic theory

employs an objectivist position based on observable choices made by individuals. His

or her utility only depends on tangible factors (goods and services), is inferred from

revealed behaviour (or preferences), and is in turn used to explain the choices made. This

modem view of utility has been influenced by the positivistic movement in philosophy.

Subjectivist experience (e.g. captured by surveys) is rejected as being unscientific,

because it is not objectively observable and is not necessary for economic theory.

However, in recent years, there has been an increasing critique for ordinal utility and

a strong advocating that utility should be measured in terms of happiness. Kahneman,

Wakker and Sarin (1997) suggested that utility theory should be back to Bentham.s

experienced utility. Experienced utility can be measured by pleasure and displeasure so

that it provides an approximately realistic explanation for situations that ordinal utility

fails to illustrate. In other words, the economic concept the richer, the happier can not

be supported. Instead, measurement of happiness is reconsidered. Happiness also is

termed as subjective well-being. The common approach to measure happiness is by

means of surveying on persons happiness or life satisfaction. This concept of happiness

can offer new insights of well-being which have been totally ignored by classical

economics (Frey and Benz, 2002). But what on earth does happiness mean? Does it mean

that people feel happier when they get more income?

31



41/107

Ng (1997) studies the importance of happiness in utility theory. He points out that

happiness is more important than the more objective concepts of choice, preference and

income since happiness is the ultimate goal of human being. In fact, the purpose that

people want to have more money is to make them happier. But it is not difficult to find

that happiness cannot be measured in terms o f money (Ng, 1997).

At the individual level, people do not evaluate their level of happiness by absolute

magnitude. The level of happiness is adjusting with regard to circumstances and

comparisons to other persons, past experience and expectations of the future (Frey and

Stutzer, 2003).

In the classical economics, higher income should lead to higher happiness. However,

33 years ago, Easterlin (1974) already answered the question whether rapid economic

growth improves human welfare. By analyzing time-series data, he concluded GNP and

its derivations cannot be used as a reliable and valid measurement of human welfare.

Although substantive evidence suggests that there is a positive relationship between

nation income and happiness, there is a truth that people in poor countries are happier

because they live under more natural and less stressful conditions (Frey and Stutzer,

2003). Moreover, a rapid economic growth may make people unhappier, because the cost

of the rapid economic growth may be environmental pollution, destruction of ecosystems

or decreasing in cultivated land, and others. If an economy is growing sharply, but the

32



42/107

growth has mined countless trees and polluted fresh air and water, people cannot enjoy

high quality of life so as not to get the maximum happiness.

There are a variety of ways to measure well-being. Usually, scholars or marketers

are used to use objective indicators, such as GDP, unemployment figures, sales, market

share to measure well-being. The advantage of objective indicators is that they are

credible and easy to interpret. The disadvantage is that objective indicators always

evaluate well-being from the aggregate level but ignore the individual level. Unlike

objective indicators, subjective indicators are experiences of individuals. Individuals

pessimism or optimism may be treated as a measurement of well-being (Antonides, 1999).

In marketing, how marketers measure the well-being of consumers?

Usually, consumer satisfaction with reference to a particular product or brand is used

as an indicator of well-being (Poiesz and Von Grumbkow, 1988). The importance of the

consumer satisfaction issue has drawn attention of marketers and scholars. On the one

hand, consumer satisfaction is the common goal of all firms. All firms want to attract new

consumers; meanwhile, they also cannot lose consumers who have brand loyalty. Only

when consumers are satisfied with goods and services, they will generate brand loyalty.

Once a firm owns a large number of consumers with brand loyalty, it is sufficient to

prove that consumers are very satisfied with its goods and services. To grasp the degree

of consumption satisfaction, many enterprises hire professional employees to do research

33



43/107

on consumer feedback. By analyzing the information, firms can improve the quality of

goods and services. Sometimes, to acquire precious and valuable feedback information,

firms would send gifts to consumers hoping that they can fill out investigation forms

which refer to the levels of satisfaction for firms goods and services. On the other hand,

scholars consider that consumer satisfaction is an important indicator which measures the

general well-being and an object which policy maker is interested in (Poiesz and Von

Grumbkow, 1988).

There are two types of consumption experience: satisfaction and dissatisfaction.

Poiesz and Von Grumbkow (1988) state: a satisfied consumer is likely to

repeat-purchase the particular good or service that produced satisfaction. Consumer

satisfaction can be measured by some objective indicators, such as time series indexes of

the quality of consumer goods, scrutiny of warranties and standard contracts, regular

content analyses o f advertising and other sales promotion and so on (Olander, 1977).

However, when consumers are not satisfied with the good and services, they will

have complaints. Because of these complaints, negative communication among

consumers will take place so that it could bring huge negative impacts on firms.

