Chapter 06 - Cognitive Limitations and Consumer Behaviour

Chapter 6 Cognitive Limitations and Consumer Behaviour

Answers to Questions for Review

1. You would be willing to pay more if case 1 were true, because you will think it will be of
more value to you.

2. Gathering information is costly, and at some point the costs of information gathering
outweigh the benefits.

3. The decision that leads to the best possible outcome may be too costly to find.

4. No. If the marginal utility of wealth decreases with wealth, then weighing gains less heavily
than losses is consistent with utility maximization, and therefore rational.

5. The policy of punishing students would be more effective because losses are felt more than
gains of the same size. This policy may not be a good one if you are interested in more than
just attendance.

Answers to Chapter 6 Problems

1. a) Combine small loss with the larger gain, because V(4 500) > V(5 000) + V(-500).
1. b) Segregate the small gain (the silver-lining effect): V(500) + V(-5 000) > V(-4 500).
1. c) Reckon the gains separately: V(5 000) + V(6 000) > V(11 000).
1. d) Combine the losses: V(-11 000) > V(-5 000) + V(-6 000).

6-1

Chapter 06 - Cognitive Limitations and Consumer Behaviour

2. (1) If the vehicle normally costs R400 000, they could raise the price to R450 000 and offer a
"R50 000 cash rebate." If buyers code the rebate as a separate event, the Kahneman-Tversky
value function says it will more than compensate for the negative effect of the higher price
(the "silver-lining effect").
2. (2) Combine the all-terrain vehicle into a package with the new Toyota Recreational Vehicle.
The resulting small percentage increase in the price of the RV will seem insignificant
[Psychophysics of perception (Weber-Fechner law); also principle of combining losses.].

6-2

Chapter 06 - Cognitive Limitations and Consumer Behaviour

3. Let us do similar examples like we discussed in the text. Suppose a disease will claim 600
lives if we do nothing. Given a choice between program A, which would save 200 lives with
certainty, or program B, which would save 600 lives with probability 1/3 and zero lives with
probability 2/3, most people pick A. But given a choice between program C, under which
400 people would die, or program D, under which there is a 1/3 chance no one will die and a
2/3 chance that all 600 will die, most people pick D. These choices are inconsistent because
the two pairs of alternatives are exactly the same. As a second example, consider the
following three apartments, which are identical expect for monthly rent and distance from
campus
a. R2 400/mo, 2 blocks from campus
b. R1 600/mo, 2.4 kilometres from campus
c. R1 620/mo, 2.6 kilometres from campus

Because C is unambiguously worse than B, its availability should not influence the likelihood
that a person chooses B over A. And yet when people are given a choice between A, B, and
C, they are much more likely to choose B than if they are given a choice between only A and
B.

4. Increased police patrols are likely to be assigned in years following unusually high crime
rates. Regression effects alone would lead us to expect crime rate reductions in the year
following an unusually bad year. So it is difficult to conclude that the reduced rates are the
result of increased patrols.

5. A "superb" meal at any restaurant is likely to be an unusually good one compared to the
meals usually served there. On his next visit, Chillyboy is likely to encounter a "normal"
meal. This is the regression-to-the-mean effect.

6-3

Chapter 06 - Cognitive Limitations and Consumer Behaviour

6. Out of every 100 people Dalgliesh interviews, 60 are liars, 40 are truthful. Of the 60 liars,
Dalgliesh identifies 48 correctly. Of the 40 truth tellers, Dalgliesh mistakenly calls 8 liars.
So out of every 56 people he says are lying, 48 really are. The probability that Jones is lying
is thus 48/56 = 6/7. In this problem, taking base rates into account raises the accuracy of
Dalgliesh's prediction, because there was a better than even chance that a randomly chosen
person would be lying.

7. For every 100 taxis in a dark alley, 15 will be green, 85 blue. The witness will identify
0.8(15) = 12 of the green taxis as green, the remaining 3 green taxis as blue; he will identify
0.8(85) = 68 of the blue taxis as blue, the remaining 17 blue taxis as green. The probability
that the cab in question was green given that the witness said it was is thus equal to 12/(12 +
17) = 0.413, and since this is less than half, the Green Taxi Company should not be held
liable.

8. You view the loss of the original deal as a loss of R2 500, the amount you would have saved.
The next deal is seen as a gain of R1 600. If you have a value function similar to the one
described in the text, V(-2 500) is much bigger than V(1 600), so you end up feeling you
are worse off. But this is irrational, since the regular ticket is R8 700 and you should compare
your purchase of R7 100 to this amount and feel better off.

No. Since you would choose the initial offer on Londolozi to this one in any case, this new
offer is an irrelevant alternative. It should not even be considered, much less be allowed to
affect your decision about the two initial offers.

6-4

Chapter 06 - Cognitive Limitations and Consumer Behaviour

10. Mary should drive across town if and only if the amount she saves is greater than the cost of
the drive. In the 10%-off TV sale she would save R1 000. She would save only R160 in the
40%-off sale on the blouse. And yet she makes the trip in the latter case but not in the
former. Her behaviour is thus irrational.

11. Racquet C is dominated by racquet B, which has more control and the same amount of
power. The rational choice model says that adding C should not affect how people choose
between A and B. As an empirical matter, Tversky has shown that the availability of an
alternative like C tends to make people more likely to choose B over A.

12. Robinson Crusoe may know that he is sorely tempted to get some coconuts before he should
if his plan is to use them in the spring. Having the bears in the way acts as a commitment
device to help him live up to his plans.

Additional Problems
1. Your favourite movie has just been released on DVD. If you were offered the choice of
buying the DVD for R80 with a R10 rebate, or the choice of simply paying R70 for the DVD
with no rebate, which offer would you choose if you acted:
a. according to the rational choice model?
b. according to the Kahneman-Tversky value function?
2. Margaret has just won a quiz show contest and can take her R10 000 prize home. Then the
show host offers her a chance to win more. The show host will flip a coin and if it comes up
heads Margaret will win R20 200, but if it is tails she will lose her original R10 000 prize.
She refused the deal. Why?

6-5

Chapter 06 - Cognitive Limitations and Consumer Behaviour

3. Lindsay has decided to open a new savings account. There are two financial banks in her
neighbourhood. One offers 6% interest and a free toaster oven with each new account. The
other bank offers 6% interest but no free toaster. Suppose the per cent is just enough to
offset the price of the toaster oven after six months, and suppose she has no immediate need
for the oven. She plans to use it as a gift to her niece who plans to get married in six months.
Which bank will she choose if she applies the principles of hedonic framing? What if she is
rational? Assume no value added tax complications and that the toaster price stays constant.

Answers to Additional Problems

1.

a) If you were rational, you would prefer to simply pay R70 for the dvd since this would
require less value added tax and you would not have to wait for your rebate.

1.

b) If you behaved according to the Kahneman-Tversky value function the loss of the extra
ten rand is more than offset by the R10 gain so you would be inclined to opt for the rebate
offer which will make you feel better off.

2.

Margaret is risk averse and so the expected value of R20 200 is not valued as much as the
R10 000 sure money.

6-6

Chapter 06 - Cognitive Limitations and Consumer Behaviour

3.

If Lindsay applies the principles of hedonic framing, she will choose the bank with the 6%
interest rate and a toaster oven, since in this case the segregated gains are weighed more
heavily than the one large single gain. But if Lindsay is rational, she will be indifferent to
either bank.

6-7