Predictably Irrational: The Hidden Forces That Shape Our Decisions by Dan Ariely
October 4, 2016
In this edition of Kathy’s CliffNotes we dip our toe into the study of behavioral economics with the book Predictably Irrational: The Hidden Forces That Shape Our Decisions by Dan Ariely who is a Professor of Psychology and Behavioral Economics at Duke University. There are some interesting implications based on these “predictably irrational” findings for a product pricing, product ranges, limiting supply, and overall marketing.
This lil’ guys expression embodies how I feel on the inside when I get a cookie.
Cookie happiness is predictably rational happiness , the opposite topic of this book.
This book challenges readers' assumptions about making decisions based on rational thought. The goal of the book is to help you fundamentally rethink what makes you and the people around you tick. Key take aways:
We have no idea of the real value of things. We can only make choices in comparison to similar options.
The old supply and demand theory explains only a fraction of what happens in the marketplace.
When appropriate, giving things away for free can make all the difference.
Social and marketplace norms don’t always mix well.
We overvalue the things we own.
Keeping too many doors open often has a higher cost than what those opportunities are actually worth.
Our experience is largely determined by our prior beliefs, perhaps more so than the quality of the actual product.
The Truth About Relativity: We always seek to draw comparisons, and we are often unaware as to how seemingly irrelevant factors such as the simple presentation of options, actually influence what we select.
Humans rarely choose things in absolute terms. We don’t have an internal value meter that tells us how much things are worth. Rather, we focus on the relative advantage of one thing over another, and estimate value accordingly. Fundamental observation: most people don’t know what they want unless they see it in context.
Restaurant Example: high-priced entrées on the menu boost revenue for the restaurant—even if no one buys them. Why? Because even though people generally won’t buy the most expensive dish on the menu, they will order the second most expensive dish
Honeymoon Example: People not only compare things, but they compare things that are easily comparable. For example, if given the following options for a honeymoon - Paris (with free breakfast), Rome (with free breakfast), and Rome (no breakfast included), most people would probably choose Rome with the free breakfast. The rationale is that it is easier to compare the two options for Rome than it is to compare Paris and Rome.
The role of the decoy effect (or asymmetric dominance effect) in the decision process: The decoy effect is the phenomenon whereby consumers will tend to have a specific change in preference between two options when also presented with a third option that is asymmetrically dominated. This effect is the "secret agent" in many decisions. In the example with the honeymoon options, Rome without free breakfast is the decoy. (It makes Rome with breakfast look superior to Rome without breakfast. Comparing Rome and Paris is difficult, so the easy comparison of Rome makes it more likely to choose Rome over Paris.) It makes Paris look inferior when compared to Rome with the free breakfast. Relativity helps people make decisions but it can also make them miserable. People compare their lives to those of others, leading to jealousy and inferiority.
The Economist Example: The Economist magazine wanted to offer these subscription options:
1. Internet-only subscription for $59.
2. Print-only subscription for $125.
But they realized that very few people would pay that much for print so they added a twist.
1. Internet-only subscription for $59.
2. Print-only subscription for $125.
3. Print-and-Internet subscription for $125.
By adding this third option for the same price as the second, they changed the basis for comparison. In this new setup, you essentially get the online for free (which doesn’t cost them much anyway) if you pay for the print, which makes the 3rd option much more attractive. Also, you’ve got two options for the same price, which makes it easy to compare those two and choose the better one, and disregard the first option even if it’s half the price.
The proportion of people (students in an experiment) who went for different options when presented with these choices:
1. Internet-only subscription for $59. – 68%
2. Print-only subscription for $125. – 32%
1. Internet-only subscription for $59. – 16%
2. Print-only subscription for $125. – 0%
3. Print-and-Internet subscription for $125. – 84%
The logic behind this is that we have no idea about the real value of each option (and of most products in general for that matter). The best we can do is compare the cost and benefit related to each one.
The Fallacy of Supply and Demand: Anchoring has a major long-term effect on our willingness to pay.
The first anchor influences not only the immediate buying decision but many others that follow. In other words, anchors have an enduring effect for present prices as well as for future prices.
