How Businesses Leverage on Cognitive Biases
Colin Chow, Research Executive
The divergence from rational choice influenced by non-economic factors, such as emotion, leading to the formation of “ill-informed” decisions or judgments are referred to as cognitive bias. These biases, making us susceptible to persuasion, wield significant influence over consumer choices and market outcomes. In the dynamic field of economics, understanding human behaviour becomes as crucial as analysing intricate market trends. Consequently, businesses have adeptly learned to exploit cognitive biases, incorporating them into their sales strategies to shape consumer behaviour and drive sales.
This essay delves into the interplay between businesses and cognitive biases, ranging from how companies exploit the biases such as the endowment effect and loss aversion bias. They do this through free trials, return policies, and product customisation otherwise known as the IKEA effect.
In their book “Dollars and Sense”, authors Ariely and Kreisler (2017)1 posited that there exist “irrational quirks” in human behaviour which kick in when we make decisions. These quirks can be distilled into three key points.
Love: Before a purchase, an emotional connection to a specific item or object emerges, intensifying upon ownership.
Sense of loss: The psychological weight of losing a possession surpasses the benefits derived from its sale, leading individuals to focus on loss rather than gains.
Assumed shared values: The inclination to believe that others will make the same value judgments as we do.
These quirks, analysed through the lens of the endowment effect or the "power of ownership", drive consumers to attribute a subjective value to their possessions exceeding their objective worth. Consequently, individuals undervalue opportunity costs, as sentimentality and emotions cloud rational thought, contributing to market distortion. This departure from classical economic principles contradicts the notion that purchasing decisions and trade are based on individuals having a well-defined value for an object (Chapman et al., 2023)2.
Endowment Effect
The endowment effect describes how people tend to value the things that they own more than they are worth to them or to others. A typical analysis or study of the endowment effect includes two factors: the buyer’s willingness to pay (WTP), and the seller's willingness to accept (WTA).
The WTP refers to the highest monetary price that the consumer is willing to pay the seller for a product; WTA refers to the lowest monetary price that the seller is willing to accept as compensation. Based on most studies pertaining to the investigation on the endowment effect, WTA is almost always higher than the WTP.
There exists a famous mug experiment on the endowment effect conducted by Kahneman et al. (1990)3. The researchers randomly assigned a group of undergraduate students to the role of either the seller or the buyer. The seller group received mugs with a university logo and were told that they could either keep their mugs or sell them to the buyer group; the buyer group was instructed to attempt to buy the mugs.
The authors also asked students at what price they would be willing to sell or buy the mugs. It was determined that the median seller’s WTA was $5.75, twice the median buyer’s WTP of $2.25. The overall ratio of median selling prices to median buying prices was 2.2, which led to substantial under trading (2.25 of 22 expected transactions).
The endowment effect presents a problem for economists because of its violation of the Coase Theorem, which states that given perfect competition and information, low (or the absence of) bargaining costs, and the absence of wealth and income effects, resources will be allocated efficiently and optimally regardless of who owns them initially (Coase, 1960)4. In other words, regardless of initial allocation (i.e., endowment) of property, in the absence of transaction costs, individuals are meant to bargain privately to correct any inefficiencies.
However, in the experiment conducted by Kahneman et al. (1990), there was no price agreement made, where the presence of the endowment effect resulted in a lower volume of transactions than expected. In this controlled market, the endowment effect thus led to an increase in market inefficiency and deadweight loss.
As expressed by Kahneman, Thaler and Knetsch (1991)5, “It [the endowment effect] might produce inertia in the economy because potential traders are more reluctant to trade than is conventionally assumed”. It would therefore appear that the presence of the endowment effect would lead to inefficiencies and challenges in the economic sense. However, many companies and corporations have manufactured techniques that would tap into consumers’ emotional connections with products, increasing their WTP.
Return Policies
One such method would be through having lenient return policies. Most firms and businesses provide for a return or exchange of a previously purchased product. When shopping in person or on e-commerce websites such as Taobao, we would often be heartened to see a “no-questions asked”, full refund policy (provided that the terms and conditions of return are met). Such policies are meant to vouch for the reliability and quality of the product, where the company is seemingly magnanimous in trying to provide the best customer service.
Whilst such sentiments may hold true, return policies objectively serve as a behavioural nudge to drive consumers to purchase higher value products, as it reduces any supposed risks associated to the purchase. A return policy thus serves to lower any psychological barriers with regards to making the initial purchase.
Diagram taken from Wang (2009), showing influence of endowment effect on return rate.
Findings from Wang (2009)6 and Huseyn et al. (2019)7 show that lenient return policies draw on the endowment effect, where firms who employ these policies have a higher probability of earning a greater degree of profits.
A lenient return policy could be defined as a money-back guarantee, as well as a longer time horizon given to the consumer to make the refund, if desired. This leverages on the consumer's attachment to the good, which deepens over time.
With reference to the diagram taken from Wang (2009), the author illustrates the retention of a particular good’s sales in comparison with its initial number of sales. It should be noted that the author had taken the number of purchases for the good with a return guarantee as a benchmark (i.e. 100%), where the good without return guarantees produced sales at a level approximately half of that of goods with the guarantee. As such, the term ‘purchasing rate’ was utilised in the plot.
