Mental Accounting Chapter 2 of Belsky & Gilovich

THE PSYCHOLOGY OF PRICE Mental AccountingChapter 2 of Belsky & Gilovich • M/M Jones go on a fishing trip. The salmon they caught were lost in transit, so receive $300 compensation. They dine out for $225, more than ever they spent at a restaurant before. Why? • Mr. X is $50 up in a poker game. With a Queen high flush, he bets $10, and wins. Mr. Y’s 100 shares of IBM are up 1/2, but is even at poker tonight. He has a King high flush, but folds, thinking if he’d been up, he’d have called.

Endowment Effectand the Fungibility of Money - review The Endowment effect -- if given an asset, people are reluctant to give it up. Biased toward the status quo. • In market experiment, owners of assets are more reluctant to give them up than buyers to get them. • No service charges at banks, with minimum balance vs. paying a service charge. • People appear to keep large minimum balances, even though more costly than paying a service charge.

Perception of Price Differences • People havelimited time and interestto study offers. • People use methods to reduce the effort to make decisions even if the decision may be sup-optimal. • Odd endings in price - some proposed reasons include: • Stereotypical Reasoning- all branded products are better than generic ones • Elimination by Aspects- product choice that cuts off at pre-assigned thresholds • Find the BEST microwave oven at American TV & Appliance • Pick those less than $500, with at least 750 Watts, etc. • Bounded Rationality- Herbert Simon, Nobel laureate. • Cash Register Theft Reduction

Perception of PercentageDifferences • People appear to use percentages rather than absolute cost differences • EXAMPLE: $1,000 -> $600 vs. $20,000 -> $19,600 • Both have $400 savings through a particular action, but which one is viewed as “more important” to undertake? • Weber-Fechner Law: evaluation relative to a base price. • The first offer involves is a 40% savings, whereas the second offers provides only a 2% savings.

Changing the price 4% each year for 5 years viewed differently than a one time 20%+ jump in prices. 2 brokerage houses, one raised fees gradually & 1 held prices constant, but eventually raised them a lot. School districts and municipalities know this. Example: Discount gas stations vs. branded ones grant a 2-cent advantage. A: $2.02 vs. $2.04 or B: $3.95 vs. $3.97 Weber-Fechner would predict that discount stations would be more successful under A than B. It is often found however that under B, people act more price conscience, the reverseof Weber-Fechner. Implications for Weber-Fechner Law

Issues in Reference Prices • Marketers realize that the ‘value’ of an offer depends on the items or information the consumer uses to compare. The benchmark. • Mutual fund managers want the benchmark to be passbook savings rates, but rules require them to use appropriate index benchmarks. • We’ll look at Reference Prices based on: 1. Current Prices 2. Past or Recalled Prices 3. Purchase Context

Current Price References • Product line pricing • “Well, a Chevy is cheaper then an Olds” • Expansion in the price-quality dimension can make mid-priced products more attractive, sometimes at the expense of competitors. Panasonic I & II vs. Emerson microwaves example: • 57% picked the low-priced Emerson vs. Panasonic, but when the bigger Panasonic II appeared, the number dropped to 27% • We read left to right: first seen price is reference point • Focal Point Pricing-- prices with odd endings • Was $7.00, now $6.89, There’s $2.29, ours $1.97

L R • Explanations of Focal Points: 1. Memory and analysis is not free 2. Used as a tool of collusion. 3. We process limited information to reduce our cost of decision-making. First number plays biggest role. “How much was the mouthwash?” “Oh, 2 something, I guess.” • Experiments • List in ascending order of price and descending order of price. Order effectsmatter on subject’s reference prices. (Asked to pick one, the Descending Order list lead to higher priced products selected.) • Catalogues list prices in generally descending order • I view this as Left to Right, as most read page 1 first.