The sensitivity we show to price changes might in fact be largely a result of our memory for the prices we have paid in the past and our desire for coherence with our past decisions—not at all a reflection of our true preferences or our level of demand.
Herding Behavior Example. You’re walking past a restaurant, and you see two people standing in line, waiting to get in. “This must be a good restaurant,” you think to yourself. “People are standing in line.” So you stand behind these people. Another person walks by. He sees three people standing in line and thinks, “This must be a fantastic restaurant,” and joins the line. Others join. We call this type of behavior herding.
Resetting Anchors Through Differentiation Example: When Howard Shultz created Starbucks, he worked diligently to separate Starbucks from other coffee shops, not through price but through ambience. Accordingly, he designed Starbucks from the very beginning to feel like a continental coffeehouse. The early shops were fragrant with the smell of roasted beans (and better-quality roasted beans than those at Dunkin’ Donuts). They sold fancy French coffee presses. The showcases presented alluring snacks—almond croissants, biscotti, raspberry custard pastries, and others. Whereas Dunkin’ Donuts had small, medium, and large coffees, Starbucks offered Short, Tall, Grande, and Venti, as well as drinks with high-pedigree names like Caffè Americano, Caffè Misto, Macchiato, and Frappuccino. Starbucks did everything in its power, in other words, to make the experience feel different—so different that we would not use the prices at Dunkin’ Donuts as an anchor, but instead would be open to the new anchor that Starbucks was preparing for us. And that, to a great extent, is how Starbucks succeeded
Demand is not, in fact, a completely separate force from supply. In order to make a man covet a thing, it is only necessary to make the thing difficult to attain.
The methods of appointing a value to an object with no previous value, like the Tahitian black pearl, is susceptible to irrational pricing. A value can be as easily (arbitrarily) assigned as by having a fancy ad with “equally” precious items and a high price tag in a window of a store on Fifth Avenue.
The Cost of Zero Cost: Zero/free is a source of irrational excitement. This is called the "zero price effect."
Zero may have an affect food purchases. Food manufacturers have to convey all kinds of information on the side of the box. They have to tell us about the calories, fat content, fiber, etc. Is it possible that the same attraction we have to zero price could also apply to zero calories, zero trans fats, zero carbs, etc.? If the same general rules apply, Pepsi will sell more cans if the label says “zero calories” than if it says “one calorie.”
Amazon Free Shipping Example: After Super Saver shipping was introduced, Amazon saw sales increases everywhere except for France
It turned out that the French division offered 1 franc ($0.20) pricing instead of free pricing.
When this was changed to free, France saw the same sales increases as elsewhere
If you are in business, and understand that, you can do some marvelous things. Want to draw a crowd? Make something FREE! Want to sell more products? Make part of the purchase FREE!
Free is one of the most powerful ways to trigger behavior
With the opportunity to receive something for free, the actual value of the product or service is no longer considered. Most transactions have an upside and a downside, but when something is FREE! we forget the downside. FREE! gives us such an emotional charge that we perceive what is being offered as immensely more valuable than it really is.
The Cost of Social Norms: Why we are happy to do things, but not when we are paid to do them. Imagine the scene if, after Thanksgiving dinner at your mother-in-law's house, you pulled out your wallet and asked, "How much do I owe you?"
There are many examples to show that people will work more for a cause than for cash. How could zero dollars be more attractive than $30? When money was mentioned, the lawyers used market norms and found the offer lacking, relative to their market salary. When no money was mentioned they used social norms and were willing to volunteer their time. Once market norms enter our considerations, the social norms depart.
It’s better to give a gift in exchange for a favor, then to offer to pay someone. Money turns the interaction from social norms to market norms. The conclusion: no one is offended by a small gift, because even small gifts keep us in the social exchange world and away from market norms. However, an explicitly priced gift in exactly the same effect as cash, and the gift no longer invoked social norms—by the mention of its cost, the gift had passed into the realm of market norms. When a social norm collides with a market norm, the social norm goes away for a long time. In other words, social relationships are not easy to reestablish.
It’s remarkable how much work companies (particularly start-ups) can get out of people when social norms (such as the excitement of building something together) are stronger than market norms (such as salaries stepping up with each promotion).