Nevertheless, the principle of the theory is maintained: retention of the good with a return guarantee which had a longer time horizon for returns was far greater (75% of original purchasing rate) than cases where consumers were less attached to them (25% of original rate for goods with return policy with a short return horizon; 50% of original rate for goods without return guarantee).
This therefore illustrates the significance of the “power of ownership”, and firms can leverage on the endowment effect to minimise returns through the medium of lenient return policies.
Loss Aversion
It could also be said that these return policies also anchor themselves on the fact that consumers are loss averse. The theory of loss aversion states that we tend to focus more on the losses than the gains.
Diagram taken from Kahneman et al (1991)8, illustrating the Kahneman – Tversky value function.
The Kahneman-Tversky value function visually represents this relationship, with the curve in the losses quadrant being notably steeper (almost double) than the gradient in the gains quadrant. Essentially, this signifies that the discomfort from losses is considered significantly more impactful than the satisfaction derived from gains.
Loss aversion also results in the underestimation of opportunity costs. When individuals are attached to a possession, their focus on potential loss overshadows considerations like the money they could gain from a sale or the creation of additional inventory space (Thaler, 1980)9.
In this context, a lenient return policy capitalises on consumers' loss aversion tendencies. Allowing consumers a longer duration to hold onto a purchased item intensifies the sentimental value attached to it. Consequently, consumers tend to undervalue the opportunity costs, such as the benefits associated with returning the item, even when the product may not objectively suit their needs.
A notable example from the 1980s illustrates the impact of a lenient return policy. In a bid to boost sales during a critical period, Chrysler's CEO, Lee Iacocca, introduced a thirty-day money-back guarantee for dissatisfied customers. Despite concerns about potential financial losses from returns, by the year's end, the total returns constituted less than two-tenths of 1% of total Chrysler cars sold. The return policy played a crucial role in consumers overcoming initial hesitations, such as the cost of buying the car, as they gradually developed an emotional attachment to the purchased cars, treating them as part of their family.
Relating this back to the earlier concepts, the implementation of a lenient return policy instilled a "no-risk" mindset among consumers, who felt secure in the ability to return the car if unsatisfied. This policy leveraged both the power of ownership (endowment effect) and the principle of loss aversion. As a result, consumers retained ownership of the vehicles at a significantly higher rate than before the policy was introduced. This demonstrates how decision-making in consumers was influenced by the perception of "no risk," surpassing the objective concerns about the vehicle.
Free Trials
It is a common occurrence to receive a “one-month free trial” offer whenever we use an app or go into a website. A well-known example would be Spotify, where a trial period is offered to the consumer to experience its “Premium” mode. This mode removes the regular disruptions and advertisements that a consumer using its “Standard” function would encounter. The ability to listen to music uninterrupted on an unlimited basis thus attract consumers to sign up for the free trial.
Free trials thus operate to give the consumer a sense of ownership (or partial ownership) over the product. Therefore, when the trial is over, the consumer would be foreign to the idea of advertisements and interruptions that he had previously been accustomed to when using Standard mode. The idea of losing the “exclusive” functions of not being interrupted during his music, along with the attachment that the consumer had grown towards Premium mode would thus influence him to make the purchase.
Anchoring Bias
Firms would look to further nudge the consumer to make the purchase by strategically lowering the price of the good at this point. A relevant scenario would be telling the consumer that Premium now costs $7.99, against the $10 that it would have cost him previously. This would prove a tempting choice for the consumer, where he would likely choose to make the transaction.
This tactic leverages on anchoring bias (or anchoring effect), which is when an individual's judgements or decisions are influenced by a reference point or "anchor". While consumers typically compare prices when shopping, the initial price they encounter becomes a significant reference point.
Aware of this psychological phenomenon, businesses use price anchors effectively in their pricing strategy. Retailers often display the manufacturer's suggested retail price (MSRP) on goods, which becomes the reference (anchor) that drives subsequent decision making. Some retailers never intend to charge the initial and often highly priced MSRP; their intended outcome is for the consumer to pay the sale price. Once the buyer is anchored at the higher MSRP, the lower advertised sale price is perceived as a favourable deal (Caceres-Santamaria, 2021)10.
In the context of our Spotify example, the initial $10 acts as the price anchor, and the reduced $7.99 becomes the sale price. If a consumer has been contemplating the Premium membership, the $10 serves as an anchor (Ariely, 2020)11, and be a provisional WTP price. Lowering the price to $7.99 enhances the likelihood of the consumer making the transaction, as the new price is below their WTP. Combined with the consumer's experience of holding the membership (leveraging the endowment effect) for a specific time, the likelihood of the purchase becomes almost certain.
This illustration, along with the instances of free trials and lenient return policies, underscores how businesses adeptly utilise multiple cognitive biases simultaneously to achieve their objectives.
The IKEA Effect and personalised goods
Previously, we had investigated the effects of the endowment effect and other cognitive biases on their impacts to consumer decision making. Whilst the endowment effect suggests that feeling connected to a particular product causes an increase in its subjective value, there exists a cognitive bias that suggests that the act of spending effort on a product increases its subjective value. This bias is called the IKEA effect.
