The Irrational Consumer

Applying Behavioural Economics to Your Business Strategy

Enrico Trevisan

• Publisher: Routledge
• Year: 2016
• Print ISBN:
  9781472413444
• eBook ISBN:
  9781317026945
• Topic: Business
• Subtopic: Business General
• Index: Business

Companies of all kinds have fallen into some of the most fundamental of traps when it comes to consumer marketing; in assuming that the motivation that drives their customers is entirely rational. Enrico Trevisan's The Irrational Consumer builds on the ground breaking works on behavioural economics of authors such as Daniel Kahneman and Richard Thaler in order to explain the fundamental drivers of customer decisions and how to incorporate these into your business strategy. Learn how consumers respond to different offer architectures and discounts; why they sometimes struggle to see the wood for the trees in a world of ever-increasing options; what are the rules of thumb they develop for making sense of value. Behavioural economics offers organizations perspectives for engaging with customers, whose views on what to buy are strongly driven by contextual factors, such as the framework and the dynamics of choices. Enrico Trevisan's The Irrational Consumer is your 'must-have' primer to this world.

CHAPTER 1
THE LOSS OF RATIONALITY

One of the principal novelties of behaviourist economics, born out of the works of Daniel Kahneman, Amos Tversky and Richard Thaler in the ’70s and ’80s, was the abandoning of the concept of homo oeconomicus – i.e. the approach to economics which had viewed the consumer (or more generally the economic agent) as a powerful ‘calculator’, able rationally and selfishly to pursue objectives determined by personal and coherent preferences.

Leaving this anthropological conception behind them, the behaviourists redefined our view of mankind in two different directions. Firstly, they asserted that the manner in which people perceive and interpret reality is strongly influenced by heuristics – more or less conscious mental strategies of simplification and reorganization of the available information. Secondly, they affirmed the existence of specific situational mechanisms which push decision-makers towards choices which are irrational – neither coherent nor consistent and not optimal in terms of the conscious objectives which they had set themselves.

1.1 HEURISTICS

Let us examine the case of heuristics and the way in which we perceive decision-making problems. The factors which we need to identify and analyse in the moment of making a choice are varied and uncertain, being often related to the future or to contexts regarding which we have incomplete information. For example, when we have to decide which model of car to buy, one of the fundamental things we ask ourselves is whether a given car is safe and reliable. Part of our willingness to pay for the car derives precisely from our expectation of acquiring a vehicle which is solid and capable of running smoothly for many miles.

One of the cognitive strategies which the consumer uses in order to arrive at a satisfactory estimation of this reliability, while committing a minimum of resources, is what behaviourists refer to as ‘availability’. By reference to this heuristic the consumer tends to make use of all the information which comes easily to mind, either because (s)he has heard it at first hand, for example in the context of a recent conversation, or perhaps through direct experience. Certainly the interested and attentive consumer will seek to accumulate a stock of data relating to the car which is as broad and as balanced as possible, by referring for example to objective external sources such as trade magazines or a motoring club; however, his mind will not evaluate the various types of information in a statistically valid way. Rather, he will – often without even being aware of it – tend to focus his attention on more easily memorable facts. Thus the frequency with which the car suffers from mechanical problems will be assessed, on the one hand, by reference to studies performed by the motoring club recording the number of calls for assistance received throughout the year for that make of car; but, on the other hand, equal or even greater weight will be given to the single anecdote heard over dinner from a neighbour describing, with a wealth of personal background details, the occasion when a specific problem arose, the trouble it caused and the costs incurred to resolve it.

From a purely statistical point of view, it makes no sense to put these two types of information on the same level, for the simple reason that the difference in sample size entails a completely different degree of representativeness and of reliability. Nevertheless, this type of distortion works when seen from the perspective of an economy of cognitive effort. Then, while over the course of evolutionary history the human mind has always been confronted with more or less direct experiences from which it has had somehow to learn in order to avoid repeating the same errors, the development of inductive statistical reasoning, together with the ability to collect information regarding single events or experiences in a systematic manner across space and time has been much more recent. The mind’s capacity to perform these two types of cognitive operation is therefore very different, as is the effort required to do so. The use of the ‘availability’ strategy is therefore comprehensible from an evolutionary point of view. It remains irrational, however, from an economic standpoint, in that it makes use of information which is insufficient for the comprehensive assessment of the costs of safety and a related rational choice based on a specific driver.

