Managerial Economics/Consumer decision making

For an organisation to be successful they must understand how consumers make decisions. People are influenced by many factors in the decision making process, including economic, psychological, and environmental factors. If firms can develop an understanding of how these elements can influence their customer base, they can make better informed decisions that align with their objective; whether that is to maximise profit or solve a problem, for example. Rational Choice Theory is a popular model for examining and modelling consumer behaviour, however it requires many assumptions that do not reflect the real world. It requires that humans behave like homo economicus: constantly rational, self-interested agents who pursue their preferences optimally . However, in reality people do not make decisions in isolation and according to well-ordered preferences. Instead, there is a complex exchange between their conscious and subconscious preferences, retained information, and external influences. Behavioural economics explores these tendencies to help us better understand why people make decisions that seem to diverge from rationality.

Behavioural Economics

Behavioural economics looks at how people make decisions and how a person’s welfare can be enhanced through improvements to their choices. Behaviour economics has become a new way to consider consumer behaviour and can be split into two sections; consumers heuristics and biases, and the effect of a situation (Reisch & Zhao 2017).

Neoclassical economics views consumers as rational and willing to search for all information before making an informed decision. Reisch and Zhao (2017) states the neoclassical approach describes a consumer who “…actively engages in a search for information on the best available product/service option, knows and considers all costs and benefits and follows his or her true preferences”.

Consumer Policy is still dominant when it comes to consumer behaviour. This describes consumer behaviour as depending, mostly, on consumer preferences and also considers any consumer biases and heuristics irrelevant (Reisch & Zhao 2017). Under consumer policy, there are three main policy tools when it comes to empowering consumers in their decision making; consumer information, advice, and education. However, when it comes to increasing and protecting the life and health of consumers, stricter policies are used. These include; laws, regulations, and financial incentives and disincentives (Reisch & Zhao 2017).

Whilst consumer policy does not consider biases and heuristics as relevant, many policies go against natural human instinct. It has been shown that freedom of choice and competition can sometimes have a negative effect for example, excessive choices can actually lead to a decrease in consumer welfare (Reisch & Zhao 2017). Therefore, consumers rely on biases and heuristics to make decisions.

Reisch & Zhao (2017) describe one of the goals of behavioural economics as a way to design policy tools that allow consumers to make more effective and efficient decisions for themselves.

Limits of the Rational Choice Model

Inattentional blindness

Inattentional blindness (also known as perceptual blindness and intellectual blindness) is a psychological phenomenon and is a key limitation to the consumer decision making process. Inattentional blindness refers to the link between attention and visual perception and explains how an event, person or thing can go fully unnoticed, despite being fully visible, due to the attention being engaged on another task, event, person or thing. The failure to notice is not associated with vision defects or deficits but rather a lack of cognitive attention, known as the human cognitive budget. It explains cognitive attention as a limited resources and when occupied, being attentive to another stimuli becomes increasingly difficult and often goes unnoticed. At any given time, cognitive attention is limited in the number of stimuli it can accurately be aware of. A simple example of inattentional blindness is missing a stop sign when driving because of an intense conversation you were having with a friend.

The concept also explains that an event person or thing we anticipate will capture our attention more easily. It is thought that this happen as we are more open to stimuli that reaffirm our current belief structure and less receptive of those that go against our beliefs as they are associated with feelings of discomfort and doubt. This has implications to the consumer decision making process as it suggests that consumers are likely to be receptive to marketing, product characteristics and pricing that support their current beliefs and personal identity.

To simply explain, inattentional blindness results from lack of awareness or consciousnesses towards an unexpected stimulus. It is the failure to fully notice visible (but unexpected) changes to the environment because our attention is readily captured and engaged with another task or things that we have already expected. This phenomenon is also not associated with vision deficits and it happens due to our limited working memory. For instance, you are on the phone, talking to your friend, while driving. You are so engaged with your conversation and failed to notice the red traffic light. You run over the stop light, nearly causing an accident.

Do Human Beings Optimise?

This subject has always started controversial debates which haven’t been able to settle on an answer that all parties agree on. The two opposing sides to this argument is the viewpoint taken by Microeconomics and the conclusions made by empirical evidence. The leading textbooks in microeconomics implicitly claim that human beings do optimise since they neglectfully forget to discuss the topic. An argument that could be made is that individuals may struggle to see through all the potential outcomes and probabilities when they are under true uncertainty. The cognitive exertion and search costs required to explore possible unknowns and their probabilities may be too costly . As a result of this, individuals may only concentrate on the ‘known unknowns’ and assign a vanishingly low probability to the ‘unknown unknowns’. In this case, individuals simply ignore events of extremely low probabilities and optimise over the rest . It is clear that Microeconomic textbooks simply imply that optimisation does occur rather than arguing their views which are theoretical and lack any definitive proof. On the other hand, empirical evidence argues that human beings tend to not optimise when making decisions. The evidence gained from experiments and real-life data has found that, while people often make mistakes that can be very costly, the number of mistakes depends on the following:

• Complexity– The complexity of a problem may influence an individual's ability to optimise. When given a simple output function, one may derive the equation and set to 0 to find an optimal output. However, if given a multivariate function with external variables, this optimisation may not be feasible without a computer. Furthermore, if the process involves multiple independent decision makers, it may not be possible to optimise with incomplete information, and begins to branch into Game Theory. For example, buying a coffee vs buying a house. Given the nature of buying a coffee at a cafe, a person will likely have complete preferences which will result in them making a good decision. Conversely, there are many different factors that you need to consider when buying a house such as location, size and price. With so many decisions to make, there is a strong likelihood that you will either make a mistake or be affected by bias tendencies compared to the simple task of buying a coffee.