Consequently, firms have to spend a lot of time and money on reducing the negative

impacts.

34



44/107

Olander (1977) provides three subjective indicators to measure consumer

(dis)satisfaction: complaints, problems and reported (dis)satisfaction. Many firms set a

special agent to record and deal with consumer complaints. The records of complaints

can reflect consumer (dis)satisfaction. However, some people who are dissatisfied with

good or service do not report their complaints to these agents, because they may consider

to no longer buy this product or go to this store. It is hard to find these consumer

problems from records of consumer complaints. Olander (1977) suggest that marketers

should design more scientific interviews for consumers to find these problems. Finally,

Olander (1977) thinks that the simplest measurement which is provided by subjective

indicator is to let consumers report and rate their own (dis)satisfaction.

However, satisfaction and dissatisfaction are not unchanged. For the same good or

service, one day, consumers may feel satisfaction, but another day, they may feel

dissatisfaction, because consumers are used to comparing current situation with past

situation and then adjusting their requirement. As Cornell University economist Robert

Frank said: humans are highly adaptable animals, quickly adjusting expectations to new

realities (David, 2004). In light of this attribute, how to judge consumption satisfaction

or dissatisfaction? Poiesz and Von Grumbkow (1988) and Antonides (1991) mentioned

three theories: Comparison level theory (Thibaut and Kelley, 1959), the

assimilation-contrast theory (Anderson, 1973; Olson and Dover, 1979) and the adaptation

level theory (Helson, 1964).

35



45/107

The comparison level theory (Thibaut and Kelley, 1959) has been applied to

consumer satisfaction by LaTour and Peat (1979). It implies that consumers compare

product attributes with a particular comparison level. This level relies on three

determinants: past experience, other consumer experiences, and commercial and

noncommercial product information (LaTour and Peat, 1979). Therefore, the product

performance is relative rather than absolute. That is, consumers feel satisfaction if

product performance is higher than this level and feel dissatisfaction if product

performance is lower than this level (Poiesz and Von Grumbkow, 1988).

The assimilation-contrast theory (Anderson, 1973; Olson and Dover, 1979) states

that consumers may psychologically ignore (assimilate) the slight distinction between the

perceived performance and the expected performance. Therefore, when the performance

of goods and services is just a little higher or lower than consumer expectations, it does

not lead to obvious consumer satisfaction or dissatisfaction. However, if the gap between

the perceived performance and the expectation is large, it could induce a relatively strong

effect on (dis)satisfaction results (Poiesz and Von Grumbkow, 1988).

The adaptation-level theory (Helson, 1964) as an approach which was used in

analyzing consumer (dis)satisfaction (Olander, 1977) suggests that (dis)satisfaction is

adjusted according to changes in consumer expectations. For example, a person is

36



46/107

satisfied with restaurant services today, but he or she may be dissatisfied with the services

tomorrow, since he or she resets his or her expectation to a higher norm. Consumer

expectations are mainly influenced by the prior experiences with similar products and the

context of communications, e.g. content of advertisement and recommendation from

sales man (Antonides, 1991). Poiesz and Von Grumbkow (1988) note that the difference

between this theory and the other comparison theories is that the adaptation-level theory

departs from satisfaction as an additive function of both expectation and

discontinuation.

37



47/107

CHAPTER 4

The Basic Themes of Behavioural Economics

Behavioural economics classifies research into main two categories: judgment and

choice (Camerer and Loewenstein, 2004). Heuristics and biases are explored in the theory

that describes how to judge the likelihood of uncertain events. Prospect theory refers to

theory that states how people make decisions under risk, while reference dependence and

loss aversion are extensions of prospect theory for decision under risky or certain

conditions.

This chapter focuses only on three basic themes of behavioural economics which

describe how people make actual judgment and choice in economic life: heuristics and

biases, prospect theory and reference-dependence and loss aversion (framing effect,

endowment effect and mental accounting).

4.1 Heuristics and Biases

Will the jacket be on sale during Christmas day? Will the central bank raise the

interest rate? Will this person achieve success in his or her career? Nobody can answer

these questions in a certain manner, since these events are uncertain. As Hal Varian (2006)

said, uncertainty is a fact of life. In classical economics, judgments of the likelihood of

uncertain events depend on the principles of probability theory. However, many scholars

38



48/107

found that people do not obey the principles of probability theory in real life since many

of these principles are neither intuitive nor simple to use (Kahneman, Slovic and Tversky,

1982).

