How We Make Decisions – Prospect Theory

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Prospect Theory is the name of the concept developed by Nobel-prize winning professor Daniel Kahneman and Amos Tversky, who were the “Godfathers of modern decision science.” It describes the hidden influences that exist that drive our behavior—and they aren’t what you think.

Before Kahneman and Tversky’s paper on Prospect Theory, most economists felt like what drove decision-making was wealth, as in, the more wealth you had, the more options were available to you.

Kahneman and Tversky disagreed. They didn’t believe wealth was the only driver in decision-making. They developed what their idea into Prospect theory, which is foundational to many other ideas associated with how we make decisions.

Three big ideas are involved in Prospect Theory:

  1. Reference Points
  2. Diminishing Sensitivity
  3. Loss Aversion

We are going to take a closer look at each of these ideas in a series of three articles. Today, let’s examine…

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Reference Points

The concept surrounding Reference Points is one of the simplest ideas in the world. Your decisions about things are highly influenced by where you started, a.k.a. your Reference Point. Moreover, where you started affects your judgments on all things, not just how you chose things you buy. For example, if you want to judge how bright the lights are in the room, then the amount of light present from where you just came from will affect how bright you perceive the lights to be where you are now, e.g., darkened movie theater vs. a bright sunny day.

Our assessments depend on our Reference Points. How hot is this water? How soft is this bed? How good is this price? How attractive is my paycheck? Where we are coming from affects all of these judgments.

Breadmakers that Brought in the Dough

Williams Sonoma conducted an unwitting “experiment” that demonstrated the concept of Reference Points in the late 1980s. At that time, the high-end kitchenware brand did the majority of their business via catalogs. Williams Sonoma introduced one of the first counter-top breadmakers priced at $279. It didn’t sell well that first year. The second year, Williams Sonoma launched a second, slightly larger model for $425. They didn’t sell many of the larger models at the higher price, but the smaller model at the lower price doubled in sales.

Now, let’s be clear, this example was not scientific. There are any number of reasons why this occurred. But one possible explanation was that when the first breadmaker came out, there was nothing else like it. Consumers had no reference point for a countertop breadmaker in use, classification or price. However, when there were two to choose from, suddenly the price of $279 when compared with $425 seemed more reasonable. From a pricing standpoint, Williams Sonoma created a Reference Point.

Reference Points Affect Experiences, Too

Reference points can also change how we view an experience. In other words, our past dealings with a company, organization, or brand were one way, then that affects how we perceive our next experience with that company, organization or brand.

A perfect example of this concept is dealing with your cable company. It’s no secret that dealing with my cable company has been a trying experience for me nearly every time. Therefore, when my next inevitable encounter occurs, I judge its success or outcome through the lens of my Reference Point, which, in my case, will undoubtedly cast it in a negative light.

However, it works the other way, too. I have had the pleasure of staying at the Mandarin Oriental hotel a few times. It has always been a great experience. From all the details, they remember to the effort they take to make me feel appreciated and valued, I always have an excellent experience there as a guest. Therefore, I judge them through the lens of my Reference Point (past experiences), which, in this case, will undoubtedly cast it in a positive light.

However, there is another benefit of a positive Reference Point. When an experience falls short of my past experiences, I tend not to judge the brand as harshly. It can also help a less than stellar experience not bother me so much.

Surprisingly, a negative Reference Point can also assist in some cases. If you have a low reference point going into an experience, and instead you get a decent or even pretty good experience, you might be thrilled. The experience is thrilling because your reference point was so low, that even a mediocre experience feels first-rate.

Leveraging Reference Points to Make Some Dough of Your Own

Whether you are introducing a new offering or you are examining your current offering, whether it is a new category or one full of competitors, you must understand your customers’ reference point. There are two lessons we can learn here that pertain to Customer Experience:

  1. Understanding your customers Reference Point upon entering your experience is vital. Your customer’s reference point will dictate much of the outcome of your Customer Experience. Many of us might assume that their Reference Point is the competition’s offer. However, it might not. It could be something else entirely, like a related experience (e.g. a cable tech visit is compared to a plumber visit; a computer training is compared to a cooking class, etc.). Figure out what it is for your customer so you know where you are starting.
  2. Determining how to sway that Reference Point is imperative to influencing your experience outcome. In the bread maker story, Williams Sonoma introduced a whole new kitchen appliance for which consumers had no reference point, and it wasn’t successful. However, when they introduced a second, more-expensive model, they swayed the customer’s perception about which breadmaker had the best value for the price. All that to say, you must discover how you can impel your customers’ reference points to make some dough of your own.

Kahneman and Tversky’s Prospect Theory helped shape the science of decision-making and was foundational to the study of Behavioral Economics, which helps determine how psychology influences why customers do what they do. Reference Points are one of the significant influences on whether a customer will or won’t buy your product or service, or even appreciate your Customer Experience. To learn more about how the Prospect Theory’s first concept of Reference Points can make or break your Customer Experience, including practical advice we can learn from this important concept, click here for a FREE replay of our brief webinar.

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