What a preposterous idea! Or is it? Consider the following experiment. The audience in one of my talks recently was asked to pretend they are bidding on a product (the projector being used for my presentation). But the process of bidding was a little unusual. Participants were supposed to answer the following thee questions on a piece of paper:
1. What are the last 3 digits of your SSN (social security number) … say, 123
2. Are you willing to pay this amount (i.e., $123) for this product?
3. What is the maximum amount you are willing to pay for this product?
When the results were analyzed, a huge correlation was found between the the last 3 of SSN of a participant, and the maximum amount he/she was willing to pay! Specifically, participants with SSN in the highest 25 percentile (i.e., 750 to 999) were willing to pay 5 times more than the participants whose SSN ended between 000 and 250. How could that be?
This phenomenon is known as Anchoring. The underlying idea is that consumers have a very poor sense of what a commodity is truly worth. So they are desperate to anchor on to something. The moment we forced them to think if they were willing to pay a certain price for the product (namely the last 3 of their SSN in USD), they started gravitating towards that number and the amount they were eventually willing to pay ended up being closer to the last 3 of their SSN than it would have been otherwise. This idea was first introduced by Dan Ariely in his book Predictably Irrational, and has since been tested and confirmed over and over, under many different scenarios. I myself have confirmed this multiple times by testing it on my unsuspecting audience!
How does this manifest itself in the real world? Well, if you are buying a TV set, do you think the maximum amount you are willing to pay for it would go up considerably if the first TV you see in the store is a $3000 plasma? Where do you think the store keeps its most expensive TV sets? Do you think the amount you are willing to pay for a meal would be dramatically different if the first entree you see is a $60 steak?
Traditional Economics Vs. Behavioral Economics
The example above illustrates an important point (beyond the fact that we are gullible suckers constantly falling for the tricks of smart retailers!) — that our decision-making process is not as rational as we would like to believe. This is the premise of the field of behavioral economics.
Traditional economics assumes that all parties, given a choice, would choose the economically optimal option for themselves. And as long as everybody behaves this way consistently, the “invisible hand” with take care of the rest, and everybody would win. This is the idea behind the efficient market, the free market. It is based on the assumption of a homo-economicus being — a person with the brain of einstein, and the memory and efficiency of a super computer so that she can take all relevant information and comptue the most economically viable decision in real time. If this sounds like a fantasy, that is because it is!
Most ordinary people, such as myself and most of you reading this blog, make decisions based on emotions, fears and irrational considerations, which is the assumption that Behavioral Economics relies on. Such decisions are often economically sub-optimal.
As irrational as our decisions are, the good news is that there is a method to the madness. The decisions we make may often be irrational, but they are predictable. Hence the apt title of the pioneering book in this field by Dan Ariely— Predictably Irrational.
There are dozens of principles of behavioral economics, with scores of examples based on studies done by social scientists that prove not only the irrationality of our behavior, but also the predictability of it.
Next Post: More mind-bending examples of human irrationality and how businesses are using this body of knowledge to steer us, influence us, and sometimes downright cheat us!