1.2 THE ANCHOR EFFECT

Many other factors influence our ability to choose and to evaluate in a rational manner. Consider the phenomenon which is referred to in the technical literature by the term ‘anchor effect’. Economic theory assumes that what is important in our decisions is the end result in terms of well-being or utility. For a given buying decision, for example, the key is the price we must pay, not what we have paid in the past. But this is not always so. In reality, in many situations it is the latter and not the former which determines our decision, because it constitutes a point of reference with regard to future occasions. In this case, the original price becomes an ‘anchor’ to which our judgement of later options is closely bound.

This was shown clearly in an experiment I organized recently involving a sample group of people potentially interested in opening a savings account. In it only 48 per cent of respondents who were offered a savings account yielding 3 per cent interest in place of 4 per cent on their existing account were inclined to accept. On the other hand, 84 per cent of respondents offered the option of passing from an interest rate of 1 per cent to 2 per cent indicated they would accept. From an economically rational standpoint, clearly it makes no sense that more people were inclined to accept a return of 2 per cent rather than 3 per cent. Evidently, the rate of return in itself is not the only factor affecting the decision, but also the difference compared to that obtained in the past. This past rate of return thus determines a point of reference (‘anchor’) in relation to which respondents evaluated the different options, which in the former case constituted a loss of 1 percentage point in the rate of return and in the latter case an equivalent gain. Obviously this 1 percentage point loss or gain played a decisive role for the majority, which was more important than the resulting interest rate obtained.

1.3 THE DEAL EFFECT

Another fundamental mechanism for understanding consumer behaviour is the so-called ‘deal effect’. According to rational theory, the sacrifice the buyer is prepared to make in order to obtain a product – the price – depends on the value we associate with the possession and use of the product, and is influenced by the various alternatives available on the market which might avoid the need to make the sacrifice, as well as naturally on the question of whether the price is affordable for us. In short, we will buy the product if we like and/or need it, if it is better than any alternative and if we can afford it.

However, in many situations the acceptable cost depends less on these considerations than on the context or the manner in which the product is sold. In actual fact, it is the context which determines our willingness to spend our money, as much as the product in itself or the nature of the buying experience. When for example I asked a group of people to choose between a current account priced at €1 and a ‘package’ comprising a current account together with a credit card at €2.50, 59 per cent of respondents chose the package while 41 per cent opted for the current account alone. However, for a second group of respondents, the same options were offered together with a further option of buying the credit card alone for €2.50. In this case, 81 per cent chose the package while 17 per cent preferred the current account alone and the remaining 2 per cent the credit card.

From a point of view of rational choice, this substantial shift in preferences in favour of the package is inexplicable. In fact, in the second experiment the credit card offered separately was clearly a sub-optimal choice. Why buy a credit card at €2.50 when I could obtain it together with a current account at the same price? Logically, apart from those (2 per cent in our study) who had absolutely no wish to acquire a current account – possibly to avoid administrative complications – 98 per cent of the sample did not opt for the card on its own. The fact of the card being offered separately nevertheless modified the distribution of preferences between the other groups.

What can have caused this shift in preferences? The simplest explanation is what Richard Thaler (1980) calls the deal effect. In the first study the two proposals could be compared only by reference to their content. In principle, it was difficult to determine whether the account alone or the package represented better value in that they involved distinct products at different prices. In the second case, the option of the credit card at €2.50 created a direct point of reference for the price of the package, which suddenly appeared to represent better value. In the specific context of the choice, the package appeared particularly interesting because it offered more than the card alone at the same price.

1.4 THE SEPARATION EFFECT

Another effect encountered in many purchasing situations is the so-called ‘separation effect’, i.e. the phenomenon whereby the very separation of the moment of payment from the moment of acquisition and enjoyment influences the buying decision and/or the effective usage of our purchase.

In this regard, classical economic theory assumes that the time delay between these two moments plays a role only in two cases: when the utility of a product now is greater than in the future, or when the potential buyer anticipates a change in the resources at his disposal during this interval. Very often, however, what is observed in practice is an influence deriving from this separation which goes beyond what might be expected in terms of capitalization or risk in relation to the product being acquired, or any possible changes in resources available.

