predicting irrationality
Source Ian Murray
Date 02/01/27/10:24

The Compromise Effect
. . . And the New Thinking About Money Is That Your Irrationality
Is Predictable

By Steven Pearlstein
Washington Post Staff Writer
Sunday, January 27, 2002; Page H01

Chances are you know someone who sells his stocks only if they have
gone up, never if they have gone down.

Or the person who regularly runs up credit card debt but would
never think of dipping into her savings account.

Or maybe the guy who refuses to pay $15 to have someone else mow
his lawn but wouldn't dream of mowing anyone else's lawn for $15.

And what about those folks who flock to all-you-can-eat buffets and
cell-phone plans with unlimited minutes?

According to traditional economic theory, such people shouldn't
exist. People aren't supposed to careen through life systematically
making bad bets, leaving money on the table, assigning different
values to the same products and paying too much for things they
don't really want. Homo economicus is supposed to make intelligent,
rational choices that maximize his or her wealth and financial

Reality, of course, turns out to be quite different from theory. As
economic actors, people are as likely to be governed by their
emotions as by reason, by prejudices as by careful cost-benefit
analysis. Their rationality is bounded by limits on their time,
intelligence and the information at their disposal.

Take the bargain hunters in the headline above. They get so excited
about the 50 percent discount on that sweater they don't realize
it's just as worthwhile for them to drive across town to get a 1.3
percent discount on a $750 chair. Ten dollars is ten dollars, any
way you slice it.

Or that investor who won't sell a falling stock, because that would
mean admitting a loss. He would be better off deciding which stocks
to hold on to based solely on his expectation of their future
performance, regardless of what happened in the past.

And by what logic should people be buying things for prices that
are vastly different from what they are willing to sell them for,
such as their time (mowing lawns) and their money (the high
interest rates paid on credit cards compared with the low rates
earned on savings deposits)?

As for folks with unlimited calling plans, they get so enchanted
with all the extra long-distance calls that seem as if they are
free, they don't focus on the fact that their monthly bills are

In recent years, a growing cadre of economists and psychologists
has begun to challenge the economic orthodoxy. Relying on clever
laboratory experiments and data from businesses and financial
markets, they have not only documented how irrational people become
around issues of money and prices, but also demonstrated how
predictably irrational they are.

"A lot of problems we have in real life come from our inability to
deal with money," explained psychologist Daniel Ariely at the Sloan
School of Management at the Massachusetts Institute of Technology.
"Money is an abstract concept that we, as human beings, don't
understand. How much money is it worth to eat sushi? Economists
used to think we could calculate that, but it is really impossible.
At any moment in time I may be able to say that I prefer sushi to a
banana. I may even have a notion of how many bananas I would trade
for one piece of sushi. But how much money are they worth? I have
no idea."

To demonstrate the point, Ariely and two colleagues,MIT's Drazen
Prelec and Carnegie Mellon economist George Loewenstein, corralled
dozens of campus volunteers into a room and showed each volunteer
one of several products: a cordless keyboard computer, a video
game, a bottle of wine. The subjects were then offered the
opportunity to buy the item at a price equal to the last two digits
of their Social Security numbers -- essentially a random price.
Additionally, they were each asked the maximum price they would be
willing to pay.

What the research revealed was that the maximum price the subjects
assigned was driven largely by the random offer they had received
only moments before: Those with high Social Security numbers
systematically bid more than those with low ones. Because they
didn't have a clue about what the merchandise was worth to them,
they were vulnerable to suggestion and manipulation.

The Compromise Effect

While such insights may be revolutionizing economics, they are
hardly news to marketers and pitchmen.

When Oriental-rug salesmen and charitable fundraisers start out by
mentioning a ridiculously high price or suggested donation, it's
not because they think they'll get it but rather to establish the
highest possible reference point in the minds of buyers and donors.
They know they will get more than they would otherwise by starting
high and coming down. The same goes for the "full" fares posted by
airlines, the suggested retail prices listed in department-store
ads and theposted room rates for hotels.

Similarly, many consumers shrink from buying either the highest- or
lowest-priced item, seeming to prefer something in between.

Companies have relied on this "compromise effect" to manipulate
their product lines to increase sales of their most profitable

Professor Itamar Simonson of the Stanford Business School notes
that retailer Williams-Sonoma Inc. was able to increase sales of
its $275 bread machine a decade ago by adding a second, slightly
larger model to its catalogue at a price of just over $400.

And Thomas Nagle, a well-known pricing consultant based in Waltham,
Mass.,reports that Xerox Corp. boosted sales of its high-volume
copier to large corporations only after it brought out a
higher-priced model with a few extra bells and whistles that
purchasing managers could feel good about rejecting.

"The general view is that the top of the line is only for people
with more money than brains," Nagle said.