• Experience – The experience of a manager may influence whether they are capable of optimising (consciously or unconsciously). An inexperienced manager may not be able to view the situation as a process that can be optimised, and go with gut feeling or intuition instead.The level of experience relies heavily on the feedback that a person receives from prior decisions they have made. Although it can be achieved, good experience is quite often gained too late and becomes ineffectual. For example, when people have to pick a superannuation fund to invest their savings in when they turn 18 or when they start a new job, they often choose the employer’s default option. This is because people only gain experience when they receive their lump sum payment in retirement and they can compare their balance with others.

• 'Availability of Feedback To optimise, the change in output from a change in variables must be measurable and available to a decision maker. Without this, there is no way of knowing how actions will affect outputs and thus no way to optimise.

• Cognitive resources/load – A manager's cognition also plays into their ability to optimise. Some people are capable of withstanding a higher cognitive load than others, and as such are more able to optimise processes with multiple variables. A person has limited resources that reach a capacity when no new information can be absorbed. There are environmental variables such as working memory, attention and mental health that affect the cognitive performance. The ability to record information varies significantly between individuals. For example, if you are asked to remember a number during a lecture, you will not be able to pay attention to the lecture and remember the number at the same time.

• Salience – A manager's ability to focus their limited perceptual resources on the task at hand may influence how they optimise. For example, when you choose a retirement fund at the age of 18 it doesn’t hold any importance to you because you only receive the money much later in life. On the contrary, when you are 18, deciding where you are going to party on Saturday night is much more important than choosing a superannuation fund.

• Importance (stakes) – The importance of a given game will influence if a person optimises. When the stakes are high some people will perform well and make good decisions. However, people can also choke under pressure if the stakes are too high and, therefore, perform poorly or make bad decisions. For example, some players in a penalty shoot-out during a final will score given the stakes are so high, while other players will miss if they succumb to the high-pressure scenario.

Therefore, based on empirical evidence, while human beings can optimise their decisions, they are often unable to as a result of the factors analysed above.

Optimisation

While some microeconomic textbooks promote that human beings optimise, empirical evidence suggest that they often do not. The ability of an individual's optimisation depends on:

• Complexity The complexity of a problem may influence an individual's ability to optimise. For example, given a simple output function, one may derive the equation and set to 0 to find an optimal output. However, if given a multivariate function with external variables, this optimisation may not be feasible without a computer. Furthermore, if the process involves multiple independent decision makers, it may not be possible to optimise with incomplete information, and begins to branch into Game Theory.
• Experience The experience of a manager may influence whether they are capable of optimising (consciously or unconsciously). An inexperienced manager may not be able to view the situation as a process that can be optimised, and go with gut feeling or intuition instead.
• Availability of Feedback To optimise, the change in output from a change in variables must be measurable and available to a decision maker. Without this, there is no way of knowing how actions will affect outputs and thus no way to optimise.
• Cognitive Resources A manager's cognition also plays into their ability to optimise. For example, some people are capable of withstanding a higher cognitive load than others, and as such are more able to optimise processes with multiple variables. A person's memory, attention span and mental health may all have an impact on their ability to optimise. For example, a penalty kick at a Football World Cup final game will have more mental pressure on an individual than when they do it at practice.
• Salience A manager's ability to focus their limited perceptual resources on the task at hand may influence how they optimise.
• Stakes The importance of a given game will influence if a person optimises. For example, if the varying outcomes of a game are indifferent or unimportant, a manager may be less willing to consciously optimise.

Bounded Rationality

Bounded rationality is the notion that people's ability to optimise decision-making is bound by their cognitive capacity. The principle observes a flaw in Rational Choice Theory as a consumer with perfect information and unlimited time may still lack the cognitive ability to optimise. Further, many consumers will prefer to outsource or cut short the decision-making process to reduce the cognitive effort required. Understanding this theory is vital for managerial economics as it is the cornerstone for the psychology behind consumer decision making. The principle is as follows:

"The capacity of the human mind for formulating and solving complex problems is very small compared with the size of the problems whose solution is required for objectively rational behaviour in the real world - or even for a reasonable approximation to such objective rationality".

Example: The pool player analogy proposed by Milton Friedman. The problem of predicting how a professional pool player plays their next shot is that it is often inaccurate. Very often, an optimisation model is incapable of representing the bounded behaviour of a person. It assumes pool players do not miss and will always optimise their decision. Consequently, the game is treated as if it is a matter of whoever went first would always win. In Summary, "the point is, if you use an optimisation model to represent the behaviour of someone who does not actually optimise, you are going to get incorrect result" (Smith, 2016).

However, bounded rationality creates opportunities for businesses. In the contemporary age, technology and Artificial Intelligence (AI) are changing the landscape of cognitive boundaries. For businesses, this presents an opportunity, by catering to the uniquely pervasive human flaws and weaknesses that many seek to overcome. An example of bounded rationality in the economics and business context can be seen with spell-check, auto-correct and editorial software. The AI behind these services erases the flaws and mistakes made by writers. These errors occur as writers are bounded by time, rationality and cognitive intelligence. Therefore, this technology has immense potential as humanity will continue to be confined by these inherent limiting factors, requiring an external solution to be sought through business's products and services. This has greater economic ramifications in the digital age, as macro trends move people towards a more polished, perfected, society.

Origins

First termed by Herbert A. Simon in 'In Models of Man', "bounded rationality" was used to describe limitations to "classical" models of rationality. The dimensions that Simon suggest to adjust are:

• limiting the types of utility functions,
• recognizing the cost of information search
• the possibility of having "multi-valued" function

Simon suggests that there are factors that influence consumer decision-making that are not taken into consideration in "classic" models such as heuristics and biases.