In real life, how do people evaluate the likelihood of uncertain events, what would

methods they like to use to judge probabilities, and do these methods obey the principles

of the probability theory? Kahneman and Tversky (1974) focused on the judgment of

uncertain events and published a series of pathbreaking papers. The most well-known one

of these papers is Judgment under Uncertainty: Heuristics and Biases (1974) which

shows that people rely on a limited number of heuristic principles which reduce the

complex tasks of assessing probabilities and predicting values to simpler judgmental

*7

operations (Kahneman and Tversky, 1974). Kahneman and Tversky (1974)

concentrated on three heuristics8: Representativeness, Availability and Anchoring which

violate either sampling principles or Bayess rule (Kahneman and Frederick, 2002).

Although heuristic is a shortcut for decision making that can save people a lot of time and

effort, sometimes it causes severe and systematic biases (Kahneman and Tversky, 1974).

4.1.1 Representativeness

Representativeness is a heuristic which is employed to assess the probability by the

7 Gerd Gigerenzer criticized that scholars should not over emphasize how to generate cognitive biases

rather center on how to make precise judgments by heuristics.

8 The three heuristics are the most famous heuristics. There are still many less famous heuristics, such as,

affect heuristic, contagion heuristic, simulation heuristic and others.

39



49/107

degree of resemblance between objects. For example, if event A is similar to event B, it

leads to high probability that A belongs to B; if A is not similar to B, it leads to low

probability that A belongs to B (Tversky and Kahneman, 1974).

Tversky and Kahneman (1974) did an experiment and its result showed that people

will neglect the prior probability if they evaluate the probability by representativeness.

One group consists of 70 engineers and 30 lawyers. Another group consists of 30

engineers and 70 lawyers. A person named Dick is a 30 year old man, He is married

with no children. A man of high ability and high motivation, he promises to be quite

successful in his field. He is well liked by his colleagues (Tversky and Kahneman, 1974).

The subjects were asked to evaluate the probability that Dick is an engineer not a lawyer

according to the description of each group. According to the probability theory, the

probability of Dick in the first group should be equal to 0.7, while the probability of Dick

in the other group should be equal to 0.3. However, the result of experiment is 0.5.

Obviously, subjects are largely influenced by the personality description of Dick and their

results indicate that subjects do not take account of prior probabilities. Consequently,

Tversky and Kahneman concluded that common people are insensitive to the prior

probability of an outcome.

In the probability theory, the law of large numbers states that as the number of

samples increases, the average of these samples converges towards the mean of the whole

40



50/107

population. Contrary to the law of large numbers, Tversky and Kahneman (1971) first

provided a psychological definition the law of small numbers that argues most people

do not notice the sample size so that it could lead to biases in probability judgment. For

example, one day, in a small hospital about 15 babies are bom, and in a large hospital

about 50 babies are bom. In the small hospital, 60 percent of 15 babies are boys. When

people know this information, they are used to thinking that the distribution of boy birth

in the small hospital is the same as the probability in the large hospital. However, they do

not realize that the sample of the large hospital is larger than the sample of the small

hospital. According to the law of large numbers, a large sample is less likely to deviate

from 50 percent.

Misconceptions of chances are beliefs in the law of small numbers (Tversky, 1974).

It means that people expect that a sequence of events generated by a random process can

represent the essential characteristics of that process even when the sequence is short.

For example, when tossing a coin for heads or tails five times, one often regards the

situation (H-T-H-T-H or T-H-T-H-T) is more likely than the situation (H-H-H-T-T). But

in fact, because a coin tossing is random, the chances of any situation are in fact equal.

That is, the probability of any outcome from tossing a coin is 1/2. Nevertheless, people

cannot understand this fact. They are likely to think that the essential characteristics of

the process will be represented, not only globally in the entire sequence, but also locally

in each of its parts (Kahneman and Tversky, 1974). Another example is the well-known

41



51/107

gamblers fallacy in which people have misconceptions of chances by using

representativeness. Many people who gamble have the belief that they will have a big

chance to win money next time after losing money previously. Actually, this probability

of a win is independent of prior outcomes (win or loss).

People always predict future events by making use of representativeness. Suppose

people want to buy stocks, they are used to predicting the future profits of companies

according to the subjective descriptions of these companies. If the subjective description

of one company is good, people would like to buy its stock. Conversely, if the description

of one company is not decent, people would doubt whether its stock will bring them

attractive returns in the future (Tversky and Kahneman, 1974). It looks like that these

predictions mainly depend on partial information which people are familiar with,

regardless of other more important information, such as the company's revenues, earnings,

cash flow, shareholder's equity and so on. However, the predictions are not affected by

this reliable and accurate information. Some unfavorable or inessential information (e.g.

the description of a company) may affect peoples judgments. That is, people are

insensitive to predictability.

