Ch.

8 Cognitive Limitations and

Consumer Behavior
Intro
Faculty tennis courts Already paid fixed fees for both
1. Outdoor: Fixed fee only courts.
2. Indoor: F + 20H

People who want to play regularly on the indoor court must commit
themselves to reserve a specific hour each week. Having done so,
they must pay for the hour whether or not they use it.
During good weather, almost everyone prefers to play on the
outdoor courts.

You are committed to pay for an indoor court at 3 PM on Sat, Oct

20. It is a warm, sunny afternoon. Where should you play, indoors or
out?

Many people made a wrong choice! (Failed to ignore sunk costs)

2
Chapter Review
} Focus on irrational behavior that is the result of failure
to see clearly how best to achieve a desired result
} Ex: failure to ignore sunk cost
} People often do want to alter these behavior once their
consequences become clear to them
} Examine several behavioral models of choice that often
do a much better job of predicting actual decisions
than the rational choice model
} These behavioral models claim no normative
significance
} They tell us, for instance, that we often do tend to ignore
sunk cost, not that we should ignore them

3
Bounded Rationality
} Herbert Simon
} Human beings are incapable of behaving like the
rational beings portrayed in standard rational choice
models
} When we ourselves confront a puzzle, we rarely reach a
solution in a neat, linear fashion. Rather, we search in
a haphazard way for potentially relevant facts and
information, and usually quit once our understanding
reaches a certain threshold. Our conclusions are often
inconsistent, even flatly incorrect. But much of the time,
we come up w/ serviceable solutions
} We are “satisficers,” not maximizers

4
Herbert Simon
Born June 15, 1916(1916-06-15)
Milwaukee, Wisconsin, USA
Died February 9, 2001 (aged 84)
Pittsburgh, Pennsylvania, USA

Nationality United States

Fields Artificial Intelligence

Cognitive psychology
Computer science
Economics
Political science

Institutions University of California

, Berkeley

5
Kahneman & Tversky
} Kahneman
} Nobel Prize in Economics (2002)
} Even with transparently simple problems, people
often violate the most fundamental axioms of
rational choice

6
Daniel Kahneman
Born 5 March 1934 (age 75)
Tel Aviv, Israel

Residence United States

Nationality Israel

Fields Psychology, economi

cs

Institutions Princeton Univer

sity 1993-

7
Experiment
} Group 1
} Imagine that, having earlier purchased tickets for $10, they
arrive at the theater to discover they have lost them
} Group 2
} Picture themselves arriving just before the performance to
buy their tickets when they find each of them has lost $10 on
the way to the theater
} Question
} Will you continue with your plan to attend the performance?
} Result
} In repeated trials, most people in the lost-ticket group say
they would not attend the performance, while 88% in the
lost-bill group say they would

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} Fungibility (exchangeable; replaceable)
} One of the most cherished tenets of the rational choice
model
} Our total wealth, not the amount we have in any
particular account, determines what we buy
} K&T expalined people apparently organize their
spending into separate “mental accounts” for food,
housing, entertainment, general expenses, and so on.
} Group 1: Act as if they debit $10 from their entertainment
accounts  For them, the loss makes the apparent cost of
seeing the show rise from $10 to $20.
} Group 2: Act as if they debit $10 from their general expense
accounts
} Rational choice model: Group 2’s assessment is the correct
one

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Asymmetric Value Function
} Event A
} You get an unexpected gift of $100
} Event B
} You return from vacation to find an $80 invoice from the city
for the repair of a broken water line on your property
} Rational choice model
} Net effect on total wealth = $20 > 0  You should regard
the occurrence of these two events as a good thing
} K&T
} People seem to weigh each event separately, and attach
considerably less importance to the gain than to the loss – so
much less that many people actually refuse to accept pairs of
events that would increase their overall wealth!

10
Utility of a Pair of Events that Increases
Total Wealth

11
K&T Value Function

- Defined over changes in

total wealth
- Steeper in losses than in
gain
- Concave in gains, and
convex in losses

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} K&T emphasized that their value function is a
purely descriptive device
} Try to summarize in the ways people actually seem to
make choices
} Not claim that people should choose in the ways
predicted by their value function
} Two features of K&T value function
} People treat gains and losses asymmetrically
} People evaluate events first and then add the separated
values together
} Ex: V(100) + V(-80) < 0

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Example: Medical Insurance
} Old Plan
} Full coverage
} Premium = $500
} New Plan
} $200 deductible
} Premium = $250
} Rational choice model
} New > Old
} Savings in premium = 250 > largest possible increase in
uncovered expenses = 200
} Reality
} Many people are adamant in their wish to remain on
14 the old plan
Rejection of a Dominant Insurance Plan

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Sunk Costs
} A thought experiment
} Imagine that you have bought a pair of fashionable
shoes for $600, only to discover that they are painfully
tight, causing considerable discomfort
} Do you continue if you had not bought the shoes but
instead had received them as a gift?
} Rational Choice Model
} ?
} Reality
} People are much more likely to say they would abandon the
shoes if they receive them as a gift.

