Applications of Behavioural economics in marketing

UNDERSTANDING THE CHOICE ARCHITECTURE OF CONSUMERS

Deepak Jangid (PGP/16/080)

IIM KOZHIKODE |

Contents
Abstract ................................................................................................................................................... 2 Introduction:............................................................................................................................................ 3 Behavioural Economics ...................................................................................................................... 3 Rational Choices ................................................................................................................................. 4 Behavioural economics: Key Concepts ................................................................................................. 5 1. 2. 3. 4. 5. 6. Context Effect: .......................................................................................................................... 5 Default Effect: ........................................................................................................................... 5 Theory of decision points: ........................................................................................................ 6 Mental Accounting: .................................................................................................................. 8 Decoupling Costs and Benefits ..................................................................................................... 9 Choice Overload: ........................................................................................................................ 10

Conclusion ............................................................................................................................................ 12 References ............................................................................................................................................. 12

11/8/2013

Abstract
This paper is an attempt to show how principles of behavioural economics can be applied to substantive marketing problems. Though it is an easy argument that these ideas are important, it is more difficult to demonstrate that importance or rather present it in a more formalized and mathematical form. However, the difficulties of realistic behavioural assumptions are not the problems to be ignored. Rather, they should be considered as an opportunity. The paper starts with emphasizing that the marketing derives its fundamentals from economics and behavioural sciences. Behavioural Economics is a reconciliation of the two. The paper mentions the four principles of making a rational decisions that classical economics advocates, and goes on to explain that these rational decisions are almost impossible to achieve. In the later sections, different principles and concepts of behavioural economics have been mentioned along with the examples. These examples are a result of thorough understanding of the concepts and their reflection upon the events occurring in the campus around the author. Learnings from these concepts and examples can be further replicated to develop more applications in the field of marketing. This paper finds out that behavioural economics plays an active role in shaping a decision frame and learnings from the same can be put to a great use in marketing.

11/8/2013

Introduction:

Introduction:
Marketing as a concept is very much based upon the notion of facilitating exchange of goods and services between agents. Almost all the marketing theories revolve around the idea of intangible resources, creation of value and inter-agent relationships. These theories derive their heritance from fundamental of classical economics and behavioural sciences. For long, economic theories have shaped the pricing mechanisms, industry structure etc. while behavioural sciences have put in fair amount of knowledge, derived from human psychology and empirical evidences, into the concepts of promotions and product launches etc. Being a science, economics gives very theoretical approach to the problems of resource allocations between individuals or firms ignoring the psychology of individual behaviour. This violates a fundamental need of inter-science acknowledgement-relationship, for example physics informs chemistry; or neuroscience informs cognitive psychology. However, most of the economic models fail to reconcile with the psychological findings and find unrealistic assumptions as their basic foundation. (1-3) The divergence between the two streams has been a result of untiring efforts of formalization of economics by economists and mathematicians. There came a point of time when the irrelevant assumption of economics were actually made irrelevant as long as t hey came up with good theories. Milton Friedman advocated that theories with patently false assumption can make surprisingly accurate predictions and hence, economic theories which assume the highly rational behaviour, ability to calculate probabilities accurately, and maximizing own wealth might prove to be useful. An early thinking about economics was a result of insights of human psychology. Adam smith, in his Theory of Moral Sentiments described ways in which people care about the interest of others. Later in his another book Wealth of Nations proposed the idea of world being governed by own-interest The latter, finds a great place in economics whereas the earlier book on sentiments is ignored. Why? Probably because the above mentioned formalization efforts in economics and validated unrealistic assumptions. (4-6)

Behavioural Economics
Behavioural economics improves the realism of the psychological assumptions underlying economic theory, promising to reunify psychology and economics in the process. Reunification should lead to better predictions about economic behaviour and better policy prescriptions. (7) What is behavioural economics?? Lets understand this from two behavioural economists- Dick Thaler and Cass Sunstein who in their book Nudge have mentioned two kind of species- Humans and Econs.