Let us take the example of the credit card. The possibility of separating the moment of payment from the moment of acquisition of goods appears to increase expenditure to a degree which is not justified by the fact that payment is postponed – on average – by a month. Instead, it appears more plausible that consumers do not have the same awareness and hence ‘memory’ for purchases made by credit card as for those paid in cash. Field studies (Soman 2001) have effectively demonstrated that differences in behaviour deriving from the separation of the moment of payment from that of acquisition cannot be explained simply by reference to a high discounting function – i.e. by an excessive weight assigned to the present in comparison to the future. It is simpler and more realistic to conclude that this separation influences our assessment of utility function, increasing the positive value associated with the acquisition and diminishing the negative value associated with the payment.

1.5 THE CHOICE EFFECT

Let us turn now to the ability to choose. Classical rationalistic theory assumes the consumer is able to efficiently assess the characteristics of a product by investing a minimum of resources in order to obtain a maximum result. In this theory, the consumer will interrupt the selection process when (s)he judges that the additional (marginal) utility obtainable by further research effort does not match that obtainable by finding a superior product. This capacity to interrupt the process of selection at the appropriate moment makes it possible to achieve an optimal management of the complexity and multiplicity of potential alternatives provided by the market. This signifies that the more alternatives are available, the greater the chances of finding the best option. Among many options, the expected utility is greater than when fewer options are available. But this is not necessarily the case.

In some situations, the number of options represents a problem and not an opportunity for the consumer, who is unable to identify the most acceptable proposition precisely because the high number of possibilities precludes comprehensive evaluation, weighing and comparison. Iyengar and Leeper (2000), for example, have demonstrated that while a vast range of choice for a given product can stimulate the interest of consumers, this does not translate necessarily into a higher level of purchases. In the context of the classical AIDA schema (Attention, Interest, Desire, Action), variety can generate attention and interest but not necessarily the desire or the act of buying.

1.6 THE ENDOWMENT EFFECT

A further interesting mechanism is the ‘endowment effect’. Classical economic theory assumes that direct costs (so-called ‘out-of-pocket costs’) are related in some way to opportunity costs or, in other words, that there is a link between the costs associated with doing or getting a certain thing or with not doing or getting it. Thus, in this view, when the price corresponds exactly to a value where the consumer will have a neutral orientation between buying and selling a given product, the fact of being a buyer or a seller should have no influence on the value of the product in question for the consumer. But this is not always so.

In reality, the value we ascribe to a product to be bought tends to be lower than the value associated with the same product once it is in our possession. Basically, our negative reaction associated with spending money in order to acquire an asset seem to outweigh the positive reaction generated by the proceeds of its sale, and likewise the loss of an asset in our possession in comparison with never having possessed it.

If someone offers us a reasonable sum to buy an old collection of VHS videos that we keep in the cellar it is possible that we will refuse. At the same time, it is extremely unlikely that we would be prepared now to pay the same sum in order to acquire these videocassettes. This phenomenon could be explained by a certain sentimental attachment to the objects in question. But if we consider the fact that these objects will probably remain closed in a box in the cellar for years, it may be easier to explain it by reference to the endowment effect. Spending money now in order to buy these videos would mean losing the money in order to obtain them. Likewise, selling them would mean losing them in order to obtain money.

In both cases, we would not accept the transaction because the negative reaction associated with losing something (whether money or videocassettes) is greater than the positive one associated with acquiring it. Even if the same sum of money or the same videocassettes are involved we would remain attached to one or the other according to the situation we started from. What determines our willingness to buy or sell is therefore not only the item/s in question, but also our role as buyers or sellers.

1.7 THE ACCOUNTING EFFECT

When we must decide whether to spend a certain sum in order to buy a certain object, another fundamental aspect influencing our decision is the way in which we categorize the object in relation to other past or future expenditure. Field studies (Tversky and Kahneman 1981) discovered for example that if, entering the cinema, I realize I have lost the ticket costing $10, I will probably not be inclined to reacquire it. If, however, on arriving at the ticket window, I realize that I have lost a $10 banknote, I will be less likely to forgo the movie.

This is because, contrary to classical theory of consumer behaviour, our decision is not directed towards an end-state of overall well-being determined by our decision, but simply an improvement or deterioration in relation to a much more context-related point of reference. In terms of overall well-being, the two scenarios are practically identical: will I go to the cinema in exchange for a reduction of $20 ($10 for the first ticket and $10 for the second ticket or $10 for the lost banknote and $10 for the ticket) in the total sum of my wealth?