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Out-of-Pocket Costs vs. OC
} Tickets for the best seats to the 2009 Super Bowl
sold for $1,000 through official channels
} In the open market went for prices as high as
$10,000
} Thousands of fans used their $1,000 tickets to
attend the game, thus passing up the opportunity
to sell them for $10,000.
} Very few of these fans, however, would have spent
$10,000 to buy a ticket for the game
} X = the value from attending the game
} V(10,000) < X < -V(-10,000)

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 } A person in 1982 bought a case of wine for $5/bottle.
} Today the same wine sells for $100/bottle.
} His wine merchant offers him $60/bottle for it.
} He refused this offer, even though the most he would
pay for the same wine today is $35/bottle.
} If out-of-pocket expenses (for the purchase of
additional wine) are coded as losses, while OC (of not
selling the wine to the merchant) are coded as forgone
gains, then the asymmetric value function allows for
just such a response
} OC = 60
} WTP = 35 < OC  But keep the wine for himself
} V(60) < X = -V(-35)
 X = the value from consuming the wine
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 affective = emotional

Affective Forecasting Errors

} In many cases, intelligent choice requires that we
predict not only which alternative will be more
satisfying at the moment but also how the experience
of each would evolve over time if chosen
} Yet adaptation typically receives little attention when
people confront purchase decisions
} We estimate the attractiveness of a good or activity by
trying it and seeing how it affects us  first
impressions
} Ex
} A house w/ a view
} A new car

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Affective Forecasting Errors
} Finding
} People tend to adapt much more quickly to the
consumption of goods than to the consumption of
experiences
} Ex 1 (decay rapidly)
} TV sets w/ bigger screens
} Refrigerators w/ greater capacity
} Ex 2 (mildly unpleasant at first, become more
pleasurable)
} Experience of vigorous exercises
} Play a musical instrument

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Example: Trade in Toyota Corolla for a new
Porsche Boxster?
} Meet the payments on the new car by working an
additional Saturday each month
}  Not spending that Sat. w/ friends
} In the long run, extra time w/ friends might well prove
to be the better choice
} Yet the short-run increment in satisfaction might easily
be higher w/ the new car
} Because the short-run effects are the most vivid and
readily available sources of information at the moment
of decision, they may bias choice in favor of the car
} cf. 충동구매

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Porsche Boxster

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Toyota Corolla

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Figure 4
Static and Rising Consumption Profiles

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} Which consumption profile would you choose?
} A: Everyone consumes $50,000 every year
} B: Everyone starts out consuming $40,000 and ends up
consuming $60,000
} When asked this question, a large sample (almost
80%) of undergraduates voiced a strong preference
for B
} The amount we consume at one point in time affects
our ability to derive pleasure from a given consumption
level later on

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Frame of Reference
} Our evaluation of everything – including material
living standard – depend on our frames of
reference
} One frame of reference
} Comparing what we currently have to what others have
} A second frame of reference
} Comparing what we currently have to what we ourselves had
in the recent past
} Someone who consumes $50,000 this year is more likely to
be satisfied w/ her standard of living if she consumed
$45,000 last year than if she had consumed $55,000
} People who consume too much too soon thus establish a
more demanding frame of reference w/in which their later
consumption must be evaluated
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 } Many of us never consciously consider the extent to
which our current spending habits affect our
evaluations of future living standards.
} To the extent that we ignore this relationship, we will
tend to save too little
} cf. Drug abuser’s failure to anticipate increasing
tolerance to his drug of choice

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Choice under Uncertainty
} K&T showed the expected utility model does not
always provide a good description of the way
people actually decide.

} Problem 1
} A: A sure gain of $240 (84%)
} B: A 25% chance of getting $1000 and a 75 chance of
getting $0 (16%)
} EV = $250
} consistent w/ EU model

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A risk-averse person will usually prefer a sure gain to a
lottery w/ slightly higher expected value

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} Problem 2
} C: A sure loss of $750
} D: A 75% chance of losing $1000 and a 25% chance of
losing $0
} EV = -750

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} Problem 2
} C: A sure loss of $750 (13%)
} D: A 75% chance of losing $1000 and a 25% chance of
losing $0 (87%)
} EV = -750
} Under EU model, risk-averse subjects ought to choose the
sure alternative