11/8/2013

Introduction:

What are Econs? Econs are mythical creatures that live on the pages of economics textbooks. They're very smart, they can look forward infinitely, they can compute something called utility of objects, and they make perfectly rational choices. Econs don't care about emotions because they don't have any. Econs have the ability of a supercomputer to make fairly complex computations in the snap of a finger. Human beings are people like everybody else-- very different. Human are different because they are emotional. They fall in love, they sometimes do silly things, regret their choices, and sometimes they choose things just because, which is a concept that Econs would never understand. Human beings are impulsive. Classic economics talks about the former while behavioural economics talks about latter.

Rational Choices
Rational choices can be attributed to what has been said about Econs above. These choices have attributes that make them the best choices that one can make for maximizing his/her gain. A rational choice must fulfil the following conditions A) Completeness: of information B) Cognition: the ability to think through the problems C) Computation: ability to process information and make fairly complex calculations D) Consistency: in decision making both internal and external However, it is almost impossible for a human being to have all the condition in mind while making any choice. People tend to make mistakes, there's a big gap between what people want to do and what they end up doing. Behavioural economics maps behavioural irregularities of human behaviour into economic theories and seeks to develop a rather practical set of solutions that classical economics fails to achieve. Role that behavioural economics can play in marketing is to fill the gap that persists in the psychology and economics. If one looks at the failure rates of new products, they're stunningly high. It turns out anywhere between 90% and 99% of new products that are launched are not successful. Why does that happen? That often happens because of a failure to understand human decision making at the last mile. Producers produce products that are technologically superior, offer cost savings. But, they don't think too much about the consumer who's going to make the final purchase. They don't think too much about the way products are displayed and sold. Behavioural economics is a unifying approach to marketing

cross-fertilization to occur. A lot of research has been carried out recently in directions of giving a more formal approach to concepts of behavioural economics.

11/8/2013

problems. Though, it lacks sufficient mass in any of the journals and their associated communities for

Behavioural economics: Key Concepts

Behavioural economics: Key Concepts

1. Context Effect: This effect was first made popular by Prof. Itamar Simonson at Stanford. The argument that he made was that in situations where people do not have a good idea of how to value objects, they use information from the context to help them make that judgment. Applications: A research conducted by Prof. Dilip Soman at University of Toronto highlights this effect. He along with some students conducted an experiment in a coffee shop. This coffee shop offered coffee in three standard sizes small, medium and large. It came as no surprise that the best-selling cup was medium cup of coffee. But what was more interesting to find out that it didnt matter how much coffee that cup contains. When they replaced the large cup of coffee with even a smaller one, they found out that the new medium cup was the most-popular cup of coffee. When people were asked about picking up the medium sized cup of coffee, they replied- the small one has too little while the large one has too much and the middle one was just right. In one another example a gas station used the same idea to make some extra profit. Earlier this gas station has been selling gasoline in three grades--87, 89, and 91. And all of a sudden, they introduced a fourth94. One of the interesting consequences of that introduction was that now the 91 grade gasoline, which used to be the extreme gasoline in terms of quality, was in the middle. And this made the sales of 91 grade went up.

2. Default Effect:
This effect explains that people have a general tendency of choosing default option even when the alternative has no economic cost. Default effect explains why are organ donation consent rates really low in countries like Canada and the United States? And why are they extremely high in other countries, like France and Austria? It turns out there are a number of differences between countries like Canada on the one hand, and Austria on the other hand, but they don't seem to explain the differences in organ donation rates. In Canada, organ donation rates are about 2.5%. In Austria, they're close to 99%, and that's a big difference. The reason is the process that people need to engage in order to donate their organs. In Canada, for example, if someone wants to donate organs, one has to go to the Department of Motor Vehicles, ask for a form, fill it out, and send it in. Then get a web code that when one goes online, accesses, and registers, and becomes an organ donor.

