How Prospect Theory Affects Product Marketing and Sales

Prospect Theory

Prospect theory was developed by Daniel Kahnemann and Amos Tversky, two psychologists who started foundational work on the study of behavioral economics. The simple explanation of prospect theory is that a loss is much more emotionally significant than a gain of the same magnitude. Losses hurt more than gains give pleasure.

In the chart above, the x-axis represents a change, a gain or a loss. The y-axis represents the pleasure or pain one feels as represented by value. As you go up the y-axis, you feel more value or pleasure. As you go down the y-axis, you feel more loss or pain/sadness.

Points AB represent a gain and points AC represent a loss of equal magnitude, but as you can see, points AC provides more pain from a loss than AB provides more pleasure from a gain. People put more weight on losses than gains. Kahnemann and Tversky believe that the pain of a loss is 2X more powerful than the pleasure of a gain.

Here is an example of this theory in practice.

Suppose I give you a choice of taking $50 with no coin toss or a 50% chance of winning $100 with a coin toss. Most people will take the $50. Even though the chance to win $100 is really good. Most people make this decision because they are risk-averse and if they lose the $50, the emotional pain would feel stronger than the happiness they feel if they won $100.

From a pure finance and risk perspective, you should take the coin toss because the amount of gain (double your money) is worth the risk. And your reference points should be that you have $0, not $50 at the point of the decision.

Prospect theory is based on behavioral biases that explain why people feel losses more acutely and stronger than the same potential gains. These biases are

• Heuristic Simplification - People try to simplify complex decisions because they have limited cognitive resources (memory, attention, processing power). The brain forces people to take shortcuts in decisions. In the coin toss example, it is easier to see that $50 than trying to process the risk and reward of winning $100.
• Loss Aversion - Any loss is painful, and people try to avoid that pain. If a new decision may lead to pain, they try to avoid it. If there is a risk of a loss, most people would avoid that risk and take the sure thing, even though they may gain less.
• Mental Accounting - People create separate mental accounts for each decision. After a decision is made, it is put away in your mental file cabinet with all the associated costs, thoughts, feelings, and circumstances when you made that decision.
• Self-Deception/Overconfidence - People tend to think they are better than they are. They believe they will know the right answer even without analysis if faced with a decision. If you ask people if they are good drivers compared to others using the choices above average, average, or below average, you should have approximately one-third in each category. But in real studies, that is not the case. In one published study, 82% of sampled college students rated themselves above average in driving ability. We know that is not correct.
• Status Quo - It is safer and less risky to stay with people's past decisions than make a new decision. Staying put and not making a new decision eliminates any potential pain.

Factoring in Product Marketing and Sales

You say prospect theory is interesting, but how does it affect how I do product marketing and sales?

Well, you come across buyers in every deal that is loss averse and refuse to buy your product even when the other choices do not exist or are drastically inferior. You might call these deals a "no decision"; the buyer decided not to change and stick with what they have. Why?

"No decision" is explained by prospect theory. Your company has not shown him enough gains to overcome the expected losses he might feel if he made a mistake in choosing you. The buyer is considering many emotional losses here: loss of money, time, reputation, sunk cost of previous product, and trust. The buyer is loss averse and what you have shown him is not a certainty but a big risk.

This is similar to the $50 coin toss example. He has the $50 (current product), and you are asking him to flip a coin where he might gain $100 or lose $50 (your product). Prospect theory has shown us, that most buyers will choose the current product. This is why you have so many "no decisions" deals.

So how do you overcome this buyer loss aversion or status quo bias?

• Provide ROIs showing more gains?
• Showing how others have benefited?
• Building trust between the salesperson the company, and the buyer?
• Minimize their perceived losses?
• Dazzle them with a list of different features?
• Have a limited-time offer?
• Lowering your price?
• Provide free trails?

Do you currently try to reduce their perceived risk or create more certainty of gains?

Please let me know your thoughts and comments. The next article will talk about how to overcome these psychological biases.

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