31
} Problem 3
} E: A 25% chance of getting $240 and a 75% chance of
losing $760 (0%)
} F: A 25% chance of getting $250 and a 75% chance of
losing $750 (100%)
} E = A + D, F = B + C
} In the first two problems, B & C was chosen by fewer
subjects even though the combination of A and D is strictly
dominated by the combination of B and C
} This poses a sharp challenge to the EU model

32
 } K&T argued that the observed patterns is exactly what
would have been predicted using their asymmetric
value function
} Problem 1
} The choice is between a certain gain and a lottery whose
possible outcomes are nonnegative
} Since the value function is concave in gains, and since the
expected value of the lottery is only slightly larger than the
sure alternative, it predicts the choice of the latter
} Problem 2
} The choice is between a certain loss and a lottery whose
possible outcomes are losses
} Since the value function is convex in losses, it predicts risk-
seeking behavior wrt such a choice
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 } K&T showed that even the simplest of decisions can be
influenced by framing the alternatives differently
} They asked a group of subjects to choose between various
policy responses to a rare disease that would claim 600 lives
if we did nothing
} One group: A or B
} Program A: save exactly 200 lives w/ certainty
} Program B: save 600 lives w/ prob. 1/3 and zero lives w/
prob. 2/3
 EV = 200
} 72% chose program A

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} A second group: C or D
} Program C: exactly 400 people would die
} Program D: 1/3 chance that no one will die and 2/3
chance that all 600 will die
} 78% chose D
} Puzzle
} A = C, B = D
} Yet subjects from the two groups chose dramatically
differently
} K&T explanation
 The first group coded “lives saved” as gains  risk averse
 The second group coded “deaths” as losses  risk seeking

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 Trial-and error method

Judgmental Heuristics and Biases

} People often make irrational decisions even when they
have the relevant facts at their fingertips
} Another difficulty confronting the rational choice model
is that we often draw erroneous inferences about what
the relevant facts are
} More important, many of the errors we make are systematic,
not random
} K&T identified three particularly simple heuristics, or
rules of thumb, that people use to make judgments
and inferences about environment
} These heuristics are efficient in the sense that they help us
economize on cognitive effort and give roughly correct
answers much of the time
} But they also give rise to large, predictable errors in many
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cases
(1) Availability
} We often estimate the frequency of an event by the
ease w/ which we can summon examples from memory
} Much of the time, there is a close correlation between the
ease w/ which we can do so and the true frequency of
occurrence
} But frequency of occurrence is not the only factor that
determines ease of recall
} 1) If the event is more vivid or sensational
 Murder vs. suicide
} 2) Other elements in the mechanics of memory
 English words that start w/ the letter r vs. words that have r
as their third letter
} 3) If the events have happened more recently
 A baseball player’s lifetime batting average against a
certain pitcher vs. the recent performance
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 Evaluation for promotion
(2) Representativeness
} What is the likelihood that object A belongs to class B?
} Suppose Steve is a shy person and we want to estimate
the likelihood that he is a librarian rather than a
salesperson
} Most people are eager to respond that Steve is much
more likely to be a librarian, because shyness is
thought to be a representative trait for librarians but
rather an unusual one for sales persons
} Such responses are often biased, however, because the
likelihood is heavily influenced by the relative
frequencies of sales persons and librarians in the overall
population

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Distribution by Type of Librarian and
Salespersons

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Regression Effect (Regression to the Mean)
} Suppose a standard IQ test is administered to 100
people and that the 20 who score highest have an
average score of 122
} It the same 20 people are then tested a second
time, their average score will almost always be
substantially smaller than 122
} The reason is that there is a certain amount of
randomness in performance on IQ tests, and the
people who did best on the first test are likely to
include disproportionately many whose
performances happened to be better than usual on
that particular test
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} We have substantial firsthand experience w/
regression effects in our daily lives
} eg. The sons of unusually tall fathers tend to be shorter
than their fathers
} K&T noted, however, that we often fail to make
adequate allowance for it in our judgments
because, they conjectured, we feel intuitively that
an output (an offspring) should be representative
of the input (the parent) that produced it

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Why does the rookie of the year in baseball
often have a mediocre second season?
} P. 250

42
} An especially pernicious consequence of our failure
to take into account regression to the mean is the
effect it has on our estimates of the relative
efficacy of praise and blame
} Someone who praises good performances is likely to
conclude, erroneously, that praise perversely causes
worse performance
} Conversely, someone who denigrates poor performance
is likely to spuriously take credit for the improvement
that in fact results from regression effects
} Wrong conclusion: blame works and praise doesn’t

