Shopping for Jackets and Calculators

In 2002, Daniel Kahneman (a psychology professor at Princeton University) was awarded the Nobel prize for his work (with Amos Tversky) in behavioural economics.  Their work sparked the new discipline of prospect theory  - a theory that suggests that people do not always make the optimal decision when it comes to risk.




The following example is quoted in their journal article "The Framing of Decisions and the Psychology of Choice"  published in Science  in 1981:


Imagine that you are about to purchase a calculator for $15.  The salesman informs you that the calculator you wish to buy is on sale for $10 at another branch, located 20 minutes drive away.  Would you make the trip to the other store?


When Tversky and Kahneman posed this question, 68% of respondants said they would make the trip. 


The pair then rephrased the question:



Imagine that you are about to purchase a Jacket for $125. The salesman informs you that the jacket you wish to buy is on sale for $120 at another branch, located 20 minutes drive away. Would you make the trip to the other store?

Logically, this is the same problem as the calculator - a saving of $5 is there to be had.  But the results in this case showed that only 29% were willing to make the trip.





In the same paper it is noted that it is the percentage saving that customers tend to take into consideration:



"...the variability of the prices at which a given product is sold by different stores is roughly proportional to the mean price of that product."



and


"Individuals who face a decsion problem and have a definite preference (i) might have a different preference in a different framing of the same problem, (ii) are normally unaware of alternative frames and of their potential effects on the relative attractiveness of options, (iii) would wish their preferences to be independent of frame, but (iv) are often uncertain how to resolve detected inconsistencies."



What they are saying is that context  influences consumer behaviour.  If the same theory is applied to financial markets, we would surely see traders paying over the odds when the orders they place are of considerable size.  Or indeed, house buyers wrapping up negotiations early when they could have squeezed a saving of a couple of thousand dollars out of the deal.  Such behaviour would exacerbate the gap between asset price and intrinsic value, expanding the bubble.