I’m learning about behavioral economics – an interesting field looking at traditional Economics enriched with psychological knowledge. We all know that Keynes and his friends tend to assume that people are rational (we are then called homo oeconomicus) and that the market is reigned by the two independent forces supply and demand.

The real world however is way more complex: we humans are unpredictable and not rational. Scientists looking into behavioral economics take that into account and analyze our decisions (which are strongly influenced by emotions and other social or cognitive factors) and the consequences they have.

I took a particular interest in Dan Ariely‘s work as he has a very fresh and imaginative way of explaining things (you will find a lot of his words throughout the text)! I haven’t even read halfway through one of his books called “predictably irrational” but my conclusion is this:

We humans don’t know what we want, don’t understand the value unless we can compare it to something, are strongly conditioned by past experiences, go crazy for free stuff, perceive a price and hence the value of a product based on a related price we have in mind and upon paying more we expect better quality.

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Lesson 1: People compare – in our world everything is relative

We don’t know the value of something unless we compare it to something else – we do so with everything! And we tend to compare things that are easy to compare. We don’t know what we want.

These two premises taken together, leave us some space to influence the person’s decision process.

The newspaper The Economist offers different subscription methods after you spent some time reading on their website. It looks like this:

– Internet subscription: 50 Euro

– Paper subscription (real newspaper): 100 Euro

– Internet & Paper subscription: 100 Euro

In an experiment conducted by Dan Ariely (Prof of Behavioral Economics at MIT’s Sloan) 85% chose the last option (and 0 the second option). This second option is called a decoy and works as a reinforcer for the 3rd option: we don’t know what we want (even though we should, since we are reading the online version of the newspaper right now) and we are overwhelmed by the decision. What’s the value of the internet subscription ? Is it expensive or cheap ? We have no idea – so we search to compare. And the easiest to compare are the two last options. We think: ha, what a bargain! internet and paper for the same price as only paper and we are strongly inclined to go for the third option. In the absence of the second option (when only shown the choice between internet and internet&print) 68% opted for the internet only subscription. It is the mere presence of the decoy option that sends us to the last and more expensive option.

The same happens in restaurants: there is always a very expensive entrée before you see the prices of the main dishes. People are inclined to buy the second most expensive menu item – the one that gives the most margin to the restaurant…

Lesson 2: The first impression – the first pricing we see – marks our perception of future prices

Our first decisions resonate over a long sequence of decisions. First impressions are important and strongly shape our future view: Remembering that gas was once 1 $ a gallon, makes every trip to the gas station a painful experience. The sensitivity we show for price changes might 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.

In all our decisions we are looking for coherence. In the price perception the theory of arbitrary coherence is especially interesting since the first price seen for a product has no real value because we cannot grasp it. It is related to a past price or to an already known product in order to make it tangible (anchoring).

Arbitrary coherence: Once an arbitrary price is established in our minds, most often through anchoring – this means, linking it to a different already known value – it will shape not only present prices but also future prices. And: present and future prices for related products as well.

But mere price tags themselves are not necessarily anchors – They become anchors once we contemplate buying a product or service. You see a new electronic thing for 70 Euro – initially this means nothing to you since the device is new and you have nothing to compare it to. Once we are contemplating buying it these 70 Euro serve as an anchor for comparison with other products. When we come across a similar product for 50 Euro, this other product seems cheap whereas a 100 Euro similar products seems overpriced. We don’t question the initial 70 Euro we saw, we accept them as our standard / our anchor.

There are only few really new products in the world – this means that we will most likely always have an anchor price in our heads already. How can we avoid this ?

One example: Starbucks. How did Starbucks get around this phenomenon ? Thinking that we are trained to pay 1 $ per coffee at any other place, say Dunking Donuts, how did Starbucks get us to pay 3times the price without comparing it to the cheaper coffee ? How did Starbucks get rid of the anchoring in our head ? Starbucks created a new experience: From the very beginning Starbucks coffee houses were designed like European coffee houses offering a nice atmosphere, the smell of freshly grounded coffee beans, fancy names unknown to Americans (Latte Macchiato…), mokka machines and beautiful mugs on display for sale and european pastries such a croissants, maccarons…You walked in to Starbucks and would feel like in a different place. The coffee is not comparable to the one we have at Dunking Donuts – subsequently we have no anchor to relate to and pay whatever price is presented to us. We start with a small coffee, on our second time walking by the store we are reminded of our past decision and confining that this decision was a good one (we liked the coffee) we go in again and order another small coffee, this goes on an on (this effect is called self-herding) until the price jump from a small coffee to a bigger one and finally to a fancy one is not such a difficult decision to make.

Lesson 3 – The price creates expectations: Higher price means higher value

Our expectations affect us by altering our subjective and even objective experiences. I’m sure you have heard about the placebo effect. Does price have such an influence, too ? Are the new high-technology instruments more effective because they are more expensive ? Is a 50 cent aspirin more effective at eliminating pain as a 10 cent no-brand medication is ?

Placebos run on the power of suggestion. And there are two mechanisms that shape the expectations that make placebos work: one is belief and the other is conditioning (based on branding, packaging or the reassurance of the caregiver).

Can we assume that high price means higher quality and do our expectations translate into the objective efficacy of the product ? A wide range of medical experiments were conducted and they show that you get what you pay for. Price can change the experience. The same applies to other consumer goods: If we see a discounted item, we will instinctively assume that its quality is less than that of a full-price item.

Lesson 4 – Zero has an incredible power on us and makes us jump for all free products

When confronted with a free product, people do not imply subtract costs from benefits. Instead they perceive the benefits associated with free products as much higher. Zero is a special price and makes us overreact to a free product – the demand curve shoots up in a very non-linear way. It’s called the Zero Price Effect.

Why do we have an irrational urge to jump for a free item, even though it is not what we originally wanted ? Most transactions have an upside and a downside but when something is free we forget the downside. We perceive what is offered as much more valuable than it really is. This might be because we are intrinsically afraid of loss. And with a free item, there is no visible possibility of loss. If we have to chose between an item with a price and one that is free, choosing the priced one means the risk of making a bad decision = the risk of loss.

The draw of zero cost is not limited to monetary transactions – it applies just as well to products.

In traditional commerce, this effect is most often seen with ‘Buy 1 get one Free’ or an additional gift ‘you buy a television and get dvds for free’. In ecommerce one of the more prominent examples is the shipping cost: On Amazon shipping is free for orders of more than 20 Euros. This lead to a huge increase in sales. Zappos does the same: http://d.pr/i/L47k

The conclusion is: In order to sell more products a part of the purchase has to be made free.

If this interest you, I recommend the free classes offered by Berkeley professor Acland as podcasts: https://itunes.apple.com/itunes-u/economics-119-001-fall-2011/id460479892?mt=10

In the mean time I will continue reading his book 🙂