Decision under uncertainty and risk
Exploring how behavioral economics like Prospect Theory can shape smarter product decisions and customer experiences.
I find the concept of Prospect Theory - how people make decisions under uncertainty and risk, often deviating from rational economic behavior - to be the most impactful in understanding how people make decisions under uncertainty and risk. For business and product applications, it has wide-ranging implications. Understanding how customers choose to use a product, what price points they find risky, or what they perceive as significant rewards is vital for business success. Traditional economic theories assume people always make rational choices to maximize benefit, but Prospect Theory suggests that people often think about possible gains and losses in ways that aren’t entirely logical. One important idea in Prospect Theory is the "reference point." This is the situation a person compares everything else to when deciding.
At TravClan, we designed a scratch card system that travel agents received after each booking. This was the initial pitch the onboarding sales team used to get them to transact for the first time. While it might seem obsolete, a small travel agent who completes fewer bookings may see this as an opportunity to earn more because their reference point is their own earnings. A scratch card that offers Rs. 50 or Rs. 100 adds value to their current business. However, the same scratch card value might not be lucrative for high-earning agents. Consider the following agent profiles:
Agent A: Completes 10 daily bookings, earning Rs. 100 on each booking Agent B: Completes 100 daily bookings, earning Rs. 100 on each booking Agent C: Completes 1000 daily bookings, earning Rs. 100 on each booking
What value of scratch cards will each of them find appealing?
For Agent A, who completes 10 daily bookings, the Rs. 50 or Rs. 100 from the scratch card is a significant addition to their earnings, making it an attractive incentive. This aligns with Prospect Theory, where individuals assess potential gains or losses relative to a personal reference point—in this case, their regular earnings. Agent B, with 100 daily bookings, might see the scratch card as a smaller but still notable benefit. However, for Agent C, who handles 1000 daily bookings, the same reward may seem negligible and might not motivate them as much. Their reference point is much higher, so the perceived value of the reward diminishes.
If I were to design a scratch card system based on Prospect Theory, it could not be the same for all users. The system's rules would need to consider the agent's business size to maintain high utility for each customer segment. Moreover, as agents' businesses grow and they move from Category A to Category B and C, they should experience increased marginal utility over time.
Many companies, such as Paytm, don’t reward customers with monetary benefits but prefer to offer gift vouchers to keep users engaged. The definition of value changes based on the type of voucher a user receives. One user might prefer a shopping voucher, while another might prefer movie tickets. If I prefer movies over shopping, I won’t see value in Paytm’s reward system if I consistently receive shopping vouchers. As a result, it’s highly likely I would shift to competitors over time.
How do companies solve this particular problem? Rewarding customers based on their preferences is one way, but collecting relevant data might be challenging. However, once done successfully, this becomes a powerful tool for customer retention.
Let’s look at another example—memberships. When you pay for a membership, you’re essentially betting on how much you’ll use it. This is where uncertainty comes in. Let’s explore three different types of memberships: Zomato Pro, holiday memberships, and gym memberships.
Food Memberships (like Zomato and Swiggy): Companies often offer a three-month membership at a discounted price of Rs. 149. If you order food online regularly, this membership might seem like a great deal. You could save money on delivery fees and get discounts on meals. But what if you’re not sure how often you’ll order food in the next three months? If you only end up ordering a few times, the Rs. 149 might feel like a waste. The value of the membership depends on your confidence in how much you’ll use it. Users have reference points, such as the number of times they recently ordered or specific events like an upcoming birthday, which increases the likelihood of usage. Companies use past data, such as ordering behavior and user information like dates of birth, to time and price memberships effectively, making them look attractive to customers. Some users might get the membership at Rs. 99, while others pay Rs. 149, often receiving prompts around their birthdays.
Holiday Memberships: Vacation memberships can be quite expensive. However, if you’re someone who plans holidays every year, this membership might be a good investment. You’ll have access to great vacation spots and probably save money over time. But if you’re unsure how often you’ll take vacations, the high cost of the membership could seem too risky. The uncertainty of whether you’ll use it enough makes the decision harder. For instance, if you’re already on vacation and a company offers you a membership, you’re more likely to buy it because your current vacation creates a reference point, making future vacations feel more probable.
Gym Memberships: Gym memberships are another example where usage plays a big role. If you’re committed to working out regularly, a gym membership offers great value. You get access to equipment, classes, and a space dedicated to fitness. But if you’re unsure how often you’ll go to the gym, the membership might not seem like such a good deal. Paying for something you might not use often feels risky, leading you to possibly opt out because of that uncertainty.
As a product manager designing products or strategies like scratch cards or memberships, it’s important to think about your customers' habits and expectations. For a travel agent with a small business, a Rs. 50 scratch cards can be valuable. For someone who orders food often, the Zomato membership could save a lot of money. But if customers are unsure about how often they’ll use a service, the offers might not be worth it.
Prospect Theory helps us understand these choices. People don’t just look at the possible outcomes; they think about how those outcomes compare to their current situation. A small reward might feel significant to someone with limited means, while a large cost might feel too risky to someone unsure about their usage. By considering these factors, businesses can design better products and offers that meet their customers’ needs and expectations.
Understanding these concepts can help product managers and businesses create more effective strategies that appeal to different types of customers. Whether it’s offering a small reward to encourage more bookings or creating a membership plan that feels like a great deal, knowing how people make decisions under uncertainty is key to success.