Prospect Theory: How Your Customers' Rationality Affects Their Decisions

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From the course by IE Business School

Market Research and Consumer Behavior

869 ratings

IE Business School

Market Research and Consumer Behavior

869 ratings

Course 1 of 5 in the Specialization Marketing Strategy

Your marketing quest begins here! The first course in this specialization lays the neccessary groundwork for an overall successful marketing strategy. It is separated into two sections: Market Research and Consumer Behavior. Gain the tools and techniques to translate a decision problem into a research question in the Market Research module. Learn how to design a research plan, analyze the data gathered and accurately interpret and communicate survey reports, translating the results into practical recommendations. You will then focus in on the consumer decision-making process, highlighting the key moments from identifying a need to buying and consuming a product. Adopt a true “consumer focus” in your managerial decisions by analyzing how consumers make decisions, what happens (in their hearts and minds) at different stages of the decision making process, and the variables that influence those decisions. This course will equip you with the knowledge required to understand the state of your product before approaching the market strategy. There’s no better place to build the foundations of your marketing journey!

From the lesson

Consumer Behavioral Fundamentals

This Course consists of two blocks: Marketing Research and Consumer Behavior. First, learners will see the tools and methods to be able to effectively conduct (or hire) and interpret marketing research. Second, they will learn the foundations of consumer behavior and the consumer decision-making process and how to use this knowledge in the formulation of effective marketing strategies and tactic. In this first module, you will head-dive into your consumer's thought-processes to really get to know what makes them tick, and, more specifically, what makes them make their purchase decisions. Getting into the mind of your customer is the first step in developing a marketing strategy that is effective.

Prospect Theory: How Your Customers' Rationality Affects Their Decisions5:53

Understanding Your Customers' Limits4:15

The Continuum of Buying-Decision Behavior4:02

Meet the Instructors

Shameek Sinha
Professor
Marketing

[MUSIC]

So far we have seen that there are three main approaches to consumer

decision making.

The first one is a rational approach that

other extreme is the motivational approach.

Now we are going to talk about prospect theory which is somewhere in between.

So what is prospect theory?

Let's take an example.

Suppose you are in the market to purchase a jacket or maybe a suit.

Now, you might have some idea about the characteristics of the suit.

What kind of product you want.

However, what the bounded rationality approach in prospect theory tells you

is that usually consumers take a reference pricing as a baseline.

What is reference pricing?

So basically the value of the price of this product

is judged with respect to a reference point.

The reference point can be a price which you have paid for

your previous jacket or maybe a price which one of your friends or

relatives might have paid for a particular brand of a jacket.

So that is the reference point.

The next concept under bounded rationality is called framing.

Under framing, you usually evaluate your loses more than your gains.

That is, if you have to pay a slightly little bit of extra price

that hurts you more, much more than if you are to pay a slightly less of a price for

that same jacket.

The third concept under prospect theory of round bounded rationality

is called risk profile.

That is, consumers usually have a diminished sensitivity and

somewhat differential reaction to gains versus losses.

It kind of dives back to the previous point where you probably would

evaluate your gains at a lesser extent than your losses.

When consumers are in the loss frame of mind they are willing to take

somewhat of a risk and this basically means that you

are willing to sacrifice some amount of money if you're getting a better product.

On the other hand, in a game frame of mind, here consumers are usually

risk neutral, that is consumers are not willing to take any kind of risk.

The next concept under bounded rationality is called risk aversion.

This again kind of ties back to what we have discussed so far, that is,

price increases probably would hurt a consumer more than the price decreases.

So basically, if you are paying a little bit more that is much worse to you

as a consumer than if you are paying a little bit of a lower price.

Under prospect theory there's a concept called mental accounting.

That is, usually money is mentally coded as a gain or a loss.

So think about it.

You are again in the market for buying this suit or a jacket, however,

you might actually decide to pay with your credit card instead of cash.

Now, of course, you are paying the same price at the end of the day.

But you still think that paying the credit card gives you some time or some kind of

mental satisfaction that you are not paying for the product immediately.

Finally, there's something called disposition effect.

That is, you somehow hold on to your losses and gains.

Especially, you hold on to your losses for longer, and sale your gains faster.

What is that?

Basically say you have the jacket and you want to exchange it for a better jacket.

Now, of course, you would be not willing to immediately exchange that jacket

because you want to maintain your status quo.

It takes a lot of effort to go and choose another jacket, it takes a lot of

effort to compare the prices, compare the characteristics of the product.

And so you have in this status quo bias.

So this tendency to favor stability over chain is what the status quo is all about.

Now, let's compare this bounded rationality approach to

something which is rational.

Of course, if you are a rational consumer, you not think about all this

different elements like reference pricing, or mental accounting, what you simply do

is just look at what this jacket or suit will give you in terms of utility,

and then you maximize that utility subject to your budget constraint

that is how much you can afford in terms of the price of the product.

Once you are in this budget constraint maximization mode,

it's of course at one extreme.

On the other extreme, there's something called a motivational approach.

There a consumer is not rational at all.

So forget about maximizing your utility,

looking at your pricing, or not even looking at this reference prices, or

things like risk aversion, you just are driven by your emotions.

So think about a product, again, this jacket, and

you'll see that in a ad for a particular company which is selling this jacket,

there is a celebrity who's endorsing it.

So you really like the celebrity, and you are completely driven by your emotions,

maybe your happiness, or maybe your sadness, maybe your anger or

fear which entirely drives your decision process.

So this is how the bounded rationality approach differs from

the completely rational approach.

So in the next videos,

we'll go onto the other processes which involves the consumer decision making.

Thank you.

[MUSIC]

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