Marketing Theory

Prof. Dr. Florian Stahl

Course Overview (Lecture Units)

Part A: Principles of Behavioral Economics & Social Psychology

I. Foundations of Preferences, Judgment and Choice
II. Foundations of Consumer Decision Making
III. Foundations of Social Psychology
Part B: Consumer Behavior
IV. External Influences: Social Status and Reference Groups
V. Internal Influences: Consumer Perception
VI. Internal Influences: Consumer Learning, Memory and Product Positioning
VII. Internal Influences: Consumer Motivation, Personality and Emotion
VIII. Internal Influences: Consumer Attitudes and Influencing Attitudes
Part C: Consumer Decision Process
IX. Pre-Purchase, Purchase and Post-Purchase Processes
Part D: Marketing Strategy
X. Creating Marketing Strategies for Customer-Centric Organizations
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Course Overview (In Detail)

II. Foundations of Consumer Decision Making

a. Decision Making under Risk

b. Prospect Theory

c. Mental Accounting

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II-a. Decision Making under Risk (1/2)

§ Decision Making can be defined as selecting one option from a

set of possible options.
§ The choice made has consequences for the individual that makes
the decision.
§ Both cognitive and social factors influence people’s decision
making abilities.
§ Two types of decision making: “risky” vs. “risk-free”
§ “Risky” decision making involves a degree of uncertainty about
the consequences of a decision, whereas in “risk-free” decision
making all the consequences of the decision are known with
certainty.

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II-a. Decision Making under Risk (2/2)

§ The expected utility of an option in a decision can be measured

as a function of the amount of utility of the outcome and the
probability of that outcome occurring.
𝒆𝒙𝒑𝒆𝒄𝒕𝒆𝒅 𝒖𝒕𝒊𝒍𝒊𝒕𝒚 𝒇𝒐𝒓 𝒐𝒑𝒕𝒊𝒐𝒏
= 𝒑𝒓𝒐𝒃𝒂𝒃𝒊𝒍𝒊𝒕𝒚 𝒐𝒇 𝒐𝒖𝒕𝒄𝒐𝒎𝒆 ×𝒖𝒕𝒊𝒍𝒊𝒕𝒚 𝒐𝒇 𝒐𝒖𝒕𝒄𝒐𝒎𝒆

§ The expected utility theory holds that, in decision making, people

choose the option that maximises the expected utility for them.

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II-a. Expected Utility

§ Imagine we consider an individual as having a utility function over

possible payoffs from a gamble, u(π).

§ The expected utility of the gamble is defined as follows:

𝒏
𝑬𝑼 = 6 𝒑𝒊 𝒖(𝝅𝒊 )
𝒊"𝟏

§ If an individual strictly prefers a sure thing to a gamble with the

same expected utility, we call this individual risk averse.

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II-a. Expected Utility – Example (1/2)

§ Choice between the following two gambles:

Gamble A: Win € 240 100%

Gamble B: Win € 400 50%
Win € 100 50%

𝑬𝑼𝑨 = 𝟐𝟒𝟎€ 𝑬𝑼𝑩 = 𝟎. 𝟓 ×𝟒𝟎𝟎 + 𝟎. 𝟓 ×𝟏𝟎𝟎 = 𝟐𝟓𝟎€ > 𝑬𝑼𝑨

An expected utility maximizer will choose gamble B!

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II-a. Expected Utility – Example (2/2)

§ Choice between the following two gambles:

Gamble A: Win € 240 100%

Gamble B: Win € 400 50%
Win € 100 50%

§ Calculate expected utility, if u(π) = π1/2 :

𝑬𝑼𝑨 = 𝟐𝟒𝟎 = 𝟏𝟓. 𝟒𝟗€

𝑬𝑼𝑩 = 𝟎. 𝟓 ×√𝟒𝟎𝟎 + 𝟎. 𝟓 ×√𝟏𝟎𝟎 = 𝟏𝟓 < 𝑬𝑼𝑨

Here an expected utility maximizer will choose Gamble A!

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Course Overview (In Detail)

II. Foundations of Consumer Decision Making

a. Decision Making under Risk

b. Prospect Theory

c. Mental Accounting

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II-b. Prospect Theory

§ Prospect theory of decision making was developed by

Kahneman and Tversky (1979, 1984) and is based on the idea of
utility-focused decision making.
§ Starting point: Expected utility theory assumes that…
§ expected utility is linear in probabilities
§ preferences are related to wealth rather than gains and losses
§ Objective: illustrate violations of expected utility theory and
develop a set of empirical regularities that inform the development
of prospect theory
§ Initial step: replace the notion of utility (usually defined only in
terms of net wealth) by value (defined in terms of gains and
losses as deviations from a reference point)
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II-b. Prospect Theory: Phases of Decision
Making
The theory proposes two phases involved in the decision-making
process:
1. Editing phase: the decision problem is represented.
Information perceived as unimportant is discarded. A
reference point is established and the outcomes of the
possible options are represented as possible gains and
losses.
2. Evaluation phase: The potential choices are evaluated, using
preconceived attitudes towards risk, gains and losses.