Factors That Influence Consumer Decision Making

Heuristics

While humans strive to make rational decisions, the ability to do so is limited by cognitive capacity. In order to deal with cognitive limitations, decisions are often made by relying on heuristics and biases. Heuristics are shortcuts or 'simple rules' that reduce the cognitive demand required to make decisions, without sacrificing significant decision quality. However, with the environmental and situational changes, heuristics efficient in one domain may not be perfectly translatable to other domains, leading to sub-optimal decision making and errors.

Why do we use Heuristics?

• Effort reduction: People may use heuristics as a type of cognitive laziness. Heuristics can reduce the mental and physical effort to make difficult choices/decisions
• Attribute substitution: It can also be suggested that Heuristics are used to replace simple related questions with more complex and challenging questions
• Fast and frugal: Theories suggest that heuristics are fast and usually accurate, thus helping people make decisions quicker.

How do people use heuristics?

• Imagine going into an ice-cream shop with a friend. Instead of deciding between the range of flavours, you might simply copy your friend's order, since in the past you know they choose tasty flavours. By copying your friend, you have reduced the cognitive 'cost' of choosing for yourself.
• Someone might hold the heuristic belief that more is always better. This might lead them to choose more of a good when the rational choice might be to have less of the good (think of someone choosing to consume more sugar; less sugar is clearly the healthier choice). This is one way that rational decision making may lead to seemingly irrational choices. Heuristics exists as it sometimes allows for fewer costs involved in making decisions and it is quicker than actively deciding. Nonetheless, relying on heuristics to facilitate choices can lead to an adverse business decision or the inefficient purchase of goods.

Examples of Heuristics

• Satisficing: Proposed by Herbert Simon: Establishment of a goal, 'x'. Once an option is found that satisfies 'x' it is chosen and the search is ended. This process passes the "good enough is good enough" test. In doing so, a human is satisficing as opposed to optimising. For example, when needing a gasoline, instead of driving around town for the gas station with the cheapest price, the driver would stop at the first station they passed with fuel under a certain price (say 130 cents per liter). Thus they are satisficing rather than optimising. This was suggested by Simon to combat constraints from rationality.
• Elimination by aspects: Proposed by Amos Tversky: Typically applied when options have different attributes. Start by giving a weight (level of importance) to each attribute. Gradually eliminate options, by comparing whether they meet the most important attribute until there is only one option left. For example, when buying a house with different attributes (e.g., different locations, sizes or prices), you can write down all important aspects and put weight for each attribute. Then eliminate alternatives that do not include the selected aspect until there is only one alternative left.
• Anchoring and Adjustment: Typically applied when asked to estimate an unknown quantity. Use the available reference point (anchor) and make adjustments based on that anchor to reach an estimate. However, these adjustments are usually insufficient, giving the anchor undue influence over the estimate. It is useful in salary negotiations. If you ask the boss for a 15% salary raise that you think you deserve that, setting your reference point higher than 15%, for example, 30%, may help you to argue successfully.
• Availability and Salience: Explained by Tversky and Kahneman to be a psychological mental reaction/ thought that occurs in one's mind after relying on an immediately available example of a certain topic. For example, after seeing the movie 'Jaws', one might be even more afraid to go to the beach as they think there would be a high chance for there to be a shark encounter.
• Familiarity Heuristic: Developed on the back of Tversky and Kahneman's work, the 'Familiarity Heuristic' describes the tendency of a person to choose things they are familiar with over something new to them. It explains consumers who repeatedly buy the same brands, never considering that another might offer them a higher level of utility.
• Attribute Substitution:Occurs when a complex decision has to be made but is made instead with a simpler heuristic. People exhibiting this bias tend to do so intuitively and haven't sufficiently thought through a concept. People can suffer under this faulty heuristic for a long time before realizing as the initial intuition can work sufficiently to move on to other problems.
• Representativeness: A shortcut used when judgments are made about the probability of an event. When judging a situation based on how similar the prospects are to the prototypes the person holds in their mind.
• Scarcity: The tendency to perceive that when an object or resource is less readily available (for example due to limited quantity or time) it is more valuable. Scarcity appeals are often used in marketing because of this heuristic.

Biases

While heuristics can be an efficient approach to problem-solving, oftentimes they can fail due to a change in circumstances or information, leading to cognitive biases. These biases influence the way decisions are made, often leading to inaccurate & irrational decision making. Cognitive biases can arise as a result of external pressures, emotions, preferences and inhibited information processing.

Cognitive Biases

Cognitive bias is a judgmental bias that has a specific mode of thinking and behavioral tendencies, which often appears under certain specific situations. It is mainly due to the fact that some people have the establishment of social reality based on their subjective thinking and subjective feelings, rather than, according to objective information and evidence. As a result, cognitive bias can lead to some systematic errors in rationality and judgment. For instance, perceptual distortion, inaccurate judgment, illogical interpretation or any other results that collectively referred to ‘irrational’ behaviour and decision making. Some cognitive biases are widely and impliedly accepted or known by the public, as some cognitive biases sometimes save the thinking time and make the action more effective/efficient (which also called Heuristic). However, most patterns of cognitive biases are more likely to be the built-in limitations of human thinking systems, which can easily lead to inappropriate and uncomfortable psychological reactions and ideas or risky decision making and regretful behaviour.

