Are We Truly Rational Consumers?
BY DRISHTI RANA / SEPTEMBER 11, 2021
In an economy where studying consumer behaviour is key to designing effective and profitable market strategies, there are many ways in which economics fails to explain how we make decisions.
o, I’ll start with a hypothetical gamble for the readers. Let’s say I offer you a bet wherein, I flip a coin and if the outcome is heads, I will pay you USD 200, and if the outcome is tails, you pay me USD 100? Fair enough? Well, more than fair for you. Statistically speaking, the expected value of the bet is 0.5 considering it’s a fair coin with a probability of heads being 0.5 times 200 plus 0.5 times negative 100, since USD 100 corresponds to a loss, so that would make it USD 50. What would you do? Would you take the bet?
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Okay, moving on, now I offer you another gamble. I will flip the coin 100 times and the bet remains the same. Take a moment and ask yourself would you take the bet this time? Most people would respond with a yes given the law of large numbers. If you win the bet you will win around USD 5000. But that’s only when you win. What guided your decision?
In the first scenario, even though the likelihood of both the outcomes are equal, the consumer tends to focus on the loss more and hence, the gains look much smaller when compared to the losses. This is because, if you lose, you know for a fact that you will lose the money that you already possess. When given the choice between two equal probabilities, more often than not people choose to retain the wealth they possess, instead of risking the money to earn more. In other words, we are valuing the losses more here because we are averse to the possibility of losing even though there exists an equal probability to win.
Illustration: Unknown via UX Collective
It demonstrates that people think in terms of expected utility relative to a reference point (the current wealth) rather than absolute outcomes. However, in the second case, we might be ready to take the risk of a loss even though the perceived gains look much larger since the perceived pay-offs justifies this risk-taking behavior. But math wouldn’t agree with this sort of justification. If you were a rational decision-maker, you would not have agreed to comply with the second bet.
When given the choice between two equal probabilities, more often than not people choose to retain the wealth they possess, instead of risking the money to earn more.
Illustration: Unknown via stimulatinghealthcare.net
The situation displayed above is a real one that occurred between two professors at Massachusetts Institute of Technology (MIT) when Professor Paul Samuelson offered this gamble to E. Cary Brown and serves as the perfect example for what is called, The Prospect theory.
However, the assumptions about rationality while engaging in market transactions do not correspond to real-life, wherein a number of ingrained heuristics come to light while making investment conclusions.
The elements of these theories do not consider the psychological buoyancy and idiosyncratic flaws in our understanding of perceived gains and losses. We would like to believe that we are rational decision-makers, and we certainly are, however, according to economic assumptions, we fail to acknowledge our susceptibility towards cognitive biases. One of the most common one being loss aversion. This would be apparent in the way people buy insurance policies. Why do people buy insurance schemes? Not to say that they should not, but what draws people towards these schemes even though they understand that the plausibility of a costly event may be minuscule.
We would like to believe that we are rational decision - makers, and we certainly are, however, according to economic assumptions, we fail to acknowledge our susceptibility towards cognitive biases.
For instance, although the likelihood of an earthquake or a tsunami is close to slim, we tend to agree to pay a premium rather than risk paying a substantial amount if such an event occurs. Similarly, in paying for health insurance, people tend to avoid enduring greater loss in terms of payment which might occur due to some health condition in the future which in reality may or may not happen. The decision-making is guided by the perceived probability of a health problem in the future rather than the actual probability.
To sum up, prospect theory offers an interesting insight into the working of human cognition while they are trying to be rational consumers. The underlying susceptibility towards cognitive biases cannot be explained by the economic assumption of consumers being rational. Investment and insurance decisions are often based on subjective interpretation of probable outcomes which requires careful examination before taking the plunge.
Illustration by Livia Cives via Dribble
About the author: Drishti Rana is an economics and psychology student from St. Xavier's College, Mumbai. She has wide ranging interests but particularly enjoys writing and reading conspiracy theories. Apart from that, she enjoys comparing Camus with Kierkegaard.
Keywords
Rational consumers, Consumer behaviour, Gamble, Utility, Pay-offs, Risks, MIT, Paunl Samuelson,E. Cary Brown, Prospect Theory,
Amos Tversky, Daniel Kahneman, Investment, Probabilities
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References
Anonymous (2020, October 14). Prospect theory. BehavioralEconomics.Com | The BE
Hub.
https://www.behavioraleconomics.com/resources/mini-encyclopedia-of-be/prospe
ct-theory/
Kahneman and Tversky’s Prospect Theory. (2017). San Jose University
Economics Department.
https://www.sjsu.edu/faculty/watkins/prospect.htm
Luo, K., Dang, S., Shihada, B., & Alouini, M. S. (2021). Prospect Theory for
Human-Centric Communications. Frontiers in Communications and Networks, 2.
https://doi.org/10.3389/frcmn.2021.634950
Schmidt, U. (2015). Insurance demand under prospect theory: a
graphical analysis. Journal of Risk and Insurance, 83(1), 77–89. https://doi.org/10.1111/jori.12098
Seth, R., & Chowdary, B. A. (2017). Behavioural Finance: A Re-Examination of
Prospect Theory. Theoretical Economics Letters, 07(05), 1134–1149.
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