Behavioral Economics 189

Recall that the basic theory of consumer demand is based on three assumptions: (1) consumers have clear preferences for some goods over others; (2) consumers face budget constraints; and (3) given their preferences, limited incomes, and the prices of different goods, consumers choose to buy combinations of goods that maximize their satisfaction (or utility). These assumptions, however, are not always realistic: Preferences are not always clear or might vary depending on the context in which choices are made, and consumer choices are not always utility-maximizing.

Perhaps our understanding of consumer demand (as well as the deci- sions of firms) would be improved if we incorporated more realistic and detailed assumptions regarding human behavior. This has been the objec- tive of the newly flourishing field of behavioral economics, which has broad- ened and enriched the study of microeconomics.23  We introduce this topic by highlighting some examples of consumer behavior that cannot be easily explained with the basic utility-maximizing assumptions that we have relied on so far:

  • There has just been a big snowstorm, so you stop at the hardware store to buy a snow shovel. You had expected to pay $20 for the shovel—the price that the store normally charges. However, you find that the store has suddenly raised the price to $40. Although you would expect a price increase because of the storm, you feel that a doubling of the price is unfair and that the store is trying to take advantage of you. Out of spite, you do not buy the shovel.24
  • Tired of being snowed in at home you decide to take a vacation in the coun- try. On the way, you stop at a highway restaurant for lunch. Even though you are unlikely to return to that restaurant, you believe that it is fair and appropriate to leave a 15-percent tip in appreciation of the good service that you received.
  • You buy this textbook from an Internet bookseller because the price is lower than the price at your local bookstore. However, you ignore the shipping cost when comparing prices.

Each of these examples illustrates plausible behavior that cannot be explained by a model based solely on the basic assumptions described in Chapters 3 and 4. Instead, we need to draw on insights from psychology and sociology to augment our basic assumptions about consumer behavior. These insights will enable us to account for more complex consumer preferences, for the use of simple rules in decision-making, and for the difficulty that people often have in understand- ing the laws of probability.

Adjustments to the standard model of consumer preferences and demand can be grouped into three categories: A tendency to value goods and services in part based on the setting one is in, a concern about the fairness of an economic transaction, and the use of simple rules of thumb as a way to cut through com- plex economic decisions. We examine each of these in turn.

Reference Points and Consumer Preferences

The standard model of consumer behavior assumes that consumers place unique values on the goods and services they purchase. However, psycholo- gists and market research studies have found that perceived value depends in part on the setting in which the purchasing decision occurs. That set- ting creates a reference point on which preferences might be at least partly based.

The reference point—the point from which the individual makes the con- sumption decision—can strongly affect that decision. Consider, for example, apartment prices in Pittsburgh and San Francisco. In Pittsburgh, the median monthly rent in 2006 for a two-bedroom apartment was about $650, while in San Francisco the rent for a similar apartment was $2,125. For someone accus- tomed to San Francisco housing prices, Pittsburgh might seem like a bargain. On the other hand, someone moving from Pittsburgh to San Francisco might feel “gouged”—thinking it unfair for housing to cost that much.25  In this exam- ple, the reference point is clearly different for long-time residents of Pittsburgh and San Francisco.

Reference points can develop for many reasons: our past consumption of a good, our experience in a market, our expectation about how prices should behave, and even the context in which we consume a good. Reference points can strongly affect the way people approach economic decisions. Below we describe several different examples of reference points and the way they affect consumer behavior.

ENDOWMENT  EFFECT A well-known example of a reference point is the endowment effect—the fact that individuals tend to value an item more when they happen to own it than when they do not. One way to think about this effect is to consider the gap between the price that a person is willing to pay for a good and the price at which she is willing to sell the same good to someone else. Our basic theory of consumer behavior says that this price should be the same, but many experiments suggest that is not what happens in practice.26

In one classroom experiment, half of the students chosen at random were given a free coffee mug with a market value of $5; the other half got nothing.27

Students with the mug were asked the price at which they would sell it back to the professor; the second group was asked the minimum amount of money that they would accept in lieu of a mug. The decision faced by both groups is simi- lar but their reference points are different. For the first group, whose reference point was possession of a mug, the average selling price was $7. For the second group, which did not have a mug, the average amount desired in lieu of a mug was $3.50. This gap in prices shows that giving up the mug was perceived to be a greater “loss” to those who had one than the “gain” from obtaining a mug for those without one. This is an endowment effect—the mug was worth more to those people who already owned it.

LOSS AVERSION The coffee mug experiment described above is also an example of loss aversion—the tendency of individuals to prefer avoiding losses over acquiring gains. The students who owned the mug and believed that its market value was indeed $5 were averse to selling it for less than $5 because doing so would have created a perceived loss. The fact that they had been given the mug for free, and thus would still have had an overall gain, didn’t matter as much.

As another example of loss aversion, people are sometimes hesitant to sell stocks at a loss, even if they could invest the proceeds in other stocks that they think are better investments. Why? Because the original price paid for the stock—which turned out to be too high given the realities of the market—acts as a reference point, and people are averse to losses. (A $1000 loss on an investment seems to “hurt” more than the perceived benefit from a $1000 gain.) While there are a variety of circumstances in which endowment effects arise, we now know that these effects tend to disappear as consumers gain relevant experience. We would not expect to see stockbrokers or other investment professionals exhibit the loss aversion described above.28

FRAMING Preferences are also influenced by framing, which is another manifestation of reference points. Framing is a tendency to rely on the con- text in which a choice is described when making a decision. How choices are framed—the names they are given, the context in which they are described, and their appearance—can affect the choices that individuals make. Are you more likely to buy a skin cream whose package claims that is will “slow the aging process” or one that is described as “making you feel young again.” These products might be essentially identical except for their packaging. Yet, in the real world where information is sometimes limited and per- spective matters, many individuals would prefer to buy the product that emphasizes youth.

Source: Pindyck Robert, Rubinfeld Daniel (2012), Microeconomics, Pearson, 8th edition.

2 thoughts on “Behavioral Economics 189

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