The Endowment Effect

Another well-documented tendency in people's economic behavior is
that they assign higher value to things they already have.

Ziv Carmon, a French marketing professor, and MIT's Ariely divided
a group of nearly 100 Duke University students into two groups. One
group was asked to state the highest price they would pay for a
ticket to the NCAA Final Four basketball tournament, a highly
prized item on that campus. The other group was told to imagine
they had such a ticket and was asked for the lowest price at which
they would be willing to sell it. The median selling price was
$1,500; the median buying price was $150.

This tenfold difference, according to Carmon and Ariely, results
from the different ways in which buyers and sellers think about a
transaction. Buyers tend to think about what else they could do
with the same amount of money, while sellers focus on the pleasure
or enjoyment they would forgo.

Marketers had already formed an intuition about this "endowment
effect." The Book-of-the-Month Club was founded on the proposition
that people are more likely to buy the monthly selection once they
have the thing in their hands. And magazine publishers figured out
that the best way to persuade subscribers to renew is to focus on
the pleasures readers will lose if they let the subscription lapse.
When furniture stores or art galleries encourage customers to take
something home and try it out for a while, they're not just being


One of the blind spots of traditional economic theory is that it
can't explain why people do generous things with their money, such
as leaving large tips for waitresses in restaurants they'll never
visit again. Behavioral economists reason that it's because people
have an emotional preference for fairness that competes with the
desire to maximize wealth.

Consumers react very negatively to what they perceive as price
gouging. The Miami Heat basketball team found that out when it
doubled the price of tickets for Game 5 of the NBA championships
back in 1997. Fans were so outraged many refused to buy tickets,
leaving hundreds of empty seats and forcing the team to return
prices to their normal levels for Game 7.

"While it is true that people prefer more money to less, we also
like to be treated fairly -- and like to treat others fairly," said
Richard Thaler of the University of Chicago, a leading behavioral
economist. "To the extent these objectives are contradictory,
people make trade-offs where their behavior appears to vary widely,
depending on the context."

Sometimes the trick for the marketer is to manipulate that context.
Thaler notes that most people think it fair for an auto dealer to
suspend a $200 rebate program for particularly hot models that are
in short supply. But only half as many thought it fair for the
dealer to impose a $200 surcharge, even though the final price
would be the same.

The Hilton hotel in Pasadena, Calif., tries to skirt the surcharge
problem during the Rose Bowl by setting aside most rooms for $999
packages that include meals, tickets and transportation to the
game. "The same people who like that proposition wouldn't tolerate
it if we raised the room rate to a higher price," explained Dennis
Koci, senior vice president for the hotel chain.

Mental Accounting

What's something worth? It all depends on how you calculate it.

Tom Nagle recalls his days as a young business professor, when he
decided to do a little freelancing by offering companies a two-day
pricing seminar, to be provided to 20 of their marketing
executives, anywhere they wanted. He set the price at $9,000 and
waited a long time before a potential buyer called. It was an
assistant to a company president who said her boss was very
interested but was having trouble with the idea of paying any
college professor $4,500 per day. The boss was looking at the price
in terms of the professor's pay. The next time someone called,
however, Nagle framed it differently. When they questioned the
price, he explained that if the company were to send 20 executives
to attend the same program offered by his university, it would cost
$480 for each one, or $9,600 total. In that context, the $9,000
price seemed fair enough.

Another way to reframe the pricing conversation is by adjusting the
time parameters. Public television stations have discovered they
can get significantly higher pledges from viewers by breaking the
total amount down to so many cents a day; 41 cents a day doesn't
sound as bad as $150 a year. On the other hand, the folks at
Smokers Anonymous like to remind their pack-a-day clients that they
can take a short Caribbean vacation for the $1,500 a year they
spend on cigarettes.

For most people, figuring out which is the right time frame to use
in their mental accounting is not always obvious.

In a recent study, Thaler, Loewenstein and two other researchers
found that New York taxi drivers could earn 20 percent more each
year if they would put in longer days when demand was high (rainy
days, for example) and shorter ones when demand was low. Instead,
drivers preferred to work each day until they covered their costs
and paid themselves a target wage -- then quit for the day
regardless of the market condition.

One of the key assumptions of economic theory is that money is
money. But behavioral economists have shown that people routinely
violate that principle by segregating income or costs into
different mental buckets or accounts, even when it winds up hurting
them financially.

Many people, for example, have vacation homes and time-share
condominiums that wind up costing them more for each day of use
than if they had vacationed at a nearby hotel. But more often than
not, such comparative calculations are never made because vacations
are supposed to be paid for out of "current income" while the condo
is mentally accounted for under a separate "investment" category.

Other studies show that while people are apt to go right out and
spend all of an unexpected windfall such as a bequest from a
distant aunt, they are loath to spend profits they make on

Spending and Guilt

For consumers, it turns out that their view of what something is
worth can be influenced by the currency in which it is paid.