Nevertheless, some other people/researcher advocates that it is controversial whether some cognitive biases should be categories as true irrationality or whether it may lead to useful attitudes and behaviours. For instance, when people want to know each other, they often ask some guiding questions which seem to be a testimony and proof of their own assumptions about others. It is an example of cognitive bias (Confirmation bias). However, some people think that this confirmatory bias should be seen as a social skill for building connections with others. According to researchers Amos Tversky and Daniel Kahneman (1992), people with identical information can end up making different even opposite decisions as they framing identical information differently. Cognitive bias plays an important role in influencing individuals' /customers' decision-making. For instance, the level of exposure of information on an advertisement to customers can influence their performance of certain actions (purchasing products).

Our brain relies on a range of different strategies to make a quick decision, especially when facing an uncertain, risky and urgent situation. Due to the limitation of capacity in the human brain, it often leads to unintentional biases when making important decisions. The list below is 8 of the common cognitive biases that often involve in customer's decision-making and purchasing behaviour (in alphabetical order).

Examples of Biases

• Availability Heuristic: Things that are easy to think of or comes to people’s mind quickly, its probability of occurrence will be overestimated. But whether a thing is easy to think of is determined by factors such as how long has it occurred, how strong are one’s emotions had been aroused at the time and other external factors. Thus, unable to reflect the actual probability of occurrence.
  • For example, after seeing some news about car thefts, people might make a judgment that vehicle theft is much more common and often than it really does. So, people make their decision of purchasing more car insurance, car security gears, and driving recorders, which sometimes can be unnecessary and wasted.

• Bandwagon Effect: people are easily influenced by the unanimous thoughts or actions of the majority of the public. The behaviour and thought of following the public are also called Herd Behaviour . The bandwagon effect influences the interaction between demand and preference. Under the bandwagon effect, when the number of people buying one good increases, people’s preference for it will also increase. This relationship will affect the phenomenon explained by the supply and demand theory, as the theory assumes that consumers will only buy products according to price and their personal preference. Therefore, some companies use this mental bias when designing their marketing strategies, such as online review writers, which make them build up a fake image of popularity in the public.
  • For example, the bandwagon effect can raise the price of a security to an unreasonable high price within a short period of time in the security trade market, if a large number of people all buy that particular security.
  • People tend to visit the restaurant that a lot of people are going, even if they need to wait for long queues, instead of choosing a restaurant that has many more spare seats.

• Confirmation Bias: People selectively memory, gather favourable information, ignore unfavourable or contradictory information and support their own existing ideas, assumptions or beliefs. Especially evident when individuals facing problems with strong emotions or traditional/cultural concepts. It is influenced by personal values, the pressure of family or traditional society or the criticism/avoidance of religious beliefs. Individuals tend to adopt a more favourable statement or selective cognition to rationalize the whole event. Thereby, resolve the external pressure and achieve the balance between mental and physical condition.
  • For example, there is the post-sale period where customers are justifying their purchase decision and seek for positive opinions that support their purchase are worthy and correct. Therefore, some companies use micro-interaction to tell their customers/users they are making the correct choice which is what the users want to believe.

• The Decoy Effect: this effect refers to the introduction of a third option to enhance the appeal of the old option. Due to the limitation of the human brain when thinking and estimating things, people tend to think about decisions that can be easily eased (cognitive ease) . The ambiguous option gives the brain tremendous pressure, thus, when there is an option that is even slightly better, we, therefore, can make a decision without the pressure and make a decision to purchase more easily. This decoy effect is also very closely related to the properties of consumer preference: Completeness, Transitivity and More is Better. This phenomenon proves that a poor option is enough to influence our judgment.
  • For example: As when estimating and judging the preference between water and soft drink, if there is sparkling water which is slightly worse than the soft drink, people will feel that soft drink is better. In this scenario, sparkling water is a ‘bait’ that guides the customer to select the target option – soft drink.

• Endowment Effect: The tendency to value something one already owns higher than on then an identical good they do not own. This is demonstrated where people are not willing to accept the cash equivalent value of a good they own or would not pay the same price for the good that they would sell it for. The endowment effect is also closely related to loss aversion. This bias can be related to the emotional or symbolic characteristics of the product.
  • For example, if a person is selling their car they will not accept the cash equivalent value offered by a car yard, they will try and sell it online for a higher price than what it's worth.
  • Based on this effect, some companies apply strategies such as 'try the products before they buy them' or 'explaining about features and show the products first, before companies show the prices for them'. This could lead to a higher willingness to pay for the product.

• Loss aversion: People prefer to avoid losses rather than equivalent gains e.g, it is better not to lose $5 than it is to find $5. The tendency for loss aversion is explained by "losses loom larger than gains". Some studies have suggested that, psychologically, losses are twice as powerful than equivalent gains. This comes into play for the endowment effect and sunk-cost fallacy, as people want to protect what they already have at the expense of potential gains.
  • For Example, we are more frustrated by losing $20 than we would be happy to accidentally find $20 on the side of the road. The same thing happened to a company's marketing strategies of giving away free coupons and the free trial comes to an end. As under both circumstances, the customer will end up feeling like they are about to lose something they had own previously – even nothing is own by anyone yet.

• Status quo bias: When people either prefer to do nothing or maintain a decision that they have already made. As a result, people are averse to change and tend to stick with default options. There are several cognitive biases that interplay with the status quo bias, such as loss aversion, the endowment effect, and regret avoidance. These biases discussed below, make it difficult for people to choose something that diverts from the status quo.
  • For example, changing the default option for organ donation from opt-in to opt-out has been associated with higher donation rates . Choice options are weighed against a chosen reference point (the "status quo") and perceived as losses or gains.