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II-b. Prospect Theory: Central Research
Results (1/2)
Features of the Prospect Theory:
The prospects theory comes with the following characteristics:
§ Certainty: People underweight outcomes that are merely
probable in comparison with outcomes that are obtained with
certainty.
§ Small probabilities: They tend to give unjustified weight to things
very unlikely to occur, regardless of whether they represent a gain
or a loss (e.g. lottery, insurance).
§ Relative positioning: They respond differently to a risk
depending on whether the outcome is a gain or a loss.
§ Loss aversion: People are far more sensitive to possible losses
than to possible gains. They have a natural loss aversion!
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II-b. Prospect Theory: Central Research
Results (2/2)
Features of the Prospect Theory:
§ Diminishing sensitivity as losses or gains mount
§ People think in terms of expected utility relative to a reference
point (e.g. current wealth) rather than absolute outcomes.
§ Framing effect: risk aversion in the positive frame vs. risk
seeking in the negative frame

Þ People are naturally conservative in their decision making: averse

to risk and averse to loss!

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 II-b. Prospect Theory – Example

£240
€240

1. Gains 0.25 €1000 Non-risk taking

0.75 €0

-€740

2. Losses 0.75 -€1000 Risk Taking

0.25 €0

When it comes to gains, people do not want to take any risk.

However, when it comes to losses people suddenly become risk
takers. 15
 II-b. Prospect Theory: Value Function

Value function is concave above the

line as decision makers will be risk
averse when choosing between
gains.

Reference point
Value function is convex below
the line as decision makers are
risk seeking when choosing
between losses.

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II-b. Prospect Theory: Framing Effect

§ The framing effect refers to the fact that people’s decision making is
often influenced by irrelevant details given in a scenario.
§ Experiment: Each participant was assigned to one of two groups. In
the first group, participants were told to imagine that a fatal disease
was about to strike the US. The disease was expected to kill 600
people. They were told to consider two programmes that had been
proposed to deal with the problem:
§ Programme A: If adopted, 200 people will be saved.
§ Programme B: If adopted, there is a 1/3 chance all 600 people
will be saved and a 2/3 chance that none of them would be
saved.
Þ 72% of people chose programme A and 18% selected
programme B.
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II-b. Prospect Theory: Framing Effect

§ For the participants in the second group, the situation stayed the
same but two other programmes were presented:
§ Programme C: If adopted, 400 people will die.
§ Programme D: If adopted, there is a 1/3 chance nobody will die
and a 2/3 chance that all 600 people will die.
Þ 22% of people selected programme C and 78% selected
programme D.

Why do we have different results even though the programmes are

basically the same for the two groups?

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II-b. Prospect Theory: Framing Effect

Conclusion:
§ Programmes A and C are the same as programmes B and D,
respectively. The only difference between the groups is how the
decision is framed: Programmes A and B are positively framed
whereas programmes C and D are negatively framed.
§ Positive framing: A is chosen by the majority (less risky choice)
§ Negative framing: D is chosen by the majority (more risky choice)
§ These results demonstrate the asymmetry between gain and loss
scenarios that is assumed by prospect theory.
§ The findings are problematic for the classical expected utility theory!

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II-b. Dan Ariely on “Loss Aversion”

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Course Overview (In Detail)

II. Foundations of Consumer Decision Making

a. Decision Making under Risk

b. Prospect Theory

c. Mental Accounting

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II-c. Opening example

§ Imagine you are shopping for a calculator and a jacket, and you
find them both at the same department store.

§ The calculator costs €25, and the jacket costs €120. You are told
that a store across town has both items, but the calculator is €15
cheaper at that store.

§ Do you buy the items at that store or do you go across town?

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II-c. A euro is a euro is a euro, right?

§ Do you spend your regular wage and end-of-year bonus the same
way?

§ You receive €1000 in inheritance from a dearly departed loved

one (vs. almost unknown) …

§ How about “tax rebate” versus “tax bonus”?

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II-c. Mental Accounting

§ Mental Accounting describes the process how individuals code,

categorize and evaluate economic outcomes.

§ According to Mental Accounting Theory developed by Thaler

(1985), individuals hark back to “mental” accounts, on which they
save and retain “gains” and “losses”.