11/8/2013

Behavioural economics: Key Concepts

In Austria, it is assumed that everyone will donate organs. But if one does not want to, he should go to the same Department of Motor Vehicles, ask for a form, fill it out, send it in, get a web code, and then de-register from being an organ donor. Essentially, the default assumption is different in Canada versus Austria, and defaults play a huge role in shaping decision-making. Defaults work because of two reasons People are extremely lazy. If obstructions are put in their approach to a certain outcome, those obstructions are enough to prevent them from reaching that outcome. Defaults signal something about everybody else. For example- if everybody is donating organs, then one would be inclined towards thinking probably thats the right thing to do. Application: The student council body at IIMK seems to find a great value of this effect. Every term there is a batch party for everyone in which every student is by default invited to have fun and by default the contribution money is deducted. Now, suppose if some students decides not to join the party and not to pay as well. The process would be to do some agitation, go to higher authorities show some disagreement or complain. May be that would get him the money back. But we dont see a lot of people doing that. Isnt that because of default effect? What if the student body chooses to switch default option from pay to choose to pay? Results would certainly be different. Wouldnt they?

3. Theory of decision points:

It refers to the phenomenon of dividing a large resource/decision into multiple points to stimulate the active decision making. Prof. Dilip Soman in one another experiment observed the behaviour of gamblers. People were given coupons in one of two conditions. In one condition, there were 100 coupons in an envelope sealed and given to participants. In a second condition, there were 10 coupons in an envelope, and 10 of these envelopes were given to the participant. So in every condition, everybody got 100 coupons. People had to actually go online, click on a button. There was a wheel that spun. With some probability, they won five coupons for every coupon that they had gambled. And there were only two rules of the gambling game. Rule number one was that they could not gamble away their winnings, so they could only gamble up to 100 coupons. Rule number two, they had to gamble one at a time. Result:

11/8/2013

Behavioural economics: Key Concepts

What was found is that a lot of people chose not to gamble, so the first few bars are actually zero. But, once they started gambling, the bars keep increasing in height and there was one person that actually gambled away all 100 of their coupons. The panel at the bottom, on the other hand, shows you conditions where, in fact, people had 10 envelopes, each with 10 coupons. And what you see there is that almost everybody gambled. There were only two people who chose not to gamble. But the height of the bars are now much lower. Some people gambled 20 coupons, some 30, some 40. And in fact, 40 was the highest number that was gambled. The reason to this is that when people opened one envelope, the coupons kind of became free. There was not much thinking that went on. People consumed a lot. But in fact, when people had to multiply open a number of envelopes that was a decision point which forced them to stop. Application: The sole destination of entertainment Crown Cinema is flooded with IIMK student community every Friday. Suppose the food-stall there starts offering 200gm popcorn bags instead

11/8/2013

Behavioural economics: Key Concepts

of 600gm bags earlier in a bid to make it more affordable. Is this step is more likely to increase or decrease the consumption? Popcorn eating is a pleasurable activity. A person does not think how tasty the popcorn is after eating every piece of it. He simply goes on eating until it is finished. This term is also called meta-decision. Now consider, a person having 3 bags of 200gm popcorn bags amounting to 600gm. After eating first pack of 200gm he is confronted with an active choice of opening the next pack. This active decision making reduces the consumption of popcorn by the individual.

4. Mental Accounting:
It is the idea that people tend to label money with certain names. And the moment money gets labelled differently, it gets spent differently. People behave like accountants. So how do people mentally account? How do they create these different categories? Well, there's a number of different ways in which they do it. They could mentally account as a function of how they earn the money. If one finds money on the streets, he is more likely going to spend it differently from if one worked really hard to earn it-- fun money, laborious money. Fun money is spent on frivolous stuff. Money that earn through my salary is typically spent on paying bills. Every mental accounting process has two components. Part one is called the metering process. The metering process looks at counting how much money is actually in the account. Part two is the scope or width of the mental account, defining the category over which that account exists.

