Tuesday, February 19, 2008

Prospect Theory and the proportion of generic sales in a category

The graph above, developed by Kahneman and Tversky in 1979, can be found at this site:

Link to paper here

It shows how consumers feel pain at a greater rate when losing money, then they feel pleasure by making profitable transactions.

A key element of Kahneman and Tversky's theory is the "reference point" that consumers use to determine at what point they are gaining of losing money. Establishing this reference point for a product or service category is essential in forecasting sales.

Given the distribution of sales by price point discussed in the previous blog entry, if this reference point is the average or median price of available alternatives, more consumers should opt for lower cost products to mitigate immediate pain ($ loss) by fogoing future possbile benefits of durability, aesthetic advantages, and brand image.

This tendency of consumers to value losses greater than they do gains ensures a large percentage of sales for almost all product categories will be available to generic/private label/store brand product that can be sold at competitive prices with a minimum of brand cachet.

When conducting research, how do integrate this insight into the forecasts we create? What is the best way to establish the reference point -- both overall, and by consumer segment? To what extent does this technique ease the challenges of pricing product?

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