§ Richard Thaler coined the term, defining it as “the inclination to

categorize and treat money differently depending on where it
comes from, where it is kept and how it is spent”.

§ Mental Account Theory is an extension of the Prospect Theory.

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II-c. Mental Accounting: Theatre Ticket
(1/2)
§ Scenario A: Imagine you have purchased a ticket to a theatre.
On reaching the theatre you find that the ticket is lost and that it
costs a €10 to buy another ticket. Would you buy another ticket or
go home?

§ Scenario B: You arrive at the theatre and queue up to buy the

ticket when you realize you have lost €10 somewhere. Would you
still buy the ticket or go home?

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II-c. Mental Accounting: Theatre Ticket
(2/2)
§ It turns out that several people would go home in scenario A, but
the same people would pull out another € 10 in scenario B. How
could you explain this phenomenon?

§ In reality, the outcomes are identical: You have lost €10 and if you
want to see the theatre you need to pay another €10. But people
often have "mental accounts”, here a mental account for
entertainment, for which they may be willing to spend €10 but not
€20.

§ Similarly, one could add a third scenario to the two above: You
own a hundred shares of a big company which is down €10 today,
and will your answer change now?

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II-c. Mental Accounting and Pricing (1/5)

§ According to the Mental-Accounting-Theory…

§ customers integrate price components (the price
components are first passed to a “mental account” before the
overall assessment is derived) or
§ segregate price components (the price components are first
assessed before the partial assessments are aggregated to an
overall assessment).

§ The Mental-Accounting-Theory attracted attention and interest in

pricing, as the theory allows marketers to evaluate price
components and pricing strategies.

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II-c. Mental Accounting and Pricing (2/5)

Multiple losses
The convex shape of the value function v(x) in the loss area means
that multiple losses are less unpleasant (diminishing marginal
losses), when the losses are integrated:

| v(-x) + v(-y) | > | v(-x-y) |

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II-c. Mental Accounting and Pricing (3/5)

Multiple gains
The concave shape of the value function v(x) in the profit area
means that multiple gains lead to a higher gratification (diminishing
marginal gains), when the gains are segregated.

v(x) + v(y) > v(x+y)

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II-c. Mental Accounting and Pricing (4/5)

Integration and Segregation of Losses and Gains

v (10) + v (10) > v (20) Segregate gains

v (-10) + v (-10) < v (-20) Integrate losses

Total Price = 3000 €

- 50 € discount on flight
- 100 € discount on sports program
- 150 € discount on hotel

= 2700 €
à The presentation of the overall price should be integrated but
discounts segregated
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 II-c. Mental Accounting and Pricing (5/5)

Integration and Segregation of Mixed Losses and Gains

Discount A free ball pen

of with the logo of
0.10 € on a the ski resort
ski pass

29.80 € day pass 29.80 € day pass

Mental integration Mental segregation

to 29.70 € Loss of 29.80 € / Gain of a ball pen

According to prospect theory, a loss is more negatively evaluated than

the related gains positively.
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II-c. Theoretical Explanation: Hedonic
Editing (1/2)

Mixed gains
§ Customers perceive positive as
well as negative price
experiences whereas the
positive price experience
dominates Less happy
§ Integrate smaller losses with
larger gains
More happy
§ Integration is preferred to
segregation.

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II-c. Theoretical Explanation: Hedonic
Editing (2/2)
Mixed losses
§ When negative price
experiences dominate, it is not
possible to determine explicitly
whether segregation is
preferred to integration or vice
versa.
Less happy
§ The individual shape of the More happy
value function v(x) as well as
the relative height of partial
losses determine the
advantageousness of
integration or segregation of
partial valuations.
§ Segregate small gains from
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larger losses
II-c. Relevance of Previous Gains and
Losses
§ Previous losses can lead to…
§ throwing good money after bad (sunk costs)
§ people taking on risks they otherwise wouldn’t (breakeven
effect)
§ Previous gains can lead to…
§ increased risk-taking (house money effect)
§ increased spending/decreased saving (windfalls, funny
money)

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Key Take-Aways of Lecture Unit II

§ The expected utility of an option in a decision can be measured as the

product of the amount of benefit of the outcome and the probability of
that outcome occurring.
§ Prospect theory considers value (not utility) and people are naturally
conservative in their decision making (averse to risk and averse to loss).
§ The framing effect refers to the fact that people’s decision making is
often influenced by irrelevant details given in a scenario.
§ Thaler’s mental accounting theory suggests that individuals hark back
to mental accounts, on which they save and retain gains and losses.
§ Generally, a marketer should integrate losses and segregate gains,
and more specifically, integrate smaller losses with larger gains (mixed
gains) and segregate small gains from larger losses (mixed losses).

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