Sunk cost effect: The moment someone actually incurs or prepays to consume something in the future, it sets up an interesting mental accounting phenomenon called the Sunk Cost Effect. What does that mean? It means the following. Let's assume a person plans to go to the AutoExpo in Delhi and pays online rs. 200. And if he lives in Chandigarh, let's say there's a really bad rainfall. It's difficult to drive. His friends tell him that it's perhaps not worth going to the AutoExpo. But he still would end up going because he already allocated some budget to certain activity and if he decides not to do it, it will be seem to him like a loss which he would certainly not prefer. This effect turns out to be relatively irrational economic behaviour, because economic theory tells us that we should make decisions based on what's going to happen in the future, ignoring sunk costs. Application: Lets us consider the example of batch party mentioned in default effect. Suppose

like parties much. But would he still go?? Most likely yes, this is a personal observation that I would like to make about myself. Though I never wanted to go to last three parties, but somehow I ended

11/8/2013

that student falls prey to default effect and ends up paying. He is not very party guy, and he doesnt

Decoupling Costs and Benefits

up attending it even just for the sake of it. Why?? Answer is the same sunk cost effect that influenced my decision and not attending the party seemed like wasting the money that I paid for party. Similarly, people don't like making losses, and so they are driven to consume that particular product opportunity. So the Sunk Cost Effect turns out to be a huge motivator in nudging people to consume products and services.

5. Decoupling Costs and Benefits

One of the key drivers of successful mental accounting is the extent to which the cost and the benefit in a mental account are coupled, or associated with each other. If, in fact, that association becomes weak, then they become decoupled, and it becomes harder to mentally account for that particular expense. Lets consider the same example of the person going to AutoExpo (4-day event). Now, there are two ways in which he can be given coupons for prepaid amount of Rs. 400. One coupon of Rs. 400 or 4 coupon of Rs. 100 for each day. The person enjoys the AutoExpo for three days very well but on the last day heavy rainfall is there. So in which condition the person is more likely to attend the event anyway? In latter condition, there is an explicit coupling between each day's worth of visit and the expense,. As a result, Rs.40 that he has prepaid is much more likely to burn the hole in your pocket in this case while in former situation he can amortize-- or allocate-- the three equal days of visiting experience across the Rs. 400. Hence, it is more likely that in the latter, he is more likely visit the event ignoring the heavy rainfall.

Pennies-a-day advertisement

This term was made popular by Prof. John Gourville at Harvard. The ad above says if you can afford this, you can afford that. In the fine print below the pictures, it essentially tells that sofa set that's being advertised is going to cost about $1,000 a month. But if it is compared to the cost of a yogurt per day, it suddenly starts becoming more affordable.That's called a pennies a day strategy. When people think about a pennies a day strategy, there are two elements of the strategy.

11/8/2013

Choice Overload:

10

A) Taking a lump sum expense, and expressing that as a daily expense. B) Providing people with a comparison which is a consumption that they occur on an ongoing basis. Comparison with a coffee is great as people usually drink coffee once a day. But comparison with something which costs $20, or $30, or $50 a day might backfire because people realize that they're actually going to spend a lot of money doing that. For example see the below picture

6. Choice Overload:
The growth of choice is becoming a big problem in many different product categories. Choice is fuelled by two simple assumptions. A) More choices you give people, the more likely they are to find something that best matches their needs. B) People need freedom of choice, that people feel better when they have more choice than less. And it turns out that both of these assumptions are actually true. Yet, people report, that they feel too much of a pressure and too much stress when they make decisions in a number of product categories. So, psychologically, what happens when people are given a lot of choices? There're two or three things that jump out. First is the idea that when you give people lots of options, they, in fact, need

elaborate, and people don't have the ability to perform those calculations.