• Sunk-cost Fallacy: Irrational behaviour in which people try to recover from costs that have already occurred. The magnitude of this effect depends on the temporal gap between payment, consumption, and options available.
  • For example, a negative consequence of this is when a person gets tickets for a concert that they happen to be sick for on the day of the event. Despite this, she will decide to go because she does not want to 'lose' the money that she already paid for the ticket.
  • For example, a positive consequence of this is gym memberships where people usually pay weekly. Therefore, the sunk-costs are higher and perceived more 'recent'. This impulses consumers to go to the gym more frequently, and it improves their welfare in the long-run.
• Ambiguity effect: The tendency to avoid options when the probability of the favorable outcome is unknown.
  • For example, when buying a house, people tend to choose a fixed rate mortgage over a variable rate mortgage even though is has statistically been shown to save money.
• Information bias: When people seek information even when it has no effect on the resulting action. People can often make better predictions or choices with less information but choose to seek extra information believing that the more information is better. This is most notably seen in medical/diagnostic environments.
  • For example, when patients are presenting symptoms and a history which suggest a diagnosis with 80% probability, and an additional test would give either a positive or negative result of a different diagnosis, there is a tendency to complete the additional test.

Anchoring & Adjustment

Anchoring and adjustment is a decision-making tool that assists primarily with numerical based topics. When individuals are faced with a situation in which a numerical answer or conclusion is needed, it can be difficult to begin estimating an answer when there is little known about the given topic. Thus, the individual is given a reference point (an 'anchor') that is readily available, and it is from here that the individual can begin to estimate and 'adjust' their value with respect to the 'anchor'. It is noted that the anchor can affect the overall figure that it chosen by the individual. For instance, if the anchor is significantly higher than the observed final figure, then the individual will more than likely select a number that is just smaller than the anchor, but still significantly larger than the final figure. Therefore, even though the anchor can assist in the decision-making process of selection figures based upon little knowledge about the subject, it can lead to skewing effects in the adjustments made by the individual in selecting their figure.

Examples of Anchoring and Adjustment

• Salary negotiation: Person A would like a 15% pay rise, however, they believe their boss will be reluctant to give a pay rise at this rate. Therefore, Person A asks for a 30% pay rise, knowing full well that the boss will not allow this. The boss is now given an anchor, in which he believes that Person A values their work at a figure that deserves a 30% raise. The boss believes this anchor is too high and settles on giving Person A a 15% pay rise. Here we see Person A receiving the pay rise that was their initial request. If Person A did request the 15% pay rise as is, the boss may believe also that this is too high, thus resulting in Person A receiving a 10% pay rise instead.

• Perceptions of value: If a good for sale is anchored to a high price then an individual's perception of the quality of that good is also likely to be higher. Similar to negotiations, sellers are able to set a price slightly above their preferred ask price and then use price reductions to create the perception of value.

• Population guess: If there was a question asking whether the population of Australia was bigger or smaller than 20 million, the respondent might give one or another answer. Then the following question asked what the respondent thought about the actual population of Australia was, the respondent would very likely guess somewhere around 20 million due to the respondent has been anchored by the previous answer. The proximity of an anchor can, therefore, improve or hinder the accuracy of one's estimation.

Mental Accounting

Mental Accounting is a concept in the field of behavioural economics that was developed and popularised by Richard Thaler. The 1999 Nobel Prize winning Economist's theory in Mental Accounting refers to how, detrimentally, people place different values on money based on subjective criteria. As a result, humans classify their finances differently based on these subjective criteria leading to irrational decision making around money management. This theory can be strongly linked between the importance of reference point and loss aversion. A study conducted at University of Gujrat, Pakistan by /ref> uncovers the similarities between mental accounting and status quo bias that leads to consumer investment decisions. This was the first study that investigates the correlation between the bias and heuristic.

Thaler's 1999 Paper 'Mental Accounting Matters' appeared in the University of Chicago's Journal of Behaviour Decision Making, where he began with the following definition "Mental accounting is the set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities." Underlying Thaler's theory is the idea of fungibility of money. Fungibility is the property of a good or commodity whose units are interchangeable and indistinguishable of another good. In the financial context, this is to say that irrespective of it's intended use, all money is the same. Thaler observed that this fungibility principle is frequently violated, for example when receiving a tax refund. Receiving a cheque from the taxation office is commonly considered and labelled as 'found money', and is therefore additional money that the recipient chooses to spend on a discretionary purchase. However, the truth is that the money always belonged to this individual in the first place as the term 'refund' suggests, a restoration of money. Therefore, these funds should not be treated as a gift and should be viewed in the same way an individual views their regular income.

People use mental accounting, a set of cognitive principles, to organise, evaluate and keep track of their finances. Essentially, instead of treating money like a fungible asset, people treat it differently according to its origin or intended use. To simplify utility maximisation problems, people develop mental accounts for different types of expenses - e.g. accommodation, savings, entertainment, groceries, etc. They allocate their budget across each of these accounts and then maximise utility within each. This can result in suboptimal investment decisions as people do not optimise across their total budget. For example, a person may continually allocate funds to a savings account but also have credit card debt. Because the savings account would have a lower interest rate than the credit card debt, any funds allocated to this account would effectively be earning a negative interest rate. If their goal is to increase their net wealth, their mental accounting bias of always allocating a portion of their income to savings is suboptimal.

Mental accounting also impacts the way people spend windfall gains e.g. a tax return or lottery win. People can very easily spend unexpected windfalls because it is not allocated to a mental account. This is despite traditional microeconomic models predicting consumers would spread the spending of a windfall to smooth consumption.

