Consumer goods are generally categorized as having three types of attributes: search, experience and credence (Nelson, 1970). The quality of a credence attribute cannot be determined either before or after purchase (e.g. the nutritional component of the food). Functional foods are usually considered to be foods with credence attributes. Since (in the absence of labelling) the functional properties cannot be inferred by the consumer before or even after purchase, consumers face uncertainty regarding the functional components of foods. Even with the presence of labelling, information uncertainty is also apparent in the functional foods market with respect to whether the functional health claim is credible, which depends on whether consumers believe that consumption of functional foods leads to specific health outcomes.
In neoclassical economic theory, expected utility theory is often used to analyze consumer choice behaviour under uncertainty. In expected utility theory, human rationality is one of the fundamental assumptions: it assumes that a consumer‘s rational choice should be consistent and
132
coherent. A great deal of evidence in the literature shows that individual consumers sometimes behave ‗inconsistently‘ and ‗irrationally‘, which violates the predictions of expected utility theory. In Prospect Theory, Kahneman and Tversky (1979) described decision problems that violate the requirement of consistency and coherence, and they ―trace these violations to the psychological principles that govern the perception of decision problems and the evaluation of options‖ (p.453). Prospect Theory evaluates decisions between alternatives which involve risk, i.e. alternatives with uncertain outcomes (e.g. gambling). In 1991, Tversky and Kahneman extended Prospect Theory and proposed a consumer choice model incorporating loss aversion in riskless choice (e.g. negotiations8), the so-called Reference-Dependent Model (RDM). The central assumption of the RDM (also for Prospect Theory), is that losses and disadvantages have a greater impact on preferences than gains and advantages (Tversky and Kahneman, 1991).
In the RDM, the reference-dependent effects are used to measure the value of changes involving a gain or a loss compared with a reference point and the changes to the reference point might lead to reversals of preference. The RDM and Prospect Theory evaluate the changes or differences of attributes rather than the absolute magnitudes. For example, the attributes of brightness, loudness or temperature, are evaluated by the past or present experience defined as a reference point, and the values are perceived according to this reference point. Therefore, the temperature could be evaluated as hot or cold depending on which reference level it has been compared to. The same principle also applies to non-sensory attributes such as health, prestige and wealth (Kahneman and Tversky, 1979).
8
Loss aversion can be involved in negotiations, since experimental evidence indicates that negotiators are less likely to achieve agreement when the attributes over which they bargain are framed as losses than when they are framed as gains (Tversky and Kahneman, 1991).
133
Think about the example of purchasing a milk product. First, consider yourself as a typical conventional milk consumer. Suppose one morning you find that the conventional milk is used up. When you go to the grocery store, you consider purchasing Omega-3 milk which is claimed to have health benefits. In this case, will you evaluate the Omega-3 milk independent of your typically consumed conventional milk? Will you consider the extra health ingredient (Omega-3) as a gain in terms of improved product quality? On the other hand, to take the opposite case, if you typically consume Omega-3 milk and consider buying conventional milk on this shopping trip, will you evaluate this conventional milk independent of Omega-3 milk? Will you treat the missing health ingredient (Omega-3) as a loss with respect to product quality? Would you have the same intensity of feeling about the ‗gain‘ and ‗loss‘ of the Omega-3 in the above two cases? Extensive empirical evidence suggests that losses will be weighed more heavily than the same magnitude of gains, which is well-known as the property of loss aversion (Tversky and Kahneman, 1991).
Some of the literature about modelling heterogeneous consumer choices focuses on taste heterogeneity, and it might be tempting to make the behavioural assumption that all differences in consumers‘ choices are reflected in their taste variations. This is likely to be an over statement. At least, there might be some reference-dependent effects in the RDM that could be used to explain part of the heterogeneity in choices (Hu, Adamowicz. and Veeman, 2006). Reference-dependent effects reflect the fact that individuals with different reference points could treat the same choice decision as a gain or a loss. A gain for one individual might be treated as a loss by another. In the economics and marketing literature, reference-dependent effects have been recognized for decades. A number of studies have focused on how to capture and measure reference-dependent effects, such as Koszegi and Rabin (2006), Munro and
134
Sugden (2003), Suzuki, Tyworth and Novack (2001), Bell and Lattin (2000), Prelec (1998), Ordonez (1998), Lattin and Bucklin (1989) and Winer (1986). Miljkovic (2005) conducted a review of the hypothesis of perfect rationality regarding rational choice and irrational individual behaviour. Putler (1992) developed a theoretical consumer choice model incorporating reference price effects. Price reference effects have been examined in the marketing literature, e.g. Winer (1988) and Briesch et al. (1997). Some researchers developed models of brand choice incorporating price reference behaviours, e.g. Winer (1986), Kalwani et al. (1990) and Lattin and Bucklin (1989).
Hardie, Johnson and Fader (1993) model loss aversion and reference-dependent effects in brand choice. The authors argue that consumer choice is influenced by the position of brands relative to multi-attribute reference points. They use the most recent brand purchased by each household as the reference brand. They found that consumers perceive losses from a reference point more than equivalent sized gains (loss aversion). Using scanner data, they generate a Multinomial Logit Model to incorporate reference-dependent effects for price and quality attributes. The developed model provides a better fit in both estimation and prediction than a standard Multinomial Logit Model, and the model‘s coefficients demonstrate significant loss aversion. Their model provides insights for the development of the econometric models in this study.
Dhami and al-Nowaihi (2007) made a comparison between Prospect Theory and Expected Utility Theory for the issue of people paying taxes. The authors argue that given relatively low audit probabilities and penalties, why should people pay taxes. According to Expected Utility Theory, evasion should be extremely attractive. So why do most taxpayers not evade? Expected utility theory is unable to explain this. If people evade taxes, the loss will be the small
135
probability of being caught and charged a penalty. The results show that the magnitude of tax evasion predicted by Prospect Theory is consistent with the data, since Prospect Theory characterizes individuals as loss averse with respect to certain reference income and they overweigh small probabilities while underweighting large ones. The authors conclude that Prospect Theory can explain the tax evasion puzzle and the behaviour of taxpayers also provides strong support for Prospect Theory.
Some researchers have examined reference-dependent effects for consumer promotions, such as Kalwani and Yim (1992) and Lattin and Bucklin (1989). Kalwani and Yim (1992) conducted an experimental study regarding price promotion and consumer price expectations. The study examined the impact of price promotion on consumers‘ price expectations and brand choice through an interactive computer-controlled experiment. The authors argue that price promotion, by introducing a product at a lower than regular price, is shown to have an adverse effect on subsequent sales, because consumers adopt the low promotion price as a reference and consider the regular price as unacceptable and greater than the price they expect to pay. The authors conclude that in the case of price expectations, promotion expectation losses loom larger than gains, which is consistent with Prospect Theory. This study suggests that although offering frequent price promotions can increase short term gains in sales, those sales increases may be offset by the losses in sales caused by consumers not receiving the promotion prices they expected.
The reference-dependent and loss aversion effects related to consumers‘ functional food choices are examined in this chapter. In addition to the reference-dependent effect for price, this chapter also examines the reference-dependent effect for the functional ingredient (e.g. Omega- 3), a credence characteristic. The sources of heterogeneity for these reference-dependent effects
136
are also examined. The following section provides an overview of Prospect Theory and the Reference-Dependent Model.