The Power of Loss: Understanding Consumer Decisions

The marketing world is built on understanding consumer behavior and guiding them on their journey to purchase. In this journey, insights from behavioral economics are an invaluable guide. In particular, Prospect Theory is a powerful tool for understanding how people perceive risk and evaluate gains and losses. This theory can help you improve the effectiveness of your marketing strategies and build deeper connections with your customers.

What is Prospect Theory?

Prospect theory is a theory that explains people's decisions under risk. The way people evaluate gains and losses is shaped by a reference point, rather than absolute utility. This reference point is usually the current situation or expectations. The importance of the theory for marketing comes from the following:

The Power of Loss: According to Prospect Theory, gains and losses are not evaluated in the same way. People feel more pain from the same amount of loss than they feel pleasure from the same amount of gain. This asymmetry is known as the “power of loss”. The value function is concave for gains (diminishing marginal utility) and convex for losses (increasing marginal loss). This means that smaller gains are more valuable than larger ones, but smaller losses are less painful.

This chart illustrates the basic principle of Prospect Theory: Losses have a stronger effect than gains. The value function is concave for gains and convex for losses. This means that small gains are more valuable than large gains, but small losses are less painful than large losses. For gains and losses at the same level, the loss is more painful.

The Importance of the Reference Point: According to Prospect Theory, people evaluate their decisions not according to absolute values, but according to a reference point. This reference point can be one's current situation, expectations, past experiences or a point of comparison. For example, earning 100 TL may be perceived as a bigger gain for someone earning 500 TL, but less important for someone earning 10,000 TL. In your marketing messages, you need to consider the reference point of your customers and shape your messages accordingly.

Risk Perception: People assess probabilities at their true value. Especially if low probabilities (e.g. winning the lottery) and high probabilities (e.g. contracting an illness) are exaggerated, mid-range probabilities are assessed more realistically. This creates opportunities and pitfalls for marketers. For example, you can attract customers' attention by exaggerating the risk of a very rare event (loss frame) or exaggerating the benefits of a low-cost product (gain frame).

Mathematical Basis of Prospect Theory

Prospect Theory uses mathematical models to analyze people's risky decisions. These models combine value functions and probability weighings. For example, we can mathematically show how Prospect Theory influences a person's decision to buy a lottery ticket:

Value Function: The value function, usually denoted v(x), measures the subjective value of the gain or loss (x). The function is usually S-shaped and steeper for losses than for gains. For example, if a person earns 100 TL, v(100) will be a positive number. However, if he loses 100 TL, v(-100) will be a negative number greater than v(100).

Probability Weighing: Probability scales, denoted w(p), reflect the subjective value of the probability of an event (p). In Prospect Theory, people perceive low probabilities as higher than their true value and high probabilities as lower than their true value. This means that probability scales are not linear. For example, if the probability of an event is 10%, the value w(0.1) may be greater than 0.1.

Example: An Investment Decision:

Let's say an investor is considering investing in the stock market and there are two different scenarios.

Scenario 1: Earnings Situation

An investment expert tells the investor:

Option A: If you sell stocks now, you will make a profit of 5,000 TL.

Option B: If you don't sell, there is a 50% chance that you will make a profit of 10,000 TL, but a 50% chance that you will not make any profit.

Predicted Outcome: According to Prospect Theory, most people prefer Option A.

This is because people are more risk averse when it comes to gains. A certain gain is more attractive than an uncertain large gain.

Scenario 2: State of Loss

Now the investor has invested in the same stock, but the market has fallen and there is now a possibility of a loss. The expert again offers two options:

Option A: If you sell the share now, you will lose 5,000 TL.

Option B: If you don't sell, there is a 50% chance that you will lose 10,000 TL, but there is a 50% chance that the market will recover and you will not lose.

Predicted Outcome: According to Prospect Theory, most people prefer Option B.

This is because people tend to take more risk when it comes to losses. Instead of accepting a certain loss, they may take a bigger risk for the chance of losing nothing.

Reflections of Prospect Theory in Marketing

Emphasizing Loss:

• People move faster for fear of missing out on a discount. For example, “This price is only valid for 24 hours!” mobilizes the consumer.
• Setting reference points shapes consumers' price perception. For example, “Previous Price: 999 TL, Now: 799 TL” increases the discount appeal.
• Offering cashback instead of a direct price reduction. For example, “Get 20 TL back for 100 TL!” creates an active sense of earning for the consumer.
• “Buy 3, pay 2” campaigns trigger a sense of loss aversion by presenting discounts as an opportunity rather than an individual price.

Promotion and Campaign Strategies

• Messages that trigger fear of loss lead consumers to purchase. For example, statements such as “If you miss this discount, you will never find it again!” accelerate the decision process by creating psychological pressure.
• People prefer multiple small gains to one big gain. Therefore, it may be more effective to offer “10% discount + 50 TL gift voucher” instead of “15% discount”.
• Free shipping or additional services may seem more attractive than a direct price cut. Instead of “10% off”, a strategy of “5% off + free shipping” may be more effective by triggering a sense of loss aversion.
• Create a sense of rarity and scarcity: Phrases such as “Only 100 units produced” or “Only 3 items left!” can increase psychological pressure to consume.

Loyalty Programs: Prioritizing Earning

• Loyalty programs show that consumers are more loyal when they feel they are already receiving a benefit. For example, “2 points for your first purchase! 10 points and you get a reward.” People are more motivated when they feel they are making progress, rather than starting the process from scratch.
• Offer progressive discounts: Progressive systems, such as “Get 10% off your 3rd purchase and 20% off your 5th purchase!” encourage loyalty

Advertising and Message Content

• Consumers care more about loss than gain, so advertising messages should emphasize the risk of loss. For example, instead of “Save 500 TL a year by using this product.”, “If you don't use this product, you will lose 500 TL a year.” has a stronger impact. “If you miss this opportunity, you may never find it at this price again.” will get the consumer to take action.

Fake Pricing

Decoy Pricing is a strategy used in the pricing of a product or service to steer the customer towards a particular price option. This strategy is usually implemented by adding a third “decoy” price option. The decoy is used as a kind of “aggravator” in the consumer's preferences and usually tries to rationalize the more expensive option when compared to the two main price options.

For example:

Three different price options can be offered:

A: 100 TL

B: 150 TL

C: (decoy): 170 TL

Here C is added to guide preferences between the two prices offered. If the consumer chooses C, he or she may feel that B is more favorable and therefore more likely to choose B. This strategy helps to create rational price choice, especially with visual comparisons.

Considerations in the Application of Prospect Theory

Knowing the Target Audience: Understanding your customers' demographics, psychological profiles and buying behavior allows you to tailor your messages more effectively.

A/B Tests: Use A/B tests to test different framing and messaging approaches. Measure which messages perform better and optimize your strategies based on the results.

Flexibility: The marketing world is constantly changing. Adapt to new trends and changes in customer behavior while maintaining the core principles of Prospect Theory.

Prospect Theory is a powerful tool for understanding people's decision-making processes. By applying this theory, marketers can shape customer behavior and increase sales. However, it is important to be ethically responsible and avoid manipulating customers. Understanding your customers, offering them value and building a mutually beneficial relationship is the most important step for long-term success. By using Prospect Theory correctly and ethically, you can build stronger bonds with your customers and develop successful marketing strategies.