How we judge a price

After years of loyal service, our toaster has finally broken. We're fond of that model and plan to buy it again. But when we get to the shop, we find it costs more than we remember. To figure out whether the price is too high, we compare it with similar products. We also rely on advice and shopping experiences shared by people around us.

Evaluating a price is a key stage in the buying process, and it's influenced by many factors. What feels like a bargain to us might seem like an excessive expense to someone else. These different perceptions stem from a mix of objective factors, such as the prices we see on display, and subjective ones, like fragments of memory from past price checks or stories we've heard from others. But how do we process and combine all this information?

Since the second half of the twentieth century, we've known that humans don't make decisions in a fully rational way. Herbert Simon's insight in the 1950s introduced the idea of "bounded rationality", suggesting that people don't always act according to the principle of expected utility - that is, they don't always choose the option with the highest gain. Instead, they're influenced by factors ranging from personal culture to environment, from incomplete information to behavioural traps hidden in the mind.

It became clear that to explain how humans make decisions - even about consumption - we needed to study behaviour. Psychologists Daniel Kahneman and Amos Tversky developed Prospect Theory in the late 1970s, a powerful tool for predicting real-world choices. In 2002, Kahneman, the only one still alive, was awarded the Nobel Prize for this work. This model marked a radical shift in approach. Here's why.

From theory about how we should behave to the reality of how we actually behave

Until then, economic theory was thought to serve two purposes: telling us how to act to maximize our interests ("normative purpose") and explaining how we actually behave ("descriptive purpose"). The assumption was simple: if humans act rationally to pursue their own benefit, then a theory that explains the correct way to do so should also describe real behaviour.

Reality, however, looks very different. People don't always make the "correct" decision even when they know it in theory, because their rationality is limited by many variables - some rooted in individual psychology, others in human nature, and others linked to the environment and so on and so forth.

Kahneman and Tversky realized that a normative theory - a rule for making decisions - couldn't describe how people actually behave. Their Prospect Theory was the first to break with that earlier approach. In presenting it, they didn't deny that there's a "right" way to act to achieve a given result; instead, they offered a model to explain - and predict - how people behave when making choices.

What are the cornerstones of Prospect Theory?

Loss aversion  

People are more willing to take risks to avoid a loss than to achieve an equivalent gain. Kahneman and Tversky's studies show that losing a certain amount of money hurts more than gaining the same amount feels good. A loss weighs roughly twice as much as an equivalent gain: it creates a strong sense of discomfort, a psychological burden that drives us to avoid or remove it at any cost.

The anchoring effect

Another key insight is that humans experience life relative to reference points (anchoring). If we move from a dark room to a bright one, the light strikes us; if we come from an already lit room, we barely notice. Similarly, an unexpected windfall or sudden expense shifts us from our initial level of wealth, triggering joy or disappointment. The intensity of these emotions, for the same shift, depends on the starting point—the brightness of the room we came from or the wealth we already had.

Developments in the theory

For a long time, it was thought that the reference point - or "anchor" - was the status quo, the starting situation, such as the level of wealth a person has at the moment of change (for example, winning the lottery or receiving a hefty fine). Later studies, however, showed that expectations about the future play an even more decisive role in defining what is perceived as a gain or a loss.

So, when it comes to spending decisions, the anchor is not so much how much money we have, but the list price of the item or service we want to buy - the expected cost. We wrote about this in the article Loss or Gain? The True Nature of Discounts: a discount can make us forget the discomfort that comes with spending. It makes us "happy" because we've saved money and therefore "gained" compared to the full price.

So, what price do we go for?

When faced with a buying opportunity, a series of mental factors come into play - loss aversion, reference points, diminishing sensitivity - alongside external factors. Combined, these help us evaluate a price and decide whether to go ahead with the purchase. Prospect Theory revealed that, in every situation, there is a subjective interpretation of objective elements, and that price evaluation is the result of an internal process shaped by emotions linked to ideas of loss and gain.

One thing is certain: paying is always an unpleasant experience because it involves a loss (money leaving our hands). The more marketing and advertising can weaken this sense of loss - by telling us about a discounted price or guaranteed savings - the more willing we are to accept it!