What drives the consumer towards a different reaction to the two situations is the fact that in the first case he attributes the cost of the two tickets to the same category of expenditure (cinema), making it appear relatively costly. In the second case, the loss of the banknote is not directly associated with the visit to the cinema but is ‘entered’ under a different category of expenditure. Spending $20 to go to the cinema might seem extravagant and so it is better to do without the second ticket – i.e. the movie. This decision need not, however, be determined necessarily by budget constraints or, more generally, reluctance to spend $20 that evening. The explanation lies rather in the fact of having a dual point of reference in the second case – $10 in relation to the cinema and $10 in relation to some indeterminate overall budget for petty weekend cash expenditure. The sacrifice associated with the cinema in the first case is therefore much greater than in the second case. Here the loss of the banknote is effectively registered under a different heading and will not greatly influence my decision on whether to go to the cinema or not. The categorization of expenditure in one way rather than in another can therefore have an immense bearing on my ‘willingness’ to spend, and this categorization is often completely arbitrary, inconsistent and highly influenced by the manner in which the choices are conceived.

1.8 THE SELF-CONTROL EFFECT

The lack of coherence in economic choices determined by the manner in which these are conceived or by how the information is processed is not the only source of irrationality in the consumer. Often there is an anomalous variation in preferences based on the placement in time of the ‘payoff’.

The key tool for the incorporation of the time factor into our choices under the theory of rational choice is the discounted-utility model and the related exponential discounting function developed by Nobel prize-winning economist Paul Samuelson in 1937. The idea underlying this approach is that present value of the ‘utility’ which we expect from an asset available today is consistently superior to the present value of the utility we would expect to obtain from the same asset if it were available tomorrow. In reality there are two different time factors which influence our choices and can often cause a reversal in our preferences.

The first is the time elapsing between the availability of one asset and that of another. The second is the interval between the moment when we determine our preferences between alternative assets and that in which the assets actually become available. Whilst the former dimension is included in the discounted-utility model, the latter is not, even though in many cases this is the decisive aspect in our choices.

For example, when we seek to acquire a health ‘asset’ by deciding on Friday to start eating less fatty foods and carbohydrates from next week, but then on Monday we succumb to the temptation of eating unhealthy food – with probable consequent feelings of guilt on Tuesday – we are faced with a case where the second of the time factors mentioned above has determined our choice. The period of time required in order for the results of a healthy diet to be seen must in fact be measured in months, if not years. The difference between the two choices, however, is the distance between the decisive moments: days in the case of choosing the diet and moments in the case of choosing the food. So, when on Friday I decide to start a diet on Monday, I know that from that moment on the results of the diet will be visible in months. When then on Monday I disobey myself and start to eat unhealthy food, it still holds true that the results of this will be visible only in the long run. The only difference between Friday and Monday is the time lapse between the moment I plan to follow the diet and the moment I must actually start to do so.

In the same way, when with the arrival of autumn we resolve to start saving for Christmas presents and therefore to reduce the number of CDs we normally purchase, only to find ourselves on the following Saturday afternoon buying them anyway, and again possibly feeling remorse the moment we leave the shop, what has determined our behaviour is the distance between the immediate payoff (the CDs) and the moment of choice between CDs and Christmas presents, rather than the distance in time between the two alternative payoffs (CDs now or Christmas presents in a few weeks).

This variation in preferences derives, however, not from any conscious awareness or from fresh circumstances which finally convince us that dieting or saving money is no longer necessary (i.e. changing our preferences in a stable manner) but rather represents a sort of rebellion against our own selves. Moving on from the moment in which we decided to make a sacrifice towards the moment of actually making it, it often happens that the willpower necessary to put our decision into practice is lacking, so causing us to fail to keep to our original plan. This desire to do something...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• List of Figures
• About the Author
• Preface
• Introduction
• 1 The Loss of Rationality
• 2 A Passion for Deals
• 3 The Sense of Possession
• 4 An Embarrassment of Riches
• 5 Sunk Costs and Re-Emerging Costs
• 6 Divide and Rule
• 7 Money Games
• 8 Ulysses, the Sirens and the Challenge of Self Control
• 9 Mind Games
• Conclusions: Seize the Moment
• Bibliography
• Index