Past Prices as Reference Price • Problem with LOW INTRODUCTORY PRICE • Leads to a low reference point • Prefer use of COUPONS or give away to avoid this problem • Experiment on Sales with and without promotional price cutting on a new toothpaste • Weekly sales with no price change 860 ---> 1,050 • the control group • Weekly sales with low initial price 1,280 ---> 1,010 • the experimental group

People appear to have Short Attention Spans • Last Price is the Reference Price • Sticker Shock in cars, when last price paid was 15 years ago. • Last comment remembered best, “Oh, my friend had problems with his Taurus,” even when your research in Consumer Reports gave it a Best Buy. • Example of Electricity • Ads emphasize that prices have greatly risen for movie tickets, whereas electricity prices are modestly higher. • Recall problem greatest for older citizens who remember much lower prices.

Cost changed in terms of a monthly cost vs.... other expenses Get HBO, it’s cheaper than going on a date to the theater per month. Get Encyclopedia Britannica, it costs just $57 per month, which is cheaper than a private tutor. “only pennies a day.” attempt to change context. Beer purchased in a hotel vs. a beer purchased at a ball park vs. a beer purchased at a convenience store. People willing to pay more for beer at hotel, even if a take out for the beach. Reference Impact by Purchase Context

Prob = f( current sample, and prior expectations) Both matter, but excess weight given to most recent data point, which means that Reference Prices are changeable. Ex: You know that Volvo’s last a long time, but some tells you that a friend’s Volvo lasted only 2 years. Ex: A witness of a traffic accident said, the “Taxi Cab was Blue,” in Lorraine, Ohio. The witness is 80% reliable in picking between Green & Blue Cabs, but 85% of the Cabs there are Green and only 15% are Blue. Juries place nearly 100% confidence in witness. Bayes would place it at less than 80%. Juries violate Bayes law. Bayesian Statistics and Decisions correct is 41%

Bayes Law Using Joint Prob. I say that I saw a: BLUE Taxi GREEN Taxi • Will say Blue 29% of the time, but be correct only 12% of the time. • Hence .12/.29 = .41 percent likely that witness is right. (.15)(.80) = (.15)(.20) = .12 .03 (.85)(.20) = (.85)(.80) = .17 .68 .29 .71 BLUE in Fact GREEN in Fact

Prospect Theory • Utility theory based on the LEVEL of wealth or income received. • Prospect theory based on the choice relative to a base point. The difference (prospect) is categorized as a gain or loss. • Transaction utility theory based on the purchase relative to reference price, is also viewed as gains or losses. • Prospect theory seems to explain several anomalies.

Prospect Theory: Asymmetry over Gain and Loss prospects. VALUE FUNCTION Losses Value function over GAINS is risk averse Value function over LOSSES is risk loving or risk seeking. Never buy a $750 stereo, but you do with a car purchase. Gains

It explains why companies pay dividends Gains should be separated It explains why companies announce all the bad news at one time Take a bath, bundle negative prospects It explains the purchases of $750 stereos in Cars. It explains packaging that says, 35% more for free. Separate gains and losses, to create a Silver Lining. It explains why we wrap Christmas and Birthday gifts separately Separate gains. Paying $.15 from a $20 bill as “breaking a bill”. Seen as a loss prospect. Uses for Prospect Theory

Mail-in Rebates • Walgreen’s sells 2 AA Energizer Batteries for $2.38. It sells a package of 10 of these same batteries for $14.29, with a $7 mail-in rebate. • Use Prospect Theory to explain the offers. Deals which say no payment until January 2009 are: • Buy Now, Pay Later, which decouples acquisition with the loss. AA

Pricing, Risk, and Survey Anomalies • People act risk averse in Prospect Theory if the choice is framed as a GAIN. • People act risk seeking in Prospect Theory if the choice is framed as a LOSS. Survey: • People can be asked what policy should be taken for an outbreak of flu that will otherwise kill 600 people. • Changing the frame • Changes the reply • ,

Payoff Matrices for Death by Flu Survey framed as saving folk This saves 200 (that is 400 will die) 1/3 of saving everyone (that is, 2/3 chance all die) In policy C, 400 will die (that is 200 are saved) In D, 1/3 chance no one dies (that is, 2/3 that all die) • 600 expected to die from the flu • most pick A • we act risk averse • Survey framed as losing people • now most pick policy D even though A and C are identical A B C D Survey framed as losing folk

Products with Failure Risk • Product failure tends to be framed as losses, so customers tend to be more risk-taking, and avoid paying for product insurance. • Sales of insurance tend to emphasize ‘protect the future,’ as a form of framing as a gain. • Coupons with Rub-Off unknown discounts, framed as gains, lead to risk averse decisions not to buy. • But if the cost of the product is framed as a Loss, the coupon gamble appeals to risk-seekers over losses.

