We tend to think that our decisions are rational. In realty, we’re deeply influenced by how choices are framed.
Prospect theory, developed by Daniel Kahneman and Amos Tversky, explains how we evaluate potential losses and gains.
The following are some of the principles derived from prospect theory.
1. Loss Aversion
Imagine I offer you two deals
A) Guaranteed gain of $50
B) 50% chance to gain $100, and 50% chance to gain $0
Most people would choose A (the sure thing) because gains feel nice, but risk feels uncomfortable.
Now reverse it:
A) Guaranteed loss of $50
B) 50% chance to lose $100, and 50% to lose nothing
People now choose B because the pain of a guaranteed loss drives them to take risks.
Loss aversion in business
Imagine you give customers a free trial of a service or product. Once they experience the benefits, canceling feels like a loss. Businesses often emphasize what users lose if they cancel (e.g. “Don’t lose the premium features”).
Humans hate losing something they’ve grown accustomed to.
2. Reference Points
People evaluate outcomes based on a reference point. The environment and context usually dictate your perception of value.
Imagine you’re at a coffee shop. A $5 latte might seem expensive if your usual drink is $3. However, in a luxury cafe where drinks are typically $8, that same $5 latte feels like a bargain (makes you think ‘wow that’s a good deal!’).
Retailers often label products with discounts. for example a regular price of $400 and the discounted price is $200, that makes customers evaluate the deal relative to the higher reference price, perceiving it as a gain.
3. Framing Effect
How messages are framed greatly influence how it’s perceived.
For example, a doctor tells you that your surgery has a 90% chance of success versus saying that it has a 10% failure rate. Even though both are the same, but you would perceive them very differently.
Another example, labeling a product as “90% fat free” versus “10% fat”
4. Diminishing Sensitivity
Imagine I give you the following offers
A) Saving $50 when buying a $100 product
B) Saving $50 when buying a $200 product
Most people choose option A because $50 feels more significant relative to the $100.
Real life examples:
- You spend $500 on a plane ticket, the airline tries to sell you a $50 upgrade service, that $50 feels cheap and you tend to make the purchase.
- You spend $50 for a family dinner meal, the restaurant offers you extra drinks or fries or whatever for $5 and that $5 feels cheap to you because of the effect that $50 made in the first place.
- You buy a laptop for $1,000, surely a laptop bag that costs $50 is no problem to you.
The psychological impact of change diminishes as amounts increase.
5. Certainty Effect
A smartphone brand writes “Two years warranty” in their product ads. Customers prefer the certainty of a refund over a risky purchase, even if it’s unlikely they’ll need to return the item.
People value the certainty of no risk, even when they rarely act on guarantees.
Takeaway
These principles are core behavioral concepts that reveal how people evaluate and perceive things. Businesses leverage these insights to shape customer decisions.
Understanding these principles helps you design strategies that align with natural human biases and decision-making patterns.