When an individual who is lucky to win a amount of money, they will tend to differentiate the (winning money) between the money he brought with him originally. the money that has recently been won could is also known as (house money). However, the money has no intrinsic difference, Thaler (2008)believes study shows that people are more willing to gamble with house money. (Richard Thaler and Cass Sunstein, 2008)

Mental accounting bias is commonly experienced in investing as well. As an example, many investors divide their assets between safe portfolios and high-risk portfolios in hope that they can prevent the negative returns from the high risk portfolio from impacting the portfolio. In this example the difference in net wealth is zero, irrespective of whether the investor holds multiple portfolios or one large one. The irrational decision making that stems from mental accounting is frequently experienced by investors. In support of Kahneman and Tvesky's popular theory on loss aversion, Thaler offers his own example where an investor owns shares in two companies; one with a paper gain and one with a paper loss. The investor needs to liquidate to raise cash and must sell one of the two stocks. Mental accounting is biased towards selling the winner even though selling the loser is typically the rational decision due to tax loss benefits, and the belief that the losing stock is a poorer investment. The pain of realising a loss and poor decision is too difficult for the investor to bear, so the investor sells the winner to avoid this.

To overcome the mental accounting bias, individuals should act as if money is perfectly fungible when allocating money against different accounts, whether the account is a budget account (everyday living expenses), a discretionary spending account, or a wealth account (savings and investments). Internally, people should have a dollar value that is the same irrespective of how the money was received, for example whether it was earned through work, won or given to them.

Theoretical Models

Rational choice theory

The Rational Choice Theory purposes that personal objectives are to be in line with decision making. Individuals are more likely to choose, out of a series of options, the one that gives them the greatest benefit or utility. In other words, the individual will do what maximises their utility out of all feasible courses of action. Rational choice theory fundamentally assumes that all humans are actively attempting to maximize their advantage in any given situation. Utility derived from goods and services vary for each consumer and is influenced by tastes and preferences. Higher utility scores, although often arbitrary numbers, means there is a greater incentive to choose that option and vice versa.

It should be noted, that Rational Choice Theory does not completely and accurately describe human behaviour. It is instead a suggested model of the ideal human behaviour.

Rational choice theory assumes three things about consumer behaviour:

1. An individual's taste or preferences determines the amount of pleasure they receive from goods and services.
2. Consumers face constraints or limits on their choices
3. Consumers seek to maximize their well-being or pleasure from consumption, subject to the constraints that they face.

Rational Choice Theory Defences

Rational choice theory has long been contested, but there are many arguments to the model's defence that explain why we learn and work with the model. It is not meant to be descriptive, nor describe what one does as an individual. It instead prescribes how one should aim to act like, and in the best case scenario how one should be making decisions. The model is normative and is based around how people should behave.

• Milton Friedman's argument states that we do not care about the behaviour of an individual, but more the behaviour of the group as a whole. The model resembles the groups behaviour 'as-if' the group members are acting rationally, whether or not that is how they are individually acting. An example of this is that of the pool player. An expert pool player does not write down their angles, power and momentum, though while they are playing it appears that they do.
• Eugene Fama (recent Nobel prize winner in economics) makes the argument that financial markets are efficient in the sense that you cannot beat the stock market consistently. If one beats the stock market one year, they will not beat it the next. If the goal is to understand markets, this is evidence that this model works quite well. He also argues that in markets when there is a lot of competition, the competition would eliminate irrational agents, resulting in firms going bankrupt.
• Dani Rodrik's argument is that we must choose the right model for the right environment. Unrealistic assumptions are not problematic, as long as they are not critical. Critical assumptions are when, if they are changed, the model changes substantially.
• Churchill has the best argument of all. ‘No one pretends that democracy (rational choice theory) is perfect or all-wise. Indeed it has been said that democracy (rational choice theory) is the worst form of Government except for all those other forms.’ Rational Choice Theory is the worst model, aside from the all the other theories. Other models offer different benefits for different circumstances at the cost of difficulty or reduced flexibility.

Utility

Utility represents the ability to satisfy a consumer's want. It is a concept used to measure individual preference for a bundle of goods, measuring the satisfaction of a product. Utility is modeled as a quantifiable property of the services or goods an individual consumes, based on the consumers wants and needs. A good may have utility but it may not be good overall for the consumer. For instance, tobacco has utility to smokers but it is harmful to their bodies. In addition, people who like to eat bananas may derive a higher utility from bananas than those who don't like bananas. Similarly, pork and lamb provides less utility to vegetarians. Utility is a subjective measure dependent on consumer preferences, but is not unrelated to objective reality. A faster car for example can provide objective improvements in transportation efficiency but people can over-ascribe value to this increased speed, leading them to attach more, subjective value to increased speed of a car. Numeric value assigned to represent the utility of a consumer's choices can be entirely arbitrary, in which case, the higher the numeric value, the more utility the choice brings. Despite this, utility can ultimately be measured in objective reality through instruments such as currency.

As an example, one consumer may enjoy pizza with 10 utility while another may hate pizza with 0 utility. The values 10 and 0 in this example are arbitrary but a utility of 10 means greater satisfaction than a utility of 0. In terms of money, a consumer is offered $5 or $10. If the consumer has a preference for more money, they will choose $10 as it offers double the utility. In this example, the dollar amounts were non-arbitrary values.

See http://www.laits.utexas.edu/~anorman/05/consumer.html for more information on utility curves and how consumers maximize utility within a given budget. If one consumes both A and B, and if the consumption of A is greater than B, whilst holding the consumption of B constant, his/her total utility U increases but the marginal utility of A decreases although it remains positive.

Utility is also a measure of “use-value”.

Utility Function

The utility function is the relationship between utility values and every possible bundle of goods: U(Z, B)

Putting the function into practice: Would Lisa be happier with bundle x = 9 burritos and 16 pizzas or bundle y = 13 burritos and 13 pizzas?