43
(3) Anchoring and Adjustment
} In one common strategy of estimation, known as
“anchoring and adjustment,”
} People first choose a preliminary estimate – an
anchor – and then adjust it in accordance w/
whatever additional information they have that
appears relevant
} K&T have discovered that this procedure often
leads to biased estimates for two reasons
} The initial anchor may be completely unrelated to the
value to be estimated
} Even when it is related, people tend to adjust too little
from it
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Example 1
} K&T asked a sample of students to estimate the
percentage of African countries that are members
of UN
} Each person was first asked to spin a wheel that
generated a number between 1 and 100
} The student was then asked whether his estimate was
higher or lower than that number
} And finally, the student was asked for his numerical
estimate of the percentage
} Students who got a 10 or below on the spin of the
wheel had a median estimate of 25%, whereas the
corresponding figure for those who got a 65 or above
was 45%
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} In similar problems, any number close at hand
seems to provide a convenient starting point
} K&T reported that giving the students monetary
payoffs for accuracy did not alter the size of the
bias

46
Example 2
} Two groups of high school students were asked to
estimate the product of 8 numbers w/in 5 seconds
} The first group was given this expression
} 8x7x6x5x4x3x2x1
} the median estimate = 2,250
} The second group was given exactly the same
numbers in reverse order
} 1x2x3x4x5x6x7x8
} The median estimate = 512
} Correct answer = 40,320

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Example 3. Estimating the failure rates of
complex projects
} A program involving 10 steps, each w/ success rate
of 90%, will fail 65% of the time
} (0.9)10 = 0.349
} When estimating failure rates for such processes,
people tend to anchor on the low failure rate for
the typical step, from which they make grossly
insufficient adjustment
} The anchoring and adjustment bias thus help
explain why the overwhelming majority of the new
businesses fail

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The Psychophysics of Perception
} Weber-Fechner law
} The property of perception whereby the just noticeable
difference in a stimulus tends to be proportional to the
value of the stimulus
} Example
} Most people are unable to distinguish a 100-watt light
bulb from a 100.5-watt light bulb
} The minimally perceptible difference is roughly proportional
to the original intensity of the stimulus
} Thaler suggested that the WF law seems to be at
work when people decide whether price
differences are worth worrying about

49
Richard Thaler
} Richard H. Thaler (born September 12, 1945, in
East Orange, NJ) is an American economist. He is
perhaps best known as a theorist in behavioral
finance, and for his collaboration with Daniel
Kahneman and others in further defining that field.
} Daniel Kahneman has cited his joint work with
Thaler as a "major factor" in his receiving the
Nobel Prize in Economics.

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} Example
} You are about to buy a clock radio in a store for $25
when a friend informs you that the same radio is selling
for only $20 in another store only 10 minutes away
} Do you go to the other store?
} What if a TV for $1050 vs. $1045?
} Most people answered yes to the first question and no
to the second
} In the rational choice model, it is inconsistent to answer
differently for the two cases

51
The Difficulty of Actually Deciding
} In a rational choice model
} There should be no difficult decisions
} If the choice between two alternatives is a close call –
that is, if the two alternatives are predicted to yield
approximately the same utility – then it should not
make much difference which is chosen
} But if one of the options clearly has a higher EU, the
choice should again be easy

52
The Difficulty of Actually Deciding
} In reality
} Difficult decisions are more the rule than the exception
} There are many pairs of alternatives over which our
utility functions just don’t seem to assign clear,
unambiguous preference rankings
} The difficulty is most pronounced when the alternatives
differ along dimensions that are hard to compare
} Ex: Cars - safety, comfort, fuel efficiency

53
} A fundamental axiom of rational choice theory
} Choices should be independent of irrelevant
alternatives
} Ex. What kind of sandwiches?
} Alternatives: roast beef & chicken  roast beef
} Alternatives: roast beef $ chicken & tuna  chicken
} According to the rational choice model, the availability of
tuna should matter only if it is the alternative the patron
most prefers

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Choosing between Two Apartments

A group of students split 50-50 in their

choices between A and B

55
Adding an Irrelevant Alternatives
The availability of C makes people
much more likely to choose B. (more
than 70% chose B)

56
 } Many people apparently find the original choice
between A and B a difficult one to make
} The appearance of C gives them a comparison they can
make comfortably, namely, between B and C
} This creates a “halo effect” for B, which makes it much
more likely to be chosen over A

[hey-loh]

57
Economic Naturalist (p.254)
} Why do real estate agents often show clients two
houses that are nearly identical, even though one
is both cheaper and in better condition than the
other?

58
The Self-Control Pitfall
} People often have difficulty carrying out plans they
believe to be in their own interests
} Ex. Quitting smoking
} Solution to the self-control problem
} Christmas clubs
} Special accounts that prohibit withdrawals until late autumn
} Whole-life insurance policies
} Impose substantial penalties on withdrawals before retirement
} Have part of her pay diverted automatically into a
savings account

59
Exercise
} 1, 5-12
} Odd # problems: Odd number teams
} Even # problems: Even number teams

60