Sudan is Africa’s largest country Slavery reappeared after the National Islamic Front took control of the Sudan Humanitarian efforts to return slaves to freedom, is called manumission. The cost of freeing a slave is $100, which many of us would be willing to pay. The unintended consequence is that enslaving somebody yields a return of $100, or a fifth of a year’s salary Slave redemption efforts have tended to increase slavery, or sometime fictitious slaves SLAVE REDEMPTION IN SUDANMBN Chapter 8

Seeing Camels in the Clouds • The cycle of days and seasons make early man look for patterns, and we do it too. • The Gambler’s Fallacy • The belief in a self-correcting pattern • Beginning of the Tom Stoppard play Rozencrantz and Gildenstern are Dead • Streaks and the Hot Hand • Most basketball fans want the ‘hot hand’ to get the ball • Less to it than meets the eye • Investing with the fund manager that did well last year is often a prescription for mediocre performance

When you go to the grocery story hungry… What happens? When you invest and you are happy or sad… What happens? Mood affects our subjective probability of success in the future We know how to make bad news into good news We’re adept at ignoring negative information when we’ve already made our minds “Don’t confuse me with the facts!” Seasonal affective disorders (SAD) works on the amount of light Depression and suicide statistics Investors tend to buy when they are more optimistic (in better weather) Differences in returns Sunny Days – Overcast Days Positive number means that there is an “effect”. Positive returns found But, there are always an equal number of buyers and sellers from around the world! Moodand Investing

Psychology of Savings Saving is a basic duty for animals and humans. • Why does saving behavior vary? • Private knowledge of life expectancy? • Belief in a Fairy Godmother who will come to help. • Differences in time preference • Low discount rates associated with some personality types that take the long view • High discount rates with impatient types • Difference is goal-orientation? Persistence? • Hard to base theories on personality generally.

Positive Election - is a decision to do something Requires overcoming fear Overcoming decision paralysis And completing a task Many Traditional & Roth IRAs were started and never continued. Negative Election - is a decision to stop something If involved in a monthly deposit saving program, it is about as hard to STOP it as to START it 401(k) with Negative Election have very high participation rates Automatic vsVolitional Methods

Incentives to Save Invest $100 each mo. Price #Shares $10 10.0 $12 8.33 18.33 Ave. price is $11 Ave. cost is $10.91 • Tax deferral or avoidance • Dollar-cost averaging • The power of compound interest • Increased sense of security • Social Security payments • Retirement plans • Preference for consumption today • Painful to think about one’s future Disincentives to Save

Poor Training in Savings • Lengthening time to economic maturity postpones savings • There are few good rôle models in savings • Not in Government, Church, or Sports Heroes • Housing as a savings substitute • The ‘safety net’ idea makes it seem as if saving is not necessary or especially virtuous

Cash Management • to smooth out uneven income and expenses Buffer for unforeseen emergencies • historically one month’s income • credit cards affect this requirement Achieve a desired goal • after the first two needs are met, move up the hierarchy of motives to saving for vacations, cars, or retirement Wealth Management • often this last goal occurs later in a household’s lifecycle Saving Motives

Suppose we try to maximize our lifetime utility May involve spending more early in life and saving later in life If you live four score years, then what is the use of having money left over? Leftover money goes to our relatives who are also part of our utility function. Fear more of running out of money than of leaving some on the table. The miserly save too much. Intergenerational Transfersversus Dying Broke !

Mental Accounting Chapter 2 of Belsky & Gilovich