Tools for Thought

As consumers, we like to think of ourselves as rational actors. Free market theory is predicated on this assumption. Supply side errors should be corrected in the marketplace as consumers vote against poor exchange values with their wallets. But is this true?

Dan Ariely’s Predictably Irrational takes a contrarian view, using the prism of Behavioral Economics — a relatively recent field of counterfoil research that examines the psychological dimension of supply and demand, often finding that humans’ capacity for dispassionate cost/benefit analysis comes up short. In a way, behavioral economics could be considered the flip side of what experts in marketing have been studying for decades, but here it’s used for intellectual self-defense against mercantile manipulation.

Predictably Irrational uses a number of experiments conducted by the author and colleagues at MIT’s Sloan School of Management, the Harvard Business School, and elsewhere to find out if how we normally make decisions is really in our own best interests.Let’s look at the general principles being argued by the author.

Chapter 1: The Truth About Relativity. People tend to look for relative advantage when choosing between options, giving marketers an opportunity to stack the deck toward a certain preferred option. For example, when Williams-Sonoma introduced a then-novel bread machine for $275, sales were cool. Instead of withdrawing it from the market or lowering the price, the company decided to introduce a larger, more expensive bread machine; then sales of the cheaper one skyrocketed. Did shoppers suddenly “need” a bread machine, or was the deluxe model what the author would call a “decoy” — a reference point for relative advantage.

Relative advantage shows itself in many forms of keeping up with the Joneses, from cars to houses. One way we can exploit relative advantage is to control the “circles” around us, moving toward smaller circles to increase our relative happiness. Buying an economy car that’s not judged by the same standard as a sports car can help someone avoid the temptation to upgrade to a sexier, more expensive model.

Chapter 2: The Fallacy of Supply and Demand. Ariely argues that humans fall subject to “arbitrary coherence” when evaluating prices. In other words, the first price we’re exposed to for a type of good or service functions as an “anchor” that influences what we’re then willing to pay in that category from then on. People who move from expensive housing markets, for example, tend to spend the same amount for a house in a much cheaper state, and vice versa.

In one experiment, the author had students write the last two digits of their Social Security numbers as a price next to a list of goods, like computer keyboards and bottles of wine; then asked them — yes or no — if they’d be willing to pay that figure for each good. Then he asked them to write down the most they’d be willing to pay. Those with SSNs between 80 and 99 placed bids that were up to 346% higher than those with numbers between 1 and 20. From studies like these the author concludes that if arbitrary pricing can hold such sway on what we’re willing to pay, we may need to reexamine the notion that free markets are self-correcting.

Chapter 3: The Cost of Zero Cost. “Free” is an emotional hot button that can drive us to acquire things we don’t need — pens, tee shirts and so on. Free is a price point with no perceived downside. People will buy an extra book from Amazon to qualify for free shipping when they could have paid $3.95 and saved themselves $16 by forgoing the book they would have otherwise left on the shelf. In one poll in a Boston mall, people who were offered the choice between a free $10 Amazon gift certificate and a $20 one for $7 overwhelmingly chose the former.

The author set up a booth to sell individual Lindt truffles and Hershey’s Kisses on a “one per customer” basis, pricing the Lindt truffle (a high quality confection) at $0.15 and the Kiss at $0.01. At these “retail” prices, 73% of customers purchased the truffle, and 27% purchased the Kiss. Then he discounted both by one cent, making the Lindt $0.14 and the Hershey $0.00. Sales of the truffle plummeted to 31%, while “sales” of the Kiss rose to 69%. Apparently, free chocolate tastes more than twice as sweet as penny chocolate. The author suggests using the allure of free in public policy. To increase adoption of hybrid vehicles, for instance, make their registration free.

Chapter 4: The Cost of Social Norms. We live simultaneously in two worlds: one of social norms and one of market norms. Programmers will spend hundreds of hours writing open source code without expecting remuneration. Friends will help us move our furniture to a new house for nothing, or at most a favor. These are social norms. The work we do to pay the bills, of course, happens in the world of market norms. We can design better incentives if we understand the difference, and avoid mixing the two norms.

