Expected Value and Consumer Choices

Argosy University

Abstract
Consumers’ choices are prey to subtle discrepancies that arise in cognitive accounting and identifying how and when you are susceptible is an important step in improving the decision making process (Tvorik, 2014). This paper will consider why people value gains and losses differently in different circumstances by addressing what mental accounting is and how it impacts consumer decision making; and how a company can take advantage of their consumers’ mental accounting (Tvorik, 2014). This writer will also consider different scenarios from differing points of view; as a marketer and as a consumer. As a marketer, this writer will analyze how I would frame certain decisions to benefit from the disparities in my own cognitive accounting. As a consumer, I will address how to avoid the pitfalls posed by the inequalities of again, my own cognitive accounting (Tvorik, 2014).

Mental accounting is a term that describes how people categorize and quantify economic outcomes (Thaler, 1980). This is similar to financial accounting in the way of using a system of debits and credits and affects how people spend and save their money, thus consumer decision-making. Mental accounting determines “when an individual chooses to act or postpone a purchase, how he or she perceives gains and losses, and how timing bears on the individual’s choices” in relation to the three mental buckets: current income, current wealth and future income (Tvorik, 2014). It is a figurative, or mental, balance sheet that compartmentalizes income and spending (Vedantam, 2007).
People will spend and save differently depending on how the money was received, earned income or “free,” unexpected money such as a tax return or lottery winnings. It can also affect decision-making in terms of when the good or service is realized. For example, according to 2011 research by the National Retail Federation (CNN), a majority of Americans are spending their tax returns on things such as vacations, major purchases or putting it in savings rather than paying down debt. This is used more frequently as discretionary money because it is being considered “free” income even though it is really just their own money, minus interest, being returned to them (Vedantam, 2007).
The sunk cost effect is “paying for the right to use a good or service will increase the rate at which the good will be utilized” (Thaler, 1980). Thaler (1980) explains the sunk cost effect concept in terms of pleasure and pain:
In terms of prospect theory, pleasure can be thought of as the value function in the domain of gains while pain corresponds to the value function in the domain of losses. When will a customer feel pain? Pain will not be felt when a purchase is made for immediate consumption (like buying a hamburger for lunch) as long as the price is ‘reasonable’… Only in the event of a loss will there be actual net pain.
Alternately if one was purchasing an asset, or something that will provide future benefit, no pain or pleasure is felt at time of purchase, but at the time the good is used or service has been provided (Thaler, 1980).
Marketing is a company’s best tool to take advantage of consumers’ mental accounting. “People prefer a supposedly free incentive to an equivalent price discount [and] people often behave irrationally when thinking about future consequences” (Welch, 2010). The challenge is not only beating competitors but convincing consumers to spend their money since they always have the option of not doing so (Welch, 2010). According to Welch (2010), by offering a delay of payment companies can increase their customers’ willingness to buy; even small delays in payment can soften the sting of parting with their money. Some mental accounts for spending include windfall gains, pocket money, income and savings. Income is less easy for consumers to spend and savings is the most difficult so understanding this and acknowledging the barrier can benefit a company by adjusting their marketing strategy (Welch, 2010).
Another way to leverage consumer mental accounting is to make the product something the customer would deem as a necessity. The concept of reason-based choice explains that consumers make purchasing choices using mental accounting based on reasons that are constructed to justify decision implicitly or explicitly (Kivetz, 1999). Kivetz (1999) explained that consumers who reasoned with themselves implicitly may be more likely to purchase necessities because they are needed rather than purchase luxury goods which could be considered waste, where as customer’s who have the opportunity to explicitly defend their purchases to others find it easier to purchase luxury items. Marketers and their companies can benefit from this by creating the perception that a product is a necessity rather than a luxury item, making it more likely to increase sales, or to encourage consumers to talk about it.
As a marketer, recognizing and understanding my own mental accounting tendencies will only benefit my career. I will be able to objectively review my decisions to ensure I accounted for all accounts. Considering scenarios from different perspectives, or accounts, will allow me to see the whole picture and make the best decisions possible for the marketing strategy. Removing the natural biases will allow me to use new techniques to reach consumers in a more effective way; playing to their mental accounts to help them realize they need to buy our product. For example, if my company was selling wine, typically considered a luxury item, I would want customers to feel it was a socially acceptable, high quality yet affordable purchase meant to share with friends and family. This encourages customers to discuss their purchase explicitly with others not only justifying their reason to buy but also is a form of free marketing for our company since they are discussing with others.
As a consumer I am now aware of how frequently marketers appeal to my mental accounting pitfalls. I have realized throughout this research how many I biases I have succumbed to because of mental accounting such as believing something was a “good deal” just because it was less than for what I had mentally prepared. I have excitedly spent my “free” tax return money knowing full well that it was actually my money returned but because of my mental accounting, I was able to justify it. The government even used this marketing strategy in recent history with the Economic Stimulus Act of 2008 which gave many American households $600 or more (Economic Stimulus Act of 2008, 2008). This law preceded the American Recovery and Reinvestment Act of 2009, which was enacted with the same goal: to spur economic activity to create and save jobs (Recovery Accountability and Transparency Board [RATB], 2014). The government encouraged its citizens to spend the money in their communities to help stimulate the economy, not to pay off debts or save it. They marketed it as “free” money.
By recognizing these marketing strategies and acknowledging my own mental accounting, I will be better able to ensure my decision-making is sound in regards to purchases no matter the cost. I will be less likely to feel buyer’s remorse when purchasing because I am able to make more confident and effective decisions.
References
CNN.com. (2011). How do Americans spend their tax refunds? National Retail Federation. Retrieved from http://money.cnn.com/pf/storysupplement/tax_refunds/
Economic Stimulus Act of 2008 § 101, 110 U.S.C. § H.R. 5140 (2008). Retrieved from http://www.gpo.gov/fdsys/pkg/BILLS-110hr5140enr/pdf/BILLS-110hr5140enr.pdf