10

11/8/2013

to make fairly complex calculations. The computations involved, the cognition involved, is fairly

Choice Overload:

11

The second thing that happens is that the potential for regret goes up. For example, a person goes to a paint shop and picks up a particular shade of paint. But then he goes home, paints his walls, and says, I wish I had picked something that was darker. And so in choices that can't be reversed, greater assortment leads to greater regret. The third thing that happens relates to a phenomenon that was first documented by Chris Hsee who is a professor at the University of Chicago. He talked about the difference between joint evaluation and separate evaluation. For example, a person goes to a store to buy stereos. He sees 15, 20, 25 different types of products in the store and listens to them carefully. He thinks about something called the harmonic distortion of the stereo. And the fact that he has got 15 in front of him makes it easier for him to compare the harmonic distortion, and pick the one that has the lowest harmonic distortion. He takes it home, and realizes it doesn't actually look very nice. It's an ugly looking piece of equipment. What's happened here is when people are given a large assortment, certain attributes-- in this case, the harmonic distortion-- seem to impact decision making to a great degree. But when reaching home, and they do not have a standard for comparison, that attribute doesn't matter anymore. And so, essentially, what's happening here is that greater assortments creates a greater distance between their choice and what keeps them happy.

Consequences
Having too much choice makes it difficult for people to compute the outcome. What are the effects of choice? Five different kinds of effects have been documented below: 1. When people are given a lot of choices, they end up not choosing at all or they choose to defer their participation. It could be realized when on a speciality tea store where people end up with the most common type of product that they could have any other place as well. 2. People tend to make choices that are conservative, that are safe, because they want to minimize the potential for regret. The bigger the choice set, the more likely are they to go with a conservative option 3. The power of status quo or defaults or recommendations. When people have too many options to choose from, they are most likely to look for simplifying cues. Like asking - which is the most popular product in your menu, which is the most top-selling item in your list, and so on and so forth. 4. The fourth effect is again the reliance on peer choices. People tend to look at what other people chose. Those other people could be someone they dine with, it could be a celebrity endorser, it

5.

People simply can't trade off subsets of the options, and so they decide they want at all or they want nothing.

11

11/8/2013

could be something that an intelligent agent recommends to us.

Conclusion

12

Solutions It is true that people suffer from over choice and it is true that if when given too much information they have problems processing it, so how can they be helped to make better choices? 1. Streamline choices: Think about your offerings, think about products that you really think add value and keep those and only those in your product mix. If there are products that are not doing well, if there are options that are not popular, consider dropping them. 2. Use a bot/agent: Help consumers understand their own preferences and help them make the right computation using an agent. 3. Organize: By careful categorization and organization, navigation could be made easier for the consumers.

Conclusion
Though very practical, behavioural economics has its limitations due to lack of formalization and mathematical knowledge. It is still in evolutionary form and has been developing newer concepts to gain its ground. Most of these principles are plug-and-play solutions which represent a good substitute for classical economics. They represent a paradigmatic shift, which require a slightly more complex models for warranted increases in accuracy. This is important for an applied discipline such as marketing.

References
1. Thaler, R. H. (1992) The Winners Curse. (Free, New York) 2. Camerer, C. F. (1995) in Handbook of Experimental Economics, eds. Kagel, J. & Roth, A. (Princeton Univ. Press, Princeton), pp. 587703. 3. Rabin, M. (1998) J. Econ. Lit. 36, 1146. 4. Smith, A. (1976) Theory of Moral Sentiments (Oxford Univ. Press, Cambridge, U.K.). 5. Smith, A. (1976) The Wealth of Nations (Oxford Univ. Press,Cambridge, U.K.). 6. Smith, V. L. (1998) South. Econ. J. 65, 119. Sci. USA, Vol. 96, pp. 1057510577, September 1999 8. Lectures of Prof. Dilip Soman @EDX; course: Behavioural economics in Action

7. Colin Camerer, Behavioral economics: Reunifying psychology and economics, Proc. Natl. Acad.

12

11/8/2013