BLOG: The Decoy Effect and Risk Aversion

By Ryan Pak, New York University Stern School of Business

The decoy effect arises when a firm offers a product that is clearly inferior to another product in order to drive sales of the latter. This phenomenon has been displayed experimentally in many different situations, but remains understudied theoretically. We develop a model of almost rational consumer choice, with a single behavioral tendency — regret aversion. Consumers aim to maximize their expected utility in a situation where they face incomplete information. We derive probability consumer choice in a setting with signal noise, where they are uncertain about the qualities of their alternatives. They display regret aversion, in that if the consumer later on discovers they have not selected the option that maximizes their ex-post utility, they face an additional utility loss. In this paper, we demonstrate that regret aversion is sufficient to generate the decoy effect in most cases, but does not do so for all possible “decoys”. We then use our findings to derive several testable implications that enable experimenters to determine for themselves whether or not regret aversion is the ultimate generator of the decoy effect in practice. Finally, we describe practical implications of our theory for firms that have reason to believe regret aversion is driving their consumer towards decoyed alternatives.

Read the full paper here.

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