When making predictions in the future uncertain world, some people appear to be

very confident by using the most representative information in their memories. The

confidence depends on the quality of the match between the input information (for

42



52/107

example, salary levels) and the predicted outcome (for example, a job position). The

better fit between the input information and the predicted outcome is, the more

confidently people predict. This confidence is called the illusion of validity. Moreover,

the internal consistency of a pattern of inputs plays an important role in peoples

confidence in making predictions. It is easier for people to confidently predict the average

of 5 identical numbers than to access the average of 5 different numbers. For example,

people can immediately speak out the average of (2,2,2,2,2) is 2, while seldom people

can confidently figure out the average of (1,2,3,4,5) at once.

Misconceptions of regression means that people cannot be aware of the principle of

regression towards the mean. The failure to understand this principle often leads to biases

in judgments. For example, a flight training instructor found that trainee had a good

performance after a punishment and a poor performance after a reward (Kahneman and

Tversky, 1974). However, he cannot realize the phenomenon of regression towards the

mean, so he could overestimate the effect of a punishment and underestimate the effect of

a reward (Kahneman and Tversky, 1974).

4.1.2 Availability

The availability heuristic is that people evaluate the probability of an event by the

ease with which instances or occurrences can be brought to mind (Kahneman and

Tversky, 1974). It is easier for people to recall familiar events. An event that happened

43



53/107


54/107

generated according to a given rule (Kahneman and Tversky, 1974). For instance, a

person is not familiar with C city. One day, he or she reads a paper and learns that a

visitors precious jewelry was stolen in C city. From then on, he or she may think the

public security of C city is of concern. Actually, this city has been peaceful and quiet all

the time. This is a rare incident in the city. Because of this incident, the individual may

think that similar cases have occurred many times in this city. In a similar manner, many

people are afraid to take airplane because there are many reports about plane accidents.

So people think that the airplane is not a safe way to travel (Kahneman and Tversky,

1974). But according to the real and scientific data, flying is the safest way to travel in

the world.

Furthermore, people always imagine that there is a correlation among some separate

events that have no relationship. Chapman and Chapman (1967) noted that although

projective testing is not helpful in the diagnosis of mental disorders, some psychologists

continue to use such tests because of a perceived, illusory, correlation between test results

and certain attributes. Availability can take a natural account for the illusory-correlation

effect. The strength of the association between two events is the base for the judgment of

how frequently two events co-occur. If the association is strong, subjects are likely to

conclude that the events have co-occurred frequently and vice versa. Therefore, subjects

might overestimate the frequency of co-occurrence of natural association.

45



55/107


56/107


57/107

Many phenomena in judgment and decision making can be explained by the

operation of these heuristics. Comparatively speaking, anchoring and adjustment models

are more used in analysis of marketing practices. For example, when we want to buy

products, we always consider three questions: Should I buy the category on this

shopping trip? Which brand should I buy? and How much should I buy?

(Chintagunta, 1993 and Wansink, Kent and Hoch, 1997). In marketing research, scholars

should be familiar with the three questions. However, previous researchers merely

focused on purchase incidence and brand choice (Bucklin and Lattin 1991; Krishna 1994

and Hardie and Barwise, 1996).

Wansink, Kent and Hoch (1997) proposed anchoring and adjustment model to

illustrate the above three questions. They described how consumers make purchase and

quantity decisions and suggested that marketers can influence quantity decisions through

anchors provided at the point o f purchase9 (POP). They made three experiments about

multiple-unit pricing (e.g., on sale 4 cans for $2), quantity limits (e.g. As Lemon

Soda sale 25 cents/can, Limit of 5 cans per person), and suggestive selling anchors

(e.g. Buy a package of ice-cream for your freezer), respectively, to explain the effect of

various POP anchors on quantity decisions. In study 1, authors examined whether a

9 Point of purchase (POP) refers to outside signs, window displays, counter prices, and so on (Pride and

Ferrell, 1977)

48



58/107

multiple-unit price promotion could stimulate consumers to purchase more than their

normal purchase. By using econometric methods and analyzing econometric results, they

suggested that marketers should use multiple-unit prices instead of single-unit prices (e.g.

On sale-4 cans for $2 versus On sale-50 cent per can). When consumers make their

quantity decisions, the number of product units presented at the POP served as an anchor.

That is, although both expressions of multiple-unit prices and single-unit prices imply the

same discount, consumers quantity decision will be affected by presenting the number of

product units which is the starting point of the anchoring effect. Study 2 examined the

impact of high purchase quantity limits on sales. Prior researches mainly studied the

impact of low purchase quantity (four units or less). Lessne and Notarantonio (1988)

suggested that low purchase limits can increase purchase incidence because consumers

will buy more price-promoted products to remedy their loss of freedom that the purchase

quantity is limited. Inman

behavioural economic ananlysis of decision making

Documents