In standard economic theory, we assume that a small number of factors influence the level of demand. In this resource, we will discuss how, in the real world, context affects a consumer’s decision.
Framing
When an individual makes a decision, they are faced with a number of options and a number of possible outcomes. The individual’s perception of the decision problem is called the decision frame and depends on how the options and outcomes are presented to them. For example, a yoghurt could be presented as “containing 5% fat” or “95% fat free”. The information is the same but is framed in a slightly different way.
There is a lot of evidence that how a decision is framed strongly affects the decisions that individuals make. For example, consider an experiment run by psychologists Amos Tversky and Daniel Kahneman (1981). Experiment participants were split into two groups and each were presented with the same options. One group had the problem framed in a positive way:
Imagine that the U.S. is preparing for the outbreak of an unusual Asian disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume that the exact scientific estimate of the consequences of the programs are as follows:
- If Program A is adopted, 200 people will be saved.
- If Program B is adopted, there is a 1/3 probability that 600 will be saved, and 2/3 probability that no people will be saved.
Which of the two programs would you favor?
72% of people chose the “safer” Program A.
The other group were presented with the options presented in a negative way.
- If Program C is adopted 400 people will die.
- If Program D is adopted there is 1/3 probability that nobody will die, and 2/3 probability that 600 people will die.
Which of the two programs would you favor?
Note that the actual outcomes of these options are the same as the ones presented to positive group. Remarkably, 78% of people presented with these options chose the “riskier” Program D.
This illustrates a common pattern when people make decisions; when presented with choices that are framed as gains, people often act risk-adverse. When presented with choices that are framed as losses, people often act risk-loving. This result has come to be known as loss-aversion, and behavioural economists have suggested this happens because people dislike losses more than they like an equivalent gain. For example, the pain from losing £10 is greater than the pleasure gained from gaining £10.
Anchoring
When making estimates or predictions there are many situations where people start from some initial value, which is then adjusted to arrive at their final estimate. This could be a starting value which is presented in the nature of the problem, or it could be the result of a person making an initial estimate or guess. This initial value is called an anchor.
In many situations people make insufficient adjustments to arrive at a final estimation. People who are exposed to a higher anchor make insufficient adjustments downward, and people who are exposed to a lower anchor make insufficient adjustments upwards. As a result, people tend to be biased towards the anchor.
In an illustrative experiment by Tversky and Kahneman (1974), subjects were asked to estimate the percentage of African countries in the United Nations. First, a number between 0 and 100 was determined by spinning a wheel of fortune in the subjects’ presence. The subjects were instructed to estimate the value of the quantity by moving upward or downward from the given number. The median estimates of the percentage were 25 and 45 for groups that received 10 and 65, respectively, as starting points.
This experiment demonstrates how even with a completely random anchor, people tend to make insufficient adjustments to their final estimate.
There may be a number of underlying reasons for anchoring. It could be that making adjustments is a process that involves effort and therefore people tend not to do much of it. Alternatively, it could be that when presented with an anchor, individuals consider it to be a plausible answer and therefore seek a final estimate which is consistent with the first estimate.
Too Much Choice
Consumers are surrounded with more choice that ever before. Shops stock a wide variety of products, and the number of various brands has been rising for at least the last 50 years. The internet presents consumers with a seemingly infinite number of goods and services from around the globe. People may often be attracted by this variety, but it has been suggested by some studies that an overabundance of options may lead to adverse consequences.
In one experiment by Lyengar and Lepper (2000), consumers shopping at a grocery store encountered a tasting booth that displayed either a limited (6) or extensive (24) selection of different flavors of jams. They found that the extensive selection of jams resulted in more people stopping at the booth to try a sample – 60% for the extensive selection and only 40% for the limited selection. However, after sampling the jams, nearly 30% of consumers who visited the limited-choice selection subsequently purchased a jar of jam compared to only 3% who were presented with the extensive selection.
This result challenges the assumption that more choice, rather than less, is desirable. It demonstrates that more being presented with more choices may initially seem more desirable but having “too much” choice may reduce an individual’s motivation to make a decision.
There may be a range of underlying reasons for this behavior. One possibility is that when presented with a small number of choices, people try to decide which option is the best for them. But when presented with many options people try to balance the tradeoff between accuracy and effort. That is, they stop comparing the choices once they find the first choice that seems satisfactory, rather than trying to find the optimal choice.
Time
People make
many decisions about the future. This could be decisions such as when to start
saving money for retirement, or non-economic decisions such as when to start a
diet or when to study for exams.
We can
think of there as being many different “selves” within decision-makers. Each
different “self” is the same decision-maker at a different point in time. For
example, consider the decision “I will
start saving for retirement next Sunday”. The decision-maker can be thought
of as a different person on each day leading up to Sunday. Time inconsistency arises if these different “selves” make
different decisions. For example, the decision-maker may decide on Saturday
afternoon that they would prefer to delay saving for retirement until the week
after.
Consider
the following choice:
(a) Which do you
prefer, to be given 500 dollars today or 505 dollars tomorrow?
(b) Which do you prefer, to be given 500 dollars 365 days from now or 505
dollars 366 days from now?
To be time consistent,
an individual must make the same choice for both (a) and (b). However, people
tend to choose 500 dollars today and 505 dollars 366 days from now.
This is an
example of present bias, or the immediacy effect. For many individuals,
the present has an especially high value compared to any time in the future. Generally,
people have a tendency to switch towards “vices” (short-term pleasures) from
virtues (long-term pleasures) as the moment of consumption approaches.
Another way
of thinking about time inconsistency is the projection
bias. People typically assume that their current preferences will stay the
same over time. For example, a person who is shopping for food when they are
hungry assumes that they will continue feeling this way in the future, and
therefore buys a lot of food. However, after they have a meal their preferences
change and they realise that they bought too much.
Fairness
Traditional
economic theory makes the assumption that individuals are completely selfish. It
assumes that if an individual is provided with an opportunity to gain at the
expense of others, they will choose to do so. However, a number of experiments have
shown that people are strongly motivated by concerns for fairness and
reciprocity.
Consider a game played
between two players that is frequently referenced as the Ultimatum Game. Player
A has $10 which they can split between the two players in any way they desire.
Player B decides either to accept the proposed split or for neither person to
receive any money. Economic theory suggests that Player A will act selfishly
and take almost the entire $10 for themselves, and Player B will accept any
money offered to them because the alternative is to receive $0.
However, experiments
have shown that when presented with the decision to split $10, almost 17% of
people will split the money evenly and 5% of people will even give all of the
$10 to the other person. This calls into question the selfish nature of the
person splitting the money.
Further, if Player B
is presented with a split that they consider to be unfair a significant number
would choose to reject the money so that both receive $0. This suggests that
people are willing to punish others for behavior that they consider unfair,
even if this is at considerable cost to themselves.
This
tendency for individuals to place a premium on fairness shapes the behavior of
individuals in many important economic situations. For example, the amount of
tax evasion is affected by people’s perception of the fairness of the tax
system. The frequency of employee theft and the work morale of employees is
affected by worker’s perception of the fairness of firm’s policies.
One
approach to explaining why individuals behave this way is by assuming that
individuals have social preferences. Their
happiness depends not only on what they receive but also what other people
receive. One explanation suggests that people become happier if other people
receive more. The hypothesis that people are altruistic has been used to
explain donations to charity. A second explanation suggests that people care
about inequality. This is consistent
with not only the tendency for people to propose fair splits of money, but also
their tendency to reject unfair splits.
