Much of consumer choice theory relies on the notion of individuals as economic agents; that is, beings of absolute rationality who don’t struggle with everyday problems like self-control and decision-fatigue. These agents conduct marginal analysis to extract every drop of wellbeing from seemingly routine decisions. In the late 70s, however, psychologists began to interfere with these mathematically convenient assumptions, birthing a new field of behavioural economics that deals with problems such as loss-aversion, unstable preferences and the aforementioned self-control issues.
Amongst the first of these challenges was a paper titled ‘Prospect Theory,’ written by psychologists Daniel Kahneman and Amos Tversky. Much of this paper was, in fact, consistent with traditional economic theory. For example, the law of diminishing returns from consumption, which is essentially the idea that the more one consumes, the less benefit is obtained from each additional unit of consumption. The main difference between ‘Prospect Theory’ and traditional economic theory was that the psychologists’ paper suggested that there were also diminishing marginal costs from losses. In fact, from the body of survey evidence obtained it seemed that not only were there diminishing costs, but they were also about two times as severe as monetary gains of equivalent magnitude. This is, of course, starkly opposed to economic rationality – why would a $100 loss hurt more than a $100 gain? It’s the same amount. Apparently, humans are wired to be loss-averse, rather than wholly rational.
At this point, you might be wondering whether their ‘survey evidence’ was actually reliable at all. While I can’t actually prove this, I can ask you questions similar to the ones they did and allow you to come to your own conclusion.
A) Would you be willing to walk 5 minutes across town to save $5 on a $15 purchase?
B) Would you be willing to walk 5 minutes across town to save $5 on a $2000 purchase?
Traditional economic theory would have individuals answer both questions the exactsameway. That is, if you were willing to walk 5 minutes for A, you’d do the same for B. But I’m willing to bet that you answered the questions differently. And you’re not alone. By answering the questions differently, individuals are violating another key economic assumption: that people have stable preferences. The idea of “stable preferences” is that each economic agent knows exactly what they want and can rank their value in an exact order. In this example, answering the questions differently means you’re being inconsistent with your valuation of time, i.e. if 5 minutes was worth $5 in A, why wasn’t it worth $5 in B? Of course, most of you already intuitively know why you answered the questions differently – Part B’s expenditure was much greater than Part A, making the $5 a smaller percentage of the purchase amount. This implies that individuals havea sense of diminishing costs as well as gains. The diagram below illustrates this concept in a far more tractable manner.
As we can see, the negative slope for losses is about two times greater than the positive slope for gains, suggesting that for every $100 in benefits gained, you’d only need $50 in losses to be back to square one (in terms of utility, not absolute value). Moreover, the fact that individuals exhibit diminishing sensitivity to both gains and losses has another interesting implication; individuals will be risk-averse for gains (as they provide increasingly lower utility) and risk-seeking for losses (as they incur lower and lower costs). The notion of risk-seeking is more obvious when we consider a thought-experiment involving an opportunity to break-even in gambling. American economist, Richard Thaler, suggested that risk-seeking was only implied if individuals thought they had an opportunity to regain their losses. To test this, he asked individuals the following questions.
- You’ve just lost $20, now choose between:
- A 33% chance to gain $20 and a 67% chance to gain nothing
- A sure $10
- You’ve just lost $20, now choose between:
- A 33% chance to gain $9 and a 67% chance of losing $9
- No further gain or loss
In Part A, 60% of individuals chose the gamble, whereas in Part B, only 40% of individuals chose the gamble. The main difference between the two questions was that Part A offered the ability to break even. And as a result of this opportunity, risk-seeking behaviour increased 20%.
More intriguing, however, is the fact that the decision-making process here is far from the risk-neutral method used in rational-agent models. Such an economic agent would use the expected value of the options, finding that in Part A, the expected value for the gamble is only $6.6 compared to the guaranteed $10. They would therefore choose the guaranteed option. In this way, it’s clear that the assumption of rationality and stable preferences don’t always hold true in reality.
Economists and students will also likely be familiar with the concept of consumer surplus. This refers to the monetary difference between the price of a good/service, and the price that a consumer is willing to pay for it. In behavioural economics, this is also known as acquisition utility. There is, however, another type of utility: transactional utility. Transactional utility considers the perceived quality of the deal. For example, consider a scenario involving a service station and a 5-star hotel. A coke at a service station would cost around $3. A coke at a 5-star hotel, however… maybe $5. That means that one’s willingness to purchase a good or service differs depending on where it is bought, despite the fact that they are homogenous, i.e. identical.
This also implies an unusual scenario when it comes to a principal-agent relationship. Suppose Tom gave his friend Sam $5 to buy him a coke from the nearby hotel. Sam, however, knows that it’s cheaper at the local service station, so he decides to buy it from the service station and tell Tom that he bought it from the hotel. When Tom hears that it only cost $3, he’s ecstatic, and has just gained $2 in transactional utility. This is despite the fact that his friend lied to him; his coke didn’t actually come from the 5-star hotel. Here we find an interesting means through which Sam can increase Tom’s perceived utility.
The idea that individuals have no issues with self-control is another implied assumption in many economic models. In other words, rational agents would have no issues resisting further consumption when they have reached the rational utility-maximising quantity. However, as most people find out during the holidays, this isn’t always true. For example, consider the following hypothetical conversation between a model economic agent and an ordinary individual:
Agent: Why did you hide your chocolates?
Human: Because I didn’t want to eat any more of them.
Agent: Why didn’t you just stop eating them instead of wasting effort to hide them?
Human: Because if they were here, I would still be eating them.
Agent: But I thought you didn’t want any more?
It’s easy to see that this conversation isn’t going anywhere. You see, by mathematically formalising the idea of marginal analysis, economists have implicitly assumed that people know exactly how much they want, and that they possess the self-control to act accordingly. But reality isn’t so simple.
Hopefully, you can see that economic assumptions aren’t infallible. But that doesn’t mean we should completely abandon them. Simplified models are built from strict logical principles, allowing us to discover connections between behaviours that would have been imperceptible without a formalised approach. Put simply, economic models are useful, but it’s important to know their limitations and strive to improve them. That is the purpose of behavioural economics. It’s also worth acknowledging that the rational-agent model is far from the pinnacle of economic research. In fact, much of modern economic theory has been directed towards dealing with consumer choices involving well-known cognitive biases, as discussed above. While we are from a “perfect theory” of consumers, modern economic research is making great progress in constructing more realistic models.