BEHAVIORAL ECONOMICS and FINANCE

2023-2024 Spring

Hakan Yıldız
Overview
• Transaction Utility and Consumer Pricing

 The Sunk Cost Fallacy

 Flat-Rate Bias
 Reference-dependent preferences
Transaction Utility and Consumer Pricing
• Transaction utility is the satisfaction or benefit a consumer
experiences when purchasing a product. The purchasing process
itself, as well as the physical characteristics of the product, affect
transaction benefit.

• Consumer pricing refers to the price a consumer agrees to pay for a

product. Consumers' reactions to pricing and how these prices affect
consumer behavior are important.
Transaction Utility and Consumer Pricing
The consumer is constantly faced with deciding what to buy and how
much to buy. To make these decisions, they must consider the potential
gain or loss from the purchase. Cost–benefit analysis is a staple of
economic policy analysis and business planning. The idea is that if the
planned benefit of a venture exceeds the cost, it may be a worthwhile
venture to engage in. More to the point, if a set of choices is mutually
exclusive (i.e., one cannot choose more than one option), then an
individual or firm should choose the option with the highest net
benefit, defined as total benefit minus total cost. The price of a good
and the atmosphere can signal quality. The price can perhaps influence
the expectations of the consumer. This could in turn influence the
consumer’s willingness to pay for the good.
Transaction Utility and Consumer Pricing
In many of our experiences we take price or atmosphere as a signal of
the quality of a good. As well, we might order items in a restaurant that
leave us wanting more when we have finished eating. This does not
imply that price always signals quality differences, nor does it mean we
should always complete a meal at a restaurant whether we like what
we are eating or not. Nonetheless, in many cases people seem to react
in curious ways to the pricing of goods. Often we hear of the need to
“get your money’s worth” for a transaction. Such a notion can take on a
life of its own, so that rather than simply losing some money, we lose
the money and have an unpleasant meal to boot.
The Sunk Cost Fallacy
Fixed versus Sunk Costs:
Fixed costs are costs that do not change with the amount of production. That is,
fixed costs remain a constant amount, they do not change whether the production
level increases or decreases. For example, rent expenses. No matter how much
production a firm produces, the amount of rent it pays remains the same.

Sunk costs refer to costs incurred in the past that can no longer be recovered. For
example, research and development costs incurred for a project. These costs are no
longer recoverable and cannot influence future decisions like profit maximization.

A firm can avoid fixed costs by stopping production or changing its production
structure. However, it cannot avoid the sunk costs like project costs incurred before
starting the associated production.
The Sunk Cost Fallacy
The "Sunk Cost Fallacy" is a decision-making fallacy in which people influence
their future decisions by considering costs or investments made in the past.
In short, it is when a person or organization makes future decisions based on
past expenditures, ignoring the fact that they cannot undo or change past
expenditures.
The sunk cost fallacy occurs when one tries to recover sunk costs by
continuing an activity for which there is a negative return.
For example, a person may go to an event for which she bought a ticket and
does not want to go later, thinking "I've already paid for it, so I should go"
and tries to compensate for her sunk cost. However, going to an event that
she does not want to attend may cause her to waste her time and energy,
which may cause her to miss other opportunities.
The Sunk Cost Fallacy
We often hear arguments such as “I can’t abandon this now, I have
worked too hard” or “I have spent too much money not to go through
with this.” Such arguments invalidate rational thought. As argued in the
previous sections, sunk costs should not influence one’s decision to
continue an activity. Rational arguments to continue must consider the
future costs and returns, not the unavoidable or past expenses.
Rational counterparts to the sunk cost arguments might be, “I can’t
abandon this now, I will get so much more out of continuing than I
would put in,” or “I have so little effort left to complete the project
relative to the benefits, that I will be better off completing it.”
The Sunk Cost Fallacy
A family pays $40 for tickets to a basketball game to be played 60 miles
from their home. On the day of the game there is a snowstorm. They
decide to go anyway, but note in passing that had the tickets been
given to them, they would have stayed home.

A man joins a tennis club and pays a $300 yearly membership fee. After
two weeks of playing he develops a tennis elbow. He continues to play
(in pain) saying “I don’t want to waste the $300!”
The Sunk Cost Fallacy
Hal Arkes and Catherine Blumer worked with the Ohio University Theater to
randomly offer different prices to the first 60 people to order tickets. Some
paid full price, $15, some received a $2 (roughly 13%) discount, and some
received a $7 (roughly 47%) discount. Over the first five plays of the 10-play
season, the full-price group attended significantly more of the plays than
either of the discount groups. Thus, it appears that at least some of the
theatergoers were led to attend more plays because they had paid too much
for the tickets to miss the plays. Their results are very suggestive of sunk cost
fallacy–style reasoning. They also observed that over the last five plays of the
season there were no real differences in attendance. They suggest that their
results show that the effects of sunk cost persist over a substantial period of
time, though not indefinitely. Following their reasoning, eventually people
forget the pain they associate with the cost of the tickets and begin to decide
attendance based on the enjoyment the play would offer.
The Sunk Cost Fallacy
Some characteristics of the sunk cost fallacy are:
• Impact of Past Investments: When individuals cannot accept that they
cannot get back past investments, they may try to recoup those
investments.
• Difficulty in Making Rational Decisions: The sunk cost fallacy can prevent
people from making rational decisions. The influence of past investments
can cloud people's decisions and make it difficult for them to choose the
most suitable option.
• Ignoring Alternative Costs: This misconception can lead to ignoring
alternative costs. Because the person is focused on recouping the sunk
cost, he or she may not see that an alternative action might be more
appropriate.
Transaction Utility and Flat-Rate Bias
Payment models.
• Linear Pricing: It is a pricing strategy in which the price for a product or
service is linearly related to the amount consumed or level of usage. For
example, the price of a product is fixed at a certain amount for each unit.
For example, if the unit price of a product is $10, the total price will be $50
if 5 units are purchased.
• Flat-Rate Pricing: It is a pricing strategy in which a fixed price is set for a
product or service and the same price is applied to all consumers. For
example, an internet service provider sets a fixed monthly fee and offers
the same service to all its customers at the same price. In this case, every
customer pays the same price, regardless of the amount or speed of usage.
Transaction Utility and Flat-Rate Bias
Transaction Utility and Flat-Rate Bias
Many services can be purchased on a per-use basis or with a fixed fee
for access. For example, a consumer can buy issues of a magazine at
the newsstand or purchase a subscription to that magazine. A
subscription usually offers a substantial discount over the newsstand
price, but it would only truly be worth the cost if the subscriber reads
the magazines she has ordered. If the subscription reduces the price
per magazine by 50%, that may be a good deal, but only if you read at
least half of the magazines that are delivered to your door.
Transaction Utility and Flat-Rate Bias
Similarly, a monthly bus pass often provides a substantial discount over
paying for individual trips if the rider makes enough trips; but a
consumer would need to determine that her level of ridership would
lead to a discount rather than an added expense.