Answer: The utility from x = the square root of 9 × 16 = 12 utils. The utility from y = the square root of 13 × 13 = 13 utils. Consequently, Lisa would prefer y to x.

Marginal Utility

Marginal utility = slope of the utility function (holding the quantity of the other good constant)

• E.g. Marginal utility of good Z: $MU_{Z}={\frac {\Delta U}{\Delta Z}}$

Marginal utility is the change in utility for a unit of change (last unit) in the good that consumer consumes. Consumers only consume a good if it increases their marginal utility. However, there is diminishing marginal utility, which means every additional unit consumed leads to a marginal utility that is less than the marginal utility brought by the previous unit consumed.

Preferences

Used primarily in decision making, preferences are a human's specific likes or dislikes, formulated by a multitude of factors such as: geographical location, education, family structure, cultural background, idiosyncratic characteristics and advertising. These factors can shape a humans preferences through both positive and negative reinforcement. Therefore, humans have preferences over their "states of worlds" and not necessarily specific goods. Utility is a term that refers to the satisfaction derived from consuming a good or service. Utility can extend into set of numerical rankings that consumers assign to various goods and services. These numerical rankings reflect the relationship between each good or service's utility values and therefore represent consumer preferences. When talking about consumer preferences, utility theory suggests that it is only important to consider which option is better compared to the other, but it is not important to consider how much better it is. Consequently, consumer preference has three main properties.

Properties of Consumer Preferences

Completeness

When facing a choice between goods, a consumer can rank them so that one and only one of the following relationships is true: For a choice between A and B, the consumer either prefers, A > B, B > A, or A = B; where ">" means "preferred to" and "=" means "indifferent".

For example if A is a large car and B is a small car, only one of the following can be true:

• The consumer prefers large cars to small cars (A > B)

• The consumer prefers bundle small cars to large cars (B > A)

• Consumer is indifferent (prefers both equally) between large and small cars (A, B)

Transitivity

A consumer's preferences over bundles are consistent in the sense that if a person prefers bundle A over bundle B, and bundle B is preferred to bundle C, then we can conclude that the consumer weakly prefers bundle A over bundle C.

Example

• Consumer prefers bundle A to bundle B (A ≳ B)
• Consumer also prefers bundle B to bundle C (B ≳ C)
• We can conclude that consumer prefers to bundle A to bundle C (A ≳ C)

Non-satiation(Monotone preferences)

Often called "more is better property" explains that all else constant, a consumer will always prefer more of a positive good (Example: leisure) rather than less. As for pollution, the reverses hold true. It means less of a negative good (Example: pollution) is always preferred to more. (Example: Pollution). In other words, a consumer will always prefer a bundle which lies on a higher indifference curve (assuming both goods are treated as positive goods).

Elasticity of Demand

Elasticity of demand explains how sensitive a product's demand is relative to price changes. Elasticity measures the percentage increase or decrease of product demand for a 1% increase in price. It looks at demand responsiveness to price changes when all else is kept constant. The price elasticity of demand affects consumer preferences. Factors affecting the elasticity of demand depends on:

Existence of close substitute

The availability of close substitutes means that consumers can switch to other products without high cost or utility imposed.

For example, from apples to oranges or Coke to Pepsi. Suppose there is an apple virus and it significantly reduces the apple harvest, consumers being indifferent between apple and oranges may consider buying more oranges rather than apples. Alternatively, if the price of Coke suddenly skyrocketed, then consumers will switch to Pepsi as it is a close substitute and consumers can enjoy a similar level of utility without paying the higher cost.

Product Differentiation

The more differentiated and novel a product is, the less elastic its demand will be. A differentiated product means that there are no close substitutes for the product meaning despite price increases, demand for the product will remain consistent.

Example: The American grocery store chain, Trader Joe’s, sells items that are unusual, unique and fancier than other brands all at a lower price, with a strong focus on customer service . Trader Joe’s differentiation strategy has been so successful that it is argued the grocery store chain does not have any true competitors.

Necessity/Addiction

Necessity/Addiction categorizes products that consumers have really low elasticity of demand, or even perfectly inelastic demand. Examples include water, cigarettes, drugs, etc. As such, consumers are willing to consume these goods at the same level even when the price increases drastically.

The opposite of necessity also holds true for products that have many close substitutes such as clothes. For example, if the price of clothes is high and you have plenty of clothes in the wardrobe, you may choose to buy less or not buy any at all. This would imply that you have a low elasticity of demand because you do not really need the clothes.

Brand loyalty

Brand loyalty refers to an attachment towards a particular image created by the company through advertising or other channels. High brand loyalty implies a relatively lower elasticity of demand. Thus, even if the price of the product increases drastically, the consumers may still be willing to pay an exorbitant price for that product.

Example: Apple INC Even though the new iPhone 11 Max Pro is essentially the same as its predecessor (iPhone XS Max), people are willing to pay a higher price for this product. The reverse also holds true for low brand loyalty. Low brand loyalty implies a low elasticity of demand. This means if the price of the product increases drastically, the consumers will switch to other products that offer a lower price without much consideration. Example: Fossil Fuel company like Caltex or BP generally have a low brand loyalty as the main determinant of their product, price, fluctuates a lot especially in Australia.

Example: Coke and Pepsi may taste similar, but some people will always buy Coke, while other people will always buy Pepsi due to brand loyalty.