The the AARP asked some lawyers to offer some of their less expensive services to needy retires for $30 an hour, they refused. When the lawyers were asked to offer the same services for free, nearly all of them agreed. The $30 hourly rate was well below market norms, but when the standard was shifted to social norms, the donation of services was entirely acceptable. Ariely suggests applying the same principle in other domains, like using gifts to reward employees instead of cash.

Chapter 5: The Influence of Arousal. How we make decisions in an emotional (”hot”) state needs to be accounted for when we’re calm and better able to evaluate things. The author uses a study of Berkley students who were first polled on a number of questions about sexual preferences, their likelihood of engaging in immoral behaviors (like getting women drunk to decrease resistance to sex), and their likelihood of engaging in unsafe sex. Once the results were in, the same poll was conducted during heavy exposure to sexually arousing pictures. The results from the aroused group were illuminating. In the series of questions on sexual preferences, the likelihood of indulging in more “adventurous” behavior increased by 72%. The likelihood of immoral behavior rose by 136%, and the likelihood of unsafe sex increased by 25%.

The author concludes that instead of relying on our rational judgement when examining an issue, we need to factor in how things will change in the heat of the moment. In this context, it makes sense to carry a condom even if one is committed to abstinence. Pregnant women who insist on a natural childbirth should prepare themselves for a change of mind once the pain of delivery actually kicks in. Whenever possible, it’s better to make decisions away from emotional triggers. When you’re considering that iPhone purchase, the Apple Store isn’t the best environment for rational judgement.

Chapter 6: The Problem of Procrastination and Self-Control. Ariely assigned three papers during a semester to each of three different classes. Students in the first class could pick any due date for each paper they wanted, but they had to stick to it. Students in the second class had until the last day of the semester to hand in their papers, and could hand them in early (but with no additional credit). Students in the third class were given three equally spaced deadlines by the professor. Which class would fare best?

In descending order: the third class (the students with no choice of deadline), the first class (with self-imposed deadlines), then the second class (no deadline prior to end of semester). Precommitted deadlines were the best approach to dealing with procrastination, partly because the teacher’s authority, partly because the students didn’t have to rethink how much time they had — no options, no deliberation. The author concludes that the best remedy to procrastination is structuring some type of precommitment into the endeavor in question, with consequences for transgressions. A “self-control” credit card, for instance, would allow the user to assign maximum expenditures in different categories ($20 a week for coffee), and any spending above and beyond that amount would result in a self-tax, transferable to a charity or another person.

Chapter 7: The High Price of Ownership. This is probably the least surprising chapter in the book. We tend to overvalue what we own. Duke University students with tickets to their college basketball games were contacted and asked how much they would be willing to sell their tickets for. Prospective buyers, who lost their chance to buy tickets, were contacted and asked how much they would be willing to buy tickets for. Sellers typically asked for between $2400 and $3000. Buyers usually were willing to pay around $175.

When we sell something, we tend to think about what we lose (the representation of fond memories) rather than what we’ll gain (money, freedom from excess baggage). The longer we own something, the more of an emotional investment we have in it. This is even true with virtual ownership, which is why it’s a good idea with online auctions to go for items nearest to closing.

Chapter 8: Keeping Doors Open. Letting go of options is hard, even when it’s in our self-interest to do so. Ariely and a colleague decided to see just how hard by designing a game with a three virtual rooms, each with different colored doors. Once in a room, they could earn a certain amount of money (up to $0.10) with each subsequent click. They game allowed a total of 100 clicks. So students had to choose between increasing their pot by a known amount, or spend one of their clicks to find out if a different room offered a better payout.

At least one student hit on the idea that it was better to stick with the former strategy: stay in one room and keep clicking. He made the most money. Other students felt compelled to move from room to room, especially when the game was modified so that one door would gradually fade away with each click, disappearing completely within 12 clicks. If this game contains a life lesson, it’s that we should pick and option and make it work. And although time wasn’t a factor in this game, it is in real life. So when we spend time deliberating over multiple options, we also need to factor in the consequences of not deciding.