One reason casinos use chips rather than money is that people tend
to be looser with something that has the appearance of play money.
Similarly, people seem to spend more on things overseas because it
just seems less painful to part with those funny bills and coins
than "real" American cash.

And then there are credit cards. MIT's Prelec recently ran an
experiment in which a group of men were asked to submit bids on a
ticket to a big sporting event. Half of the group was told they
could pay only in cash, the other half told they could pay only by
credit card. The cash bids were half as high as the bids made with

"People feel guilty about spending money, which is part of the big
appeal of credit cards," explained Prelec. "With the card, the
payments are not only delayed, they are lumped in with all sorts of
other expenses."

In fact, marketers have now come up with all sorts of schemes to
separate the buying and paying and take advantage of this
all-too-human instinct to avoid guilt about spending.

Although people probably wind up spending more money on their
vacations by going to all-inclusive resorts, paying in advance
offers the emotional advantage of not feeling guilty every time you
have the urge to play tennis or get another planter's punch from
the pool bar. All-you-can-eat restaurants and high-volume calling
plans work on the same premise.

"We are able to get slightly more money from our customers in a way
that they perceive is a value to them," said Harry Campbell, a
Sprint vice president for marketing and sales, explaining his
company's successful new $25-for-500-minutes plan. "People like the
fact that they know what their bill is going to be and they can
increase their usage in a guilt-free way."

Less guilt, yes, but not quite guilt-free. Having paid for goods or
services in advance, people can feel bad if they don't get their
money's worth. Health clubs, for example, notice that people come
to work out much more frequently in the first months after paying
the annual membership fee. And Thaler found in an experiment that
regular patrons at a pizza joint that offered unlimited slices for
$5 wound up eating considerably more than a group given a coupon
allowing them to eat for free.

In fact, experience shows that people get very confused when
thinking about "sunk costs" -- the money they have already spent
for a project or purchase or investment. Rationally, they should
forget about sunk costs and focus only on what the costs and
benefits are going forward. Emotionally, they can't.

Psychologists Amos Tversky and Daniel Kahneman of Princeton
University explored a situation in an oft-cited experiment
involving a theater ticket back in 1984. They told one group of
subjects to imagine that they have arrived at the theater only to
discover that they have lost their ticket. Would you pay another
$10 to buy another ticket? they asked. A second group were asked to
imagine that they are going to the play but haven't bought a ticket
in advance. Then, when they arrive at the theater, they realize
they have lost a $10 bill. Would they still buy a ticket?

In both cases, the subjects were presented with essentially the
same simple question: Would you want to spend $10 to see the play?
That's largely the way the cash-losing group thought of it, with 88
percent opting to buy the ticket. But the ticket losers, focusing
on sunk costs, tended to frame the question in a different way: Am
I willing to spend $20 to see a $10 play? Only 46 percent said yes.

This focus on sunk costs and the aversion to losses play out every
day in financial markets. Numerous studies have shown that
investors systematically make bad decisions because of their
reluctance to sell stocks or bonds on which they have a loss.

And Thaler has done extensive work showing that the reason stocks
have outperformed bonds over long periods of time is that investors
have exaggerated perceptions of the relative riskiness of stocks.
As a result, investors generally put too much money in bonds and
too little into stocks, driving their relative prices in opposite
directions. Absent that bias, Thaler argues, the returns on stocks
and bonds would have probably converged -- just as economic theory

Fear of risk also animates insurance markets, where independent
studies show that people pay too much to insure themselves against
risks of high frequency and low financial impact (low-deductible
auto policies, for example, and service contracts on home
appliances) while often failing to insure themselves against
low-frequency, high-impact events (floods and earthquakes).

Homo Economicus

Vs. Homo Sapiens

Okay, so we're a bit crazy when it comes to money. But once we are
confronted with these facts, surely we'll learn our lesson and
become more rational in our economic behavior, right?

Alas, the early evidence is that we won't. In several of the
experiments cited here, subjects were later presented with the
results and the analysis and asked to go through the exercise
again. In most cases the results were nearly identical.

"The thing that is striking is how little people learn," said
Kahneman, the Princeton psychologist.

Yet, like others in the behavioral economics crowd, Kahneman is
loath to call such behavior crazy or silly or even irrational.

"A lot of the so-called mistakes are the simplification people need
to do just to get on with their lives," he said. "We don't have
unlimited horizons, our attention can be switched from one thing to
another, and our brains are limited. Putting bad words on it is
unnecessary. We don't expect people to be able to run 50 miles an
hour. So why should we expect them to have 360-degree recognition?"

Economist Loewenstein at Carnegie Mellon agreed.

"People make these choices and behave this way because it makes
them happier," he said. "I don't find that unreasonable or

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