A Test of Prospect Theory in the Used Car Market: The Non-Linear Effects of Age and Reliability on Price

Abstract

ABSTRACT Prospect theory (Kahneman & Tversky, 1979) suggests that consumers compare decision criteria against a reference point when evaluating alternatives. It further posits that consumers are risk seeking losses (below the reference point) and risk-averse gains (above the reference point). In this paper we investigate whether consumers behave according to prospect theory in the used car market. We further consider that consumers use available classification schemes and establish separate reference points within each different class of the same product. In this case we test the idea that consumers compare reliability of automobiles using reference points based on age. We find empirical support the prospect theory predictions that consumers are risk seeking when the reliability of a specific brand/model of a car is below the average the age category and risk averse when the reliability is above average. The paper concludes with suggestions alternative reference categories and a discussion of implications academics and practitioners. INTRODUCTION Prospect theory (Kahneman and Tversky, 1979) explains how people make choices among alternatives (prospects) by comparing them to reference points. The significance of this theory has been recognized by the Nobel Prize awarded to Daniel Kahneman in 2002 for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under (The Nobel foundation, 2002). Traditionally, people's choices were explained and predicted by the expected utility theory (Von Neumann & Morgenstern, 1944) which suggests that individuals make rational choices based on the level of relevant decision criteria (Friedman & Savage, 1948). However, the rationality assumptions of the expected utility theory have been empirically shown to be violated on numerous occasions (Slovic & Tversky, 1974). In particular, human choices often depend on the framing of a problem (Tversky & Kahneman, 1986; Hogarth & Reder, 1986), which cannot be explained by the expected utility theory, but follow the propositions of the prospect theory (Kahneman & Tversky, 1979; Shafir, 1999). According to the prospect theory, people do not use the absolute value of the outcome but rather 'code' the alternative as a gain or a loss relative to a reference point. The resulting losses or gains are then weighed by their perceived probabilities of occurrence, forming a non-linear value function. People approach gains and losses differently, generally acting risk-averse on gains and risk-seeking on losses (Kahneman and Tversky, 1979). While prospect theory has been widely applied to decisions regarding financial outcomes and time, it has not found much application in relation to choices regarding product quality (Ong, 1994). Given that quality is an important aspect used by the consumers in their evaluations, it is important to study it. However, the difficulty of operationali/ing and measuring it has been a major stumbling block on the way to empirical research of decision-making under uncertainty using quality (Ong, 1994). In our paper, we empirically test the ideas of prospect theory applied to quality in the used car market. We believe that the prices on the used car market are close to the manifestation of the car's utility to the consumer, given that the market is not dominated by few major players and is close to a competitive market. Furthermore, there is plenty of information regarding various aspects of quality of the used vehicles that are readily available to the consumers to base their judgment on and to the inquiring researchers to conduct an empirical investigation. In particular, the data on car's reliability (the aspect of quality related to the car's performing its core function, transportation) lends itself to our research. We are looking the non-linear effect of the car's reliability on its price in the used car market as predicted by the prospect theory. …

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