Prospect theory is a psychological theory in behavioral economics that explains how people make decisions under uncertainty. It was developed in 1979 by psychologists Daniel Kahneman and Amos Tversky, who were awarded the Nobel Prize in Economics in 2002.
This is contrasted with basic economic theory, which focuses on how people, firms, and societies allocate scarce resources. It is based on the assumption that people and firms make rational decisions based on their own self-interest and try to maximize their own well-being or profit.
Prospect theory differs from basic economic theory in the way it views risk. Basic economic theory assumes that people are risk-averse, meaning they prefer a certain outcome to an uncertain outcome, even if the uncertain outcome has the potential to be more beneficial. Prospect theory, on the other hand, suggests that people are risk-seeking when faced with losses and risk-averse when faced with gains.
Always Bet On Black
A classic example is a gambler at a casino. Let’s pretend she enters the casino with $100. Prospect Theory posits that in our scenario when she wins $100 more, she will gain two units of psychological happiness. However, if she were to lose those $100, her psychological satisfaction would drop by four units instead.
In both scenarios, her wealth was affected by the same amount, +100 or -100, but her happiness changes to different degrees based on the outcome. This is because we are hard-wired to avoid losses; they hurt us more than wins help us. In a pervasive situation, the gambler will continue to bet, taking greater and greater risks in an attempt to ride the curve of the function back to the reference point, aka getting out of the hole. If they can just get back to breaking even, things will turn out ok. But as we know, the house always wins.
Implications For Marketers
When you see a pop-up sale for a pair of jeans you weren’t considering buying, you might get them simply because they are on discount. When encountering unexpected stimuli, such as 50% off or limited-time offers, individuals often experience a shift in their reference point. The allure of a perceived gain—like acquiring a desirable item at a seemingly advantageous price—overrides their initial plans or budget constraints. This altered reference point, coupled with the allure of a potential gain, creates a psychological impetus to make unplanned purchases, leading to impulse shopping behavior.
Moreover, emotions play a significant role in this process. Positive emotions triggered by the potential gain from an impulse purchase can overshadow rational decision-making, leading us to prioritize the immediate gratification of acquiring an item over the long-term consequences of deviating from our intended shopping plan.
This is why a marketer must avoid using dark patterns that deceive and prey on the customer. It is great to market the 50% off sale; who wouldn’t want that? But it’s become widespread to see pop-up modals forcing users to decline the offer by clicking on language that says things like “No, I want to pay full price” or “No, I’m fine spending more than I need to” instead of a simple “No, thanks” or “Decline offer”.
Image source: UX Booth
To be clear, I believe using Prospect Theory to increase sales can and should be done, but ethics should be at the forefront of strategy. A flash sale with a countdown timer is perfectly reasonable, but having that timer reset daily with no true sense of urgency is deceitful and potentially illegal, according to the FTC. Highlighting limited quantities (10 left in stock!) is great way to nudge customers to purchase what they intended to expeditiously, but not if you actually have 100 left and are just using psychology to fool them.
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