Kivetz, R. (1999, August). Advances in Research on Mental Accounting and Reason-Based Choice. Stanford University Marketing Letters, 10 (3), 249-266. Retrieved from http://www.columbia.edu/~rk566/research/Mental_Accounting_Reason_based_Choice.pdf
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Recovery Accountability and Transparency Board. (2014, May 1). The American Recovery and Reinvestment Act. Retrieved from http://www.recovery.gov/arra/Pages/default.aspx
Thaler, R. H. (1980). Towards a positive theory of consumer choice. Journal of Economic Behavior and Organization, 1, 39–60. Retrieved from http://www.eief.it/butler/files/2009/11/thaler80.pdf
Tvorik, S. (2014). Assignment 2: Expected Value and Consumer Choices. Argosy University Online. Retrieved from http://myeclassonline.com/re/DotNextLaunch.asp?courseid=10686110&userid=17095279&sessionid=9a49d1640f&tabid=dtwlxzhR25xWBmevdbFZHGUVVJ/2pAZu/GUEjDwgxo89wEbN+FZK5A351GrONF35MW96k1HXRRJABAYGg+/XxA==&sessionFirstAuthStore=true&macid=yGVtzPq81sBuE5Ire4FQF0QckgvZ6/XXJb2Voes4dUQcuz2idTnHOgzFABWs8J3f+JBlTZaPHXJKB8CB1j3fOTEY3/fphwJeR+nXlP0LdCX7XE225eR45c/2VdO9L9YNwJ5tdXW5iIYTb++eg4bcwBphy5Slz1EFksciWROOKPngyFYGnWAfJyUC9K4336790bW6O20ZncIljCjBlM9O51Abl1XaCqZuPDBIQbz6/ANpTqfsnf5DJrrgdiUqXiOX
Vedantam, S. (2007, May 19). Mental Accounting. The Washington Post. Retrieved from http://www.washingtonpost.com/wp-dyn/content/article/2007/05/19/AR2007051900316.html
Welch, N. (2010, February). A marketer’s guide to behavioral economics. McKinsey&Company. Retrieved from http://www.mckinsey.com/insights/marketing_sales/a_marketers_guide_to_behavioral_economics