The effect of prospect theory on consumer behavior under nonlinear pricing
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School of Business |
Master's thesis
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Date
2024
Department
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Mcode
Degree programme
Economics
Language
en
Pages
58 + 4
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Abstract
Thesis examines how prospect theory, from the field of behavioral economics, affects consumers’ decision-making in markets with nonlinear pricing. By combining theoretical frameworks and empirical studies, an outcome of flat-rate bias is recognized, as an outcome from the principles of prospect theory, to create deviations to consumers' consumption decisions when compared to rational models of consumer decision theory. Using utility theory and behavioral economics, decision-making research is examined from its early stages in the 18th century to the modern day. This enables the thesis to introduce the fundamental concepts of decision theory and how behavioral economics has been able to provide answers to significant gaps empirically observed in the traditional decision theory. Consumers’ decision-making is proven to be strongly affected by cognitive biases. Kahneman and Tversky were among the first, in the 1970’s, to empirically test their existence, bringing to light important biases such as loss aversion, overestimation and reference dependency, that they used to create the prospect theory which proved the importance losses have on humans compared to equal gains and how it affects consumers behavior to try to avoid those losses. Later empirical studies conducted by Lambrecht & Skiera (2006) and Herweg & Mierendorff (2013), further advanced concepts of prospect theory by providing proof to the existence of flat-rate bias. They provided evidence on how loss averse or overestimating consumers’ have a natural tendency to prefer flat-rate pricing options even if they know it being more expensive. A key explanation for the phenomenon was explained as a psychological safety mechanism where the consumers’ can eliminate the possibility for future cost variations with the flat-rate. Since consumers are reference dependent, variable costs create the possibility for them to produce monthly billing costs higher than their reference point which would be perceived as loss, and humans try to naturally avoid this according to the prospect theory. Studies highlighted the welfare effect flat-rate bias can have as specific consumer groups can systematically overpay for their products or services that include variable, usage based nonlinear pricing, by choosing an option that eliminates that variation such as flat-rate price. Thesis concludes that a deeper understanding of behavioral factors affecting consumers decision-making is essential for consumers, companies and policymakers to have, in order for them to improve consumers consumption outcomes and the unequal distribution of consumer surplus.Description
Thesis advisor
Välimäki, JuusoKeywords
consumer behavior, flat-rate bias, prospect theory, nonlinear pricing