Switching costs

Switching Costs are incurred by consumers as a result of changing brands, suppliers or products. They are comprised of actual/tangible or perceived/intangible costs, which, arise from a variety of sources including monetary, product adoption, shopping/search and other psychological factors. Conceptually, Switching Costs are critical to evaluating consumer decisions, because they demonstrate the pervasive influence of non-economic factors on economic decisions. Importantly, the underlying psychology of intangible Switching Costs mean that consumer economic decisions are subconsciously influenced. For example, it has been found that the psychological phenomenon of cognitive dissonance can lock consumers into making choices which ‘rationalise’ their previous decisions, without complete regard to monetary factors.

A low switching cost creates an ease of entry into a market. The higher the switching cost the less likely it is for a firm to be successful in a new market. Within the context of business, Switching Costs can be applied as part of product development and competition strategy, allowing firms to secure their competitive advantage by diminishing the relative attractiveness of competing products. In practice, Switching Costs are closely related to the concept of Tying. Microsoft exemplified this practice by leveraging switching costs through their ecosystem of software and hardware. Once a user begins to use Microsoft’s integrated products, the perceived cost and actual effort of switching to another competitor, such as Apple, raises an additional barrier to competition. Over time, this allows Microsoft to capture further profits through upgrades and follow-on purchases, as Switching Costs increase as the user becomes more entrenched.

Tangible cost The tangible cost can be referred to as costs that are incurred while changing to a different brand of computer, for example changing from Windows to Apple. There are certain products that are incompatible with Apple's operating system such as a mouse, thumb drive or charger. Thus, the tangible cost of switching brand is the purchase of compatible complementary products.

Intangible costs Intangible costs can be time and effort. For example, Kenan currently uses yellow highlighters from 'Stabilo Boss'. Assuming that he dislikes 'Stabilo Boss' after experiencing it for a while, he may research other brands online and find a better substitute such as 'Pental' to buy instead. The time and effort spent on searching for the replacement is the intangible cost.

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Budget Constraints

A budget constraint is a series of combinations/bundles of two goods that can be bought, given the entire budget allowance is spent on those two goods. The budget constraint is graphed as a straight, downward-sloping line between the Y and X axes. Opportunity sets exist below the budget constraint and consist of all possible bundles of goods that can be consumed without using the entire budget. A simple formula for a budget constraint is:

$p_{1}X_{1}+p_{2}X_{2}=Y$

where p1,2 = price of good 1,2

X1,2 = quantity of good 1,2; and

Y = budget allowance

If $p_{1}X_{1}+p_{2}X_{2}<Y$, then this combination would be considered an opportunity set, as the total cost of the bundle is less than the total budget.

Constrained Utility Maximization

Consumers face the constrained optimization problem where they choose a bundle of goods or services that maximizes their utility. Moreover, changes in price affect the quantity demanded. This could be explained by two factors: purchasing power and substitution effect.

• Purchasing Power: The price of a good decreases, so the consumer purchasing power increases. This means that consumers are saving money because of the reduction of the price; therefore, they can afford to buy other products now. For example, the price of new houses is 600 square feet at $1000 now. One month later, the new price is 600 square feet at $800. Therefore, consumers are saving $200 more which they can use it to upgrade and get a better house.

• Substitution Effect: if the price of a good declines, the good is cheaper related to its substitutes products. Therefore, consumers choose to buy more of that product and less of the substitutes because the utility or satisfaction for that product is greater than before. For example, the price for movies tickets decreases relative to the price of restaurant meals, from $10 to $8. Consumers will choose to go more often to the movies and reduce restaurant meals.

Summary

The below section aims at briefly summarising the key take aways from this topic:

Inattentional Blindness: Failure to perceive an unexpected stimulus in plain sight. Example: Awareness test - https://www.youtube.com/watch?v=Ahg6qcgoay4

Limited Cognitive Budget: When focusing on one task we sacrifice others, our working memory is limited and our attention is more readily captured by things we except.

Human Optimisation: Economic theory says humans optimise but empirically this is not always the case. The ability to optimise depends on a number of factors such as complexity, stakes at play, info asymmetry etc.

Heuristics: Simple rules of thumb the human brain uses to reduce cognitive effort when making a decision. E.g. copying what your friend does under the assumption they made an educated decision. To save you both thinking, you simply go with what your friend chooses. It is important to note that heuristics may lead to biases.

Biases: People are influenced by cognitive biases that can negatively impact decision making. These biases can arise as a result of external pressures, emotions, preferences and inhibited information processing.

Bounded Rationality: The human brain has a bounded ability to solve problems.

Anchoring and Adjustment: A reference point/anchor is often useful in negotiations. E.g. Salary negotiations: set a wage slightly above what you are after and this gives room for the employer to negotiate back down to what you desired. If you started at what salary you wanted, you may have ended up receiving less than hoped for. Also note that a 'status quo bias' is when the status quo is taken as the reference point.

Rational Choice Theory: Individual tastes/preferences mean that the same good can be valued differently depending on the individual. Consumers face constraints (budget) and intend to maximise their consumption. The required properties for preferences include: completeness (options can be all ranked w.r.t one another), transitivity (a > b, b > c implies a > c), and monotonicity (more is better).

Opportunity Set: All the bundles possible (inefficient or efficient) w.r.t the budget constraint.

Determinants of Elasticity of Demand:

- Existence of close substitutes

- Necessity/addiction

- Brand Loyalty

- Switching costs: actual, cognitive

Why do we assume consumers are rational when they are not?:

- As a whole, a populous can be represented as rational (Milton Friedman)

- The fact you can’t beat the stock market is evidence that it works, competition would eliminate irrational agents (Eugene Fame)

- Unrealistic assumptions are only bad if they are critical in the sense that they change the overall result (Dani Rodrik)

- Democracy isn’t perfect but it is still better than the other options (Churchill)