Behavioral Economics 101: Influencing Customer Choice

Learnings from Behavioral Economics (and its related discipline behavioral finance) have important ramifications for many industries such as wealth management, consumer goods, insurance, healthcare, technology and professional services.  BE findings are grounded in science, based on cognitive and social psychology experiments conducted over the past 30 years.  Managers can use BE to help understand how consumers decide which products they purchase, when they purchase them and what they pay for them.   Firms that ignore these learnings run the risk of squandering capital, upsetting customers and missing revenue opportunities.  Although many BE principles are well known, it is surprising how many managers are unaware of the basic concepts when designing, pricing and distributing their offering. For example:   

Loss Aversion says that people strongly prefer avoiding losses to acquiring gains.  Some studies suggest that losses are twice as powerful, psychologically, as gains.  Loss aversion has many implications for marketers. To improve retention, use trial periods to take advantage of the buyer’s tendency to value the good more after she uses it. Additionally, when debating whether to reduce prices consumers would prefer to avoid a publicized price increase than get a price decrease (assuming the net effect of a price change is zero).

The Endowment Effect suggests that individuals tend to place a higher value on a product that they own versus an identical product that they use but do not own.  In consumer and engineering goods businesses, encouraging purchase of a good, as opposed to a leasing arrangement, is more likely to increase customer satisfaction. Furthermore, delivering a digital good in a package will communicate higher value because it provides a tangible manifestation of ownership (versus digital files on a PC)

People experiencing a Status Quo Bias will not change an established behavior unless the incentive and ease of change is compelling.  Research suggests that a new product must deliver 9 times the value as the incumbent – regardless of the risk profile – to incite someone to switch.  Though the existence of a SQB is obvious, many companies launch new products and upgrade old ones without delivering better value.  Even when the new product does have demonstratable benefits, many firms fail to communicate these advantages through advertising and messaging 

According to the Money Illusion, individuals tend to think of money in nominal rather than real terms (i.e. after the effects of inflation or extra costs).  As a result, MI can influence pricing in many ways. Price stickiness occurs when companies are reluctant to raise prices or change sales contracts in response to inflationary effects.  Not only does profitability suffer – especially if input costs are rising – but the brand image can slowly move out of synch with the desired price level. Furthermore, the MI suggests that an a la carte pricing approach (with costs added incrementally) will generate more trial than a bundled pricing strategy that reflects total cost.

Herd behavior describes how individuals can act together without planned direction.  Stock market bubbles and crashes are an obvious example of this effect.  Savvy organizations are leveraging herding behavior through crowdsourcing strategies that trigger word of mouth promotion, perform support and develop open source products like software. More tactically, marketers can exploit herding effects by using leadership positioning in advertising or by publicizing large client lists and case studies.

BE is not the final answer for all product or investment decisions.  However, managers would be prudent to heed its key observations as part of its product management activities. In a future post, we will consider how BE impacts strategic decision making in organizations.

For more information on our services and experience, please visit the Quanta Consulting Inc. web site.


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