Prospect Theory

Prospect theory helps us understand how buyers perceive a set of gains and losses in a product deal.
The theory, proposed by Daniel Kahneman and Amos Tversky, has a critical outcome, which is
highlighted in the prospect theory value function detailed below.

There are four key effects related to prospect theory.

Reference Price Effect

In many markets, buyers to the previous price they paid for a product when developing pricing
points in their own minds, determining what price they are willing to pay during the next purchasing
decision. The way that past prices affect the buyer’s opinion regarding current prices is known as a
reference price effect. Mathematically, it can be written as follows:

Reference Price= b (last observed price) + (1-b) (currently observed price)

The moderating factor b defines the level of impact that previously prices have on current reference
prices. A large B infers that past prices essentially control the reference prices that buyers hold with
respect to a product, whereas a small b suggests that currently observed prices primarily regulate
the consumer’s reference prices (Smith, 2012).

Endowment Effect

According to the endowment effect, buyers place more value in a product once they possess it than
they would otherwise.

Comparison Set Effect

The product, along with its next best comparable alternatives under consideration in a specific
purchasing deal, form a comparison.

Framing effect

The framing effect is linked to many facets of prospect theory. For example, framing a deal in a
positive light will obviously make it more eye catching then framing the same deal in a negative way.
Therefore, rather than showcasing the price and cost related with using a product, companies
should highlight the benefits and value that the product delivers. In addition, rather than just
grouping all of the positive factors of the deal into one common frame, the disaggregated and
itemized presentation of the deal influences buyers to a much greater extent (Smith, 2012).