Money, as it turns out, is very often the most expensive way to motivate people. Social norms are not only cheaper, but often more effective as well.
The workplace is not just a source of money but also a source of motivation and self-definition.
When price is not a part of the exchange, we become less selfish maximizers and start caring about the welfare of others
The Problem of Procrastination and Self-Control: Why we can’t make ourselves do what we want to do. Avoiding temptation altogether is easier than overcoming it.
We also exhibit problems with self-control when we attend too frequently to tasks that we should put off—such as obsessively checking our e-mail
Over the last decade Americans have shown surprisingly little self-control. Ariely blames this lack of self-control on people's two states in which they make their judgments—cool state and hot state. In our cool state we make rational long-term decisions, whereas in our hot state we give in to immediate gratification and put off our decisions made in the cool state. Ariely describes putting off these goals for immediate gratification as procrastination. With proper motivators such as deadlines and penalties, people are more willing to meet deadlines or long-term goals. The author states that based on his experience with his students, deadlines set by authority figures such as teachers and supervisors make us start working on a specific task earlier. If we set the deadlines ourselves, we might not perform well. Moreover, we will not start making any progress towards the completion of the task until the deadline approaches.
The High Price of Ownership: Why we overvalue what we have
The "endowment effect" means that when we own something, we begin to value it more than other people do.
Three reasons why we do not always think rationally when it comes to our possessions:
Ownership is such a big part of our society that we tend to focus on what we may lose rather than on what we may gain.
The connection we feel to the things we own makes it difficult for us to dispose of them.
We assume that people will see the transaction through our eyes.
Some peculiarities of ownership:
The more work you put into something, the more ownership you begin to feel for it (The "IKEA effect")
We can begin to feel ownership even before we own something (The "eBay effect").
This is why trials and money-back guarantees work so well! People hate to downgrade.
These ownership quirks apply to ideas as well as things...which is why we end up with ideologies that no longer seem rational.
Keeping Doors Open: Why options distract us from our main objectives
In 210 BC, Xiang Yu led an army against the Ch'in Dynasty. While his troops slept, he burned his ships and smashed all the cooking pots. He explained to his troops that they had to either fight their way to victory or die. His troops won 9 consecutive battles. Eliminating options improved the focus of his troops.
We feel compelled to preserve options, even at great expense, even when it doesn't make sense.
In running back and forth among the things that might be important, we forget to spend enough time on what really is important.
The Effect of Expectations: Why the mind gets what it expects. Previously held expectations can cloud our point of view.
Beer Taste Test Example: Students visiting the pub tasted two types of beer -- Budweiser and the MIT Brew (which contains balsamic vinegar).In the “blind test” the majority preferred the altered brew, but when they were told in advance that it was vinegar-laced, they chose the original Budweiser. Another group of students was made aware of the vinegar content immediately after tasting both kinds of drinks. However, they still reported that they preferred the MIT Brew, proving that knowledge after the experience does not affect our sensory perceptions.
Expectations Shape Stereotypes Example. Stereotypes provide us with knowledge before the actual experience and thus influence our perceptions. The author describes an experiment in which an objective math exam was administered to two groups of Asian-American women. Before taking the test, the women from the first group were asked questions regarding gender-related issues, whereas the second group had to answer questions about race-related issues. The second group did better than the first one and met the expectation that Asians are good at math.
Expectations can influence nearly every aspect in one’s life. Expectations can override our senses, partially blinding us from the truth.
The Impact of Variable Rewards:
Variable Rewards are More Motivating: under the variable schedule of reinforcement, the arrival of the reward is unpredictable. On the face of it, one might expect that the fixed schedules of reinforcement would be more motivating and rewarding because the rat (or the used-car dealer) can learn to predict the outcome of his work. Instead, Skinner found that the variable schedules were actually more motivating. The most telling result was that when the rewards ceased, the rats who were under the fixed schedules stopped working almost immediately, but those under the variable schedules kept working for a very long time. This variable schedule of reinforcement also works wonders for motivating people. It is the magic (or, more accurately, dark magic) that underlies gambling and playing the lottery.