The IKEA effect, as unveiled in a 2011 study by Dan Ariely, Michael I. Norton, and Daniel Mochon, reveals that people tend to value a self-assembled product more than one that comes pre-assembled. With this heightened appreciation, consumers will increase their WTP.
In Experiment 1A of Ariely et al.'s (2011) study, 52 students were assigned to assemble an ordinary IKEA storage box (builder group), while another group (non-builders) inspected a fully pre-assembled box. Subsequently, the builders were asked to value (or “bid” for) the boxes they assembled, and non-builders were asked to value the pre-assembled box. Results indicated that builders bid significantly more for their boxes (M = $0.78) compared to non-builders, who valued the box at M = $0.48. Additionally, on a 7-point likeability scale, builders also rated their boxes higher (M = 3.81) than non-builders (M = 2.50), reinforcing the notion that investing effort elevates perceived value, both intrinsically and extrinsically (as shown with builders indicating a higher WTP).
Firms often look to exploit this behaviour through the means of product customisation, charging a higher price to do-it-yourself (DIY) products. By the IKEA effect, this is effective as consumers are willing to pay a premium for products that they have customised to their preferences (Schreier, 2006)12, i.e., having a greater WTP towards customised goods versus standardised goods.
The popular sneaker brand Nike does this by allowing customers to customise their own sneakers, creating an experience where consumers feel some form of attachment to the product they had created. It was also shown that consumers who “lack precise knowledge of what they want” can “understand their preferences more clearly” through experimentation via a customisation interface (Franke and Hader, 2013)13.
As such, brands like Nike attract a broad range of consumers from the allowance of customisation in their products, where they charge these consumers a premium for their customised goods ($100, non-customised vs $150 or above, customised).
Whilst it would not bring much additional costs to Nike to supply a different coloured swoosh or sole; most of which are already in their inventory, consumers continue to pay for these products at a level well above their objective market price, exhibiting higher levels of utility when creating these products than when purchasing standard models (Franck and Schreier, 2008)14. This example therefore demonstrates how consumers act irrationally towards valuing a product which they have invested effort in making, where their WTP is subconsciously driven up to a level greater than its objective worth.
This example vividly illustrates how consumers, driven by the IKEA effect, assign a higher value to products they actively contributed to creating. Firms adeptly leverage this cognitive bias, charging premiums on personalised goods. Statistics by Abraham et al. (2017)15 from the Boston Consulting Group affirm the effectiveness of this practice, revealing that brands embracing a personalised experience witness gains in firm revenue by 6 to 10 percent.
Conclusion
This essay set out to investigate some of the cognitive biases businesses leverage on to not only influence consumer choices but also reshape market dynamics, demonstrating how businesses ingeniously employ cognitive biases concurrently, employing tactics ranging from pricing strategies and return policies to personalised product offerings. This investigation unfolded with the endowment effect, revealing how consumers tend to value possessions more than their objective worth, leads to the undervaluation of opportunity costs and market distortion.
This examination extended to the realm of return policies, uncovering the dual leveraging of the Endowment Effect and Loss Aversion. By offering lenient return policies, businesses capitalise on consumers' attachment to products, reducing psychological barriers and influencing purchase decisions. The case of Chrysler's innovative money-back guarantee in the 1980s underscored how such policies could distort rational decision-making, encouraging consumers to treat products as part of their personal domain.
The strategic use of free trials illuminates how companies create a sense of ownership during trial periods, influencing subsequent purchasing decisions. Anchoring bias was then discussed as a tactic where businesses strategically lower prices, anchoring consumers to higher reference points, thereby enhancing the perceived value of discounted goods.
Lastly, the IKEA Effect was unveiled as a cognitive bias wherein consumers attribute higher value to self-assembled products, leading to increased WTP. Through the means of product customisation, brands leverage on this bias, whereby charging premiums for personalised goods.
By comprehending human behaviour, businesses skilfully manoeuvre through the complex terrain of consumer decision-making, highlighting the influential role of cognitive biases in shaping market results. Consequently, it becomes imperative to acknowledge the pivotal role that behavioural factors play in the market, extending beyond the considerations presented in traditional or classical economic theory.
References
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Caceres-Santamaria, A. "The Anchoring Effect," Federal Reserve Bank of St. Louis, Economic Research, Page One Economics, April 2021.
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Franke, N., Hader, C. (2014). Mass or Only “Niche Customisation”? Why We Should Interpret Configuration Toolkits as Learning Instruments, Journal of Product Innovation Management, 31: 1214-1234. https://doi.org/10.1111/jpim.12137.
Franke, N., Schreier, M. (2008). Product uniqueness as a driver of customer utility in mass customization. Market Lett 19, 93–107. https://doi.org/10.1007/s11002-007-9029-7.
Abraham, M., Mitchelmore, S., Collins, S., Maness, J., Kistulinec, M., Khodabandeh, S., Hoenig, D., & Visser, J. (2017). “Profiting from personalization”. BCG Global.