The flat-rate bias occurs when consumers choose to use the fixed-fee
option when they would have been better off choosing the per-use
option.
Transaction Utility and Flat-Rate Bias
Telephone and cell phone plans are often offered in both flat-rate and pay-as-you-
go options. In the late 1980s, Southwestern Bell Telephone introduced extended
area service (EAS), which offered unlimited calling to the Dallas area for a set of
customers in a nearby community who would normally have to pay relatively high
per-minute longdistance fees. The cost of EAS was $19.85 per month. Donald
Kridel, Dale Lehman, and Dennis Weisman examined a sample of 2,200 EAS
customers and found that only 24% of the customers had placed enough calls to
the Dallas calling area to exceed the $19.85 cost of service had they instead been
charged the per-minute fee. Thus, 76% had chosen the flat rate when they should
have chosen a linear-pricing option, displaying the flat-rate bias. Similar results
(though perhaps not as strong) were found when examining behavior when
selecting more general long-distance usage. Thus the telephone company might
have been able to increase their profits by inducing customers to pay for services
that 76% never used. Analogously, consumers today need to be wary of relatively
expensive flat fees for unlimited phone, text, or data plans. Many of us may be
lining the pockets of the phone companies without enjoying any greater benefits.
Transaction Utility and Flat-Rate Bias
Another context in which the consumer can choose between flat-rate and
linear pricing is in attending a gym. Members usually pay a monthly fee that
allows them to attend the gym whenever they like. Alternatively, some gyms
offer a fee for use or a pass that is good for a small number of uses. Gyms
regularly lament that a large number of customers join the gym when they
resolve to finally get in shape but, soon after, their resolve fades and they
stop coming. Stefano Della Vigna and Ulrike Malmendier analyzed the
membership decisions and attendance records for close to 8,000 gym
members over a three-year period. These members could pay a monthly fee
of $70 or could purchase a 10-visit pass for $100. The average gym member
attended the gym just 4.3 times per month. At that rate, a person could use a
10-visit pass for an entire year and pay just $600. Instead, using the monthly
membership option costs $840 per year. Over the course of membership, an
average person pays about $600 more than necessary ($1,400 total) for the
level of gym attendance, making the flat-rate bias rather costly.
Procedural Explanations for Flat-Rate Bias
• Flat-Rate Bias can be caused by psychological factors such as
consumers' avoidance of uncertainty and search for simplicity.
• This bias can be attributed to consumers wanting to avoid the risk of
facing higher costs and being able to predict their costs in advance.
• The notion of transaction utility seems to suggest that using a flat rate
would encourage the consumer to use more of the product to reduce
the average price per unit of consumption.
• Nonetheless, before purchasing, consumers might think very
differently about transaction utility and their future potential use of a
consumption good.
Procedural Explanations for Flat-Rate Bias
• Framing Effect: The framing effect is the phenomenon that how a decision
is presented affects people's decisions. When people are presented with
the same option in different ways, they may react differently to these
options. (Gym example)
• Payment Decoupling: Payment separation is the separation of the cost of a
product from the payment process. For example, when paying a monthly
fee for a subscription service, this payment may be a separate
consideration when using the service.
• For example, when you take a taxi and go somewhere, you pay the taxi
driver immediately at the end of the journey. When you go with your own
vehicle, you feel as if you are traveling for free since you do not pay
anything.
Reference-Dependent Preferences
Often our perception of how good a deal we have achieved depends not
only on the amount we are able to consume and the quality of the good itself
but also on the context within which we make our purchase. In some
contexts, items are expected to be more expensive than in other contexts.
This leads consumers to display very different demand behavior depending
upon the purchase context. Someone might refuse to purchase a good in
one venue because it is too expensive, but the same person might purchase
the good at an identical price when in a context where the price seems
justified. Consumers might use cues from the environment or memory of
previous transactions in similar contexts to form an idea of what is a fair
price. A comparison used to aid in making a decision is called a reference
point.
Reference-Dependent Preferences
For example, your reference point may be the price you have paid in the
past at a particular establishment. If a hamburger has always cost $5 at a
particular restaurant, that hamburger might feel like a particularly good deal
if you could purchase it for $3. It might feel like a terrible deal if the price
rose to $6. Thus the reference point can play an important role in
determining the consumer’s transaction utility. The reference point may be
influenced by the context. An identical hamburger at another restaurant
might always be priced at $2. Here it might feel like you have been ripped off
if they were to suddenly increase the price to $3.