Chapter 9: The Effect of Expectations. Which is better — Budweiser or MIT Brew? MIT Brew is a beer hack: Budweiser with two drops of balsamic vinegar. When MIT students were offered a sample of “standard commercial beer” and one, they were informed, with vinegar added, they typically reported preferring the former, despite the fact that they had the opposite reaction when they weren’t informed of the “secret ingredient.” The author cites other experiments in which food and beverages served in different containers evoked different results on taste tests.

The passage on the power of stereotypes was interesting. In one experiment, one group of Asian-American women were asked questions about their race, then given a math test. Another group of Asian-American women were asked questions about their gender, then given the same math test. The group primed to think about their racial identity performed above average on the math test, presumably based on the stereotype that Asian-Americans have a higher aptitude for mathematics. The group primed to think about their gender identity performed below average, based on the stereotype that women have a lower aptitude for mathematics.

Chapter 10: The Power of Price. This is mostly a chapter about placebo effects in general, adding a couple of observations on the increased potency of more expensive placebos, continuing the theme of expectations. Subjects were individually brought into a waiting room, where they read brochures about a painkiller called Veladone. According to the brochure, Veladone was a fast-acting wonder drug that cost $2.50 a dose. A subsequent group of test subjects read the same brochure, but with the price scratched out and replaced with a handwritten $0.10.

In both groups, the subjects were called into a testing room, where they were given a series of electric shocks of different intensities; then they were given Veladone (yes, a placebo) 15 minutes before the mild torture was repeated. Almost all the subjects experienced pain relief from the $2.50 dose, but only half of the subjects receiving the $0.10 dose did.

Chapter 11: The Context of Our Character, Part I. Some types of dishonesty are different than others. Someone who robs a liquor store is likely to get a harsher sentence if caught than an executive who embezzles 20 times as much from his company. But what about socially accepted dishonesty, like “borrowing” office supplies or exaggerating losses to insurance companies? How do people who generally consider themselves honest behave when offered the opportunity to get away with dishonest behavior?

The author uses a series of quizzes administered to students at the Harvard Business School that gave different groups increased opportunities to cheat, complete with a money jar from which one group could pay themselves. While students who could cheat on the tests (the ones not in the control group) did, in fact, cheat, none of them took more money than they were allotted to take for their correct answers (even if the answers were obtained dishonestly). Curiously, in similar honesty tests, non-control groups asked to recall the Ten Commandments or sign a secular honor code prior to testing did not cheat at all. The mere reminder of ethical codes or social norms was sufficient.

Chapter 12: The Context of Our Character, Part II. The author sneaks into MIT dorms and slips six-packs of Coke into communal refrigerators. The Cokes typically disappear within three days. Ariely repeats the experiment, substituting the Cokes for six one-dollar bills on a plate. Even after three days, not one bill disappears. Like the students at Harvard, the thought of taking real cash gave them pause, even if Cokes were fair game.

Ariely continues his discourse with more tests like the ones in the previous chapter, where more correct answers are rewarded with more money. When cash is replaced with tokens, redeemable for cash immediately afterward, cheating more than doubles. This kind of sophistry is particularly relevant in a world where cash is obsolescent.

Chapter 13: Beer and Free Lunches. When customers in a brewery were verbally offered a selection of five free beers to pick from, individuals within a group at each table would tend to pick different beers. When customers were handed a list of the same beers to pick from by checking their preference (thereby making their selection private), their selections overlapped considerably. This suggests that in our culture, we make our choices in part to express our individuality, even at the expense of getting what we really want. The same experiment was repeated in Hong Kong, where individuality is considered almost eccentric, and the results were almost exactly the opposite.

The chapter ends with a summation of the book’s main theme: that economics would make more sense if it were based on how people actually behave, rather than how they should behave.

Is Predictably Irrational worth reading?

It would be hard for any of us to maintain the level of objectivity required to be entirely rational consumers, but reading this book is a good first step toward arming yourself against manipulation. It’s also a fun read just for the experiments conducted (despite the length of this review, I’ve only included a few), and because Ariely approaches what could be a very dry subject with a sense of humor. He doesn’t pretend to have many answers to translate his insights into policy, but at least he’s laid the groundwork for us to ask the right questions.