What are some of the principles in Behavioural Economics that you would suggest to businesses - such as department stores - that seek to increase profits?
BEHAVIOURAL economics (BE) is a branch of economics that studies the interaction between human emotions and decision-making. Two concepts in BE might be of value to managers in serving their customers: loss aversion and mental accounting.
Loss aversion refers to a person's tendency to be overly or disproportionately averse to losses. Studies have shown that the grief of losing $100 is greater than the joy you would get from receiving the same amount. A corollary to the loss aversion concept is that of aggregating losses and disaggregating gains. The total grief you feel from losing $10 10 times is more than the grief of a one-time $100 loss, even though in both instances, the total amount of loss is the same. Similarly, you get more joy in receiving $10 in 10 instalments than receiving $100 at one go. This is one reason why stores like Daiso are popular: buying 10 things costing $2 each may give more pleasure to someone than buying one thing costing $20. For retail managers, this means providing many small positive experiences to their customers and limiting the occurrence of negative experiences.
Conversely, disaggregating losses means you may prefer to suffer a one- time loss of $100 rather than suffer 10 losses of $10. So, for example, a shop may want to offer customers the full version of the product with downgrade options, rather than a basic product with upgrade options, since customers would not want to have to pay small sums periodically to keep upgrading the product.
The common practice of offering package prices for spa and beauty services is a good example of how to apply loss aversion and disaggregation of losses. In this case, it is easier to persuade a customer to fork out one big sum at once - say, $1,000 for 10 treatments - than to persuade her to pay $100 10 times. Many businesses will offer a discounted price or free gift to sweeten - and seal - the deal. This approach also heightens the sense of value for money, as the joy of receiving $1,000 in benefits is separated into 10 treatments.
Another related concept linked to loss aversion is called endowment effect and status quo bias. Endowment effect is when one asks more than one is willing to pay for an object in one's possession. You may have paid $5 for a pen, but you will not let go of it for $5. You want to be compensated extra for losing the pen you already have. You may suggest that this is due to the emotional value attached to the object in possession. But it has been shown in laboratory experiments that the same effect happens even when people are given a coffee mug just moments before they trade it; they are not likely to develop any emotional attachment to a mug in just a few minutes.
Status quo bias is when a person has a bias towards remaining at the status quo even when a change would appear to make him better off. Consider car purchases. One car is sold with a CD player bundled in. Another car is sold without, but can be fitted with the CD player with an extra charge. The price of each car, when the latter is fitted with the CD player, is the same.
Standard economic theory would suggest that the demand for the car with the CD player as the default option should be the same as the one with the CD player included as an optional choice, since the total cost of each is the same. In other words, one should not expect any difference in demand for CD players, whether a car fitted with a CD player is the default option with a downgrade possibility, or a car without a CD player is the default option with an upgrade possibility.
In reality, more CD players are sold when a car with a CD player is offered as the default, than when a car without a CD player is offered as a default.
By Chong Juin Kuan
The writer is from the department of marketing at the NUS Business School.
Studies have shown that the grief of losing $100 is greater than the joy you would get from receiving the same amount.
