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Predictably Irrational, by Dan Ariely
When we set the price of a Lindt truffle at 15 cents and a Kiss at one cent, we were not surprised to find that our customers acted with a good deal of rationality: they compared the price and quality of the Kiss with the price and quality of the the truffle, and then made their choice: About 73 percent of them chose the truffle and 27 percent chose a Kiss.
Now we decided to see how FREE! might change the situation. So we offered the Lindt truffle for 14 cents and the Kisses free...
But what a difference FREE! made. The humble Hershey's Kiss became a big favorite. Some 69 percent of our customers (up from 27 percent before) chose the FREE! Kiss, giving up the opportunity to get the LIndt truffle for a very good price.
That is from Dan Ariely's new and excellent Predictably Irrational: The Hidden Forces that Shape Our Decisions. Here is Dan's book-related blog. All of a sudden my head is spinning, wondering what a relative price ratio really means (we can't divide by zero). Or is this just the Alchian and Allen theorem on steroids, namely the claim that fixed charges encourage the consumption of the higher quality good? Or I think: "Zero, is there something special about that number?"
There is more on the way in behavioral economics. There is Sway: The Irresistible Pull of Irrational Behavior, by Ori and Rom Brafman and Nudge: Improving Decisions About Health, Wealth and Happiness, the defense of voluntary paternalism from Richard Thaler and Cass Sunstein, due out later this June and April respectively.
Posted by Tyler Cowen on February 3, 2008 at 11:35 AM in Books | Permalink
Comments
When Tim Harford was here in Seattle a few days ago, the events coordinator introduced him but said, "[b]efore Tim starts, I'd like to let you know about upcoming talks that may be of interest." Among them was Dan Ariely. Everyone had a good laugh. Interestingly, Tim's talk was free whereas Dan's talk is $5. Interpret that as you will.
Posted by: Trey at Feb 3, 2008 11:46:09 AM
Maybe handing over 1 cent entails a transaction cost of 1 dollar.
Posted by: Unit at Feb 3, 2008 12:04:55 PM
Was the test done in a store, on the street, in a lab? Many people don't carry change with them so a penny might as well equal a dollar, even before transaction costs.
Posted by: Hei Lun Chan at Feb 3, 2008 12:33:29 PM
2 points:
1) I agree with the others that hidden transaction costs make the kiss more expensive than a penny and are mostly eliminated when kiss is free. I would buy the lindt over the kiss just to cut down on the amount of change i have to carry in pocket. change which would inevitably fall out and raise the price of the candy I bought, but would raise the price of the kiss by a greater percentage because there is more change to lose.
2) what is the absolute number of people that bought candy in either case? it's quite possible that giving away the kiss for free induced lots of people who wouldn't have otherwise bought candy at any price to take it. this would naturally skew the ratio towards the kiss.
Posted by: BK at Feb 3, 2008 12:54:18 PM
What in the world is a Lindt Truffle? If I knew it was some sort of awesome candy imported from Switzerland or something similar, I would buy it for 14 cents over the generic kiss. But I have no familiarity with the brand at all.
Another possible skew, mayhaps?
Posted by: Robert Olson at Feb 3, 2008 12:56:39 PM
Perhaps it is, in part, a question of transaction costs. Lindt is a better tasting treat, I think. But if you place a price on the two items I must take a second, my wife ten minutes, to decide which she would prefer. If one is free, I don't think about relative prices, I just respond yes or no.
Even if it is selling for only a penny, I must decide do I want a candy, what kind of candy do I prefer, is their a catch to the offer, etc. But if it is free, I just make an instant decision of yes or no. Like rarely offers such simple options.
Most people know what a Hershey Kiss is, research cost is minimal, acquisition costs are minimal. I can even grab some for my wife for later consumption safe in the knowledge that if I guessed wrong about her preferences, I am out nothing.
So what does the little test prove? If you give people very simple choices, they will take the choice that involves the least effort to get a reward.
Posted by: DanC at Feb 3, 2008 1:03:25 PM
BK,
Interesting comment. It hadn't occured to me, but there really is a cost to breaking a dollar. You end up with more pennies in a jar, more change lost, etc.
You also have to reach in your pocket, see if you have fourteen cents, get out your wallet if not, etc. Or you can just grab a free Kiss. I think the transaction cost explanation has a lot of merit.
Posted by: Bernard Yomtov at Feb 3, 2008 1:06:04 PM
Like much the work done by behavioral decision theorists the finding are compelling and counter intuitive. Compelling because we have an empirical finding that goes against both our theoretical expectations. Counter intuitive because it also violates our practical expectations. Who would not prefer the truffle comes to my mind in this situation.
I like many formally trained in economic theory, am uncomfortable with the theoretical implications. I do, however, recall my disbelief when first presented with the axioms of choice. I also regularly experience students question the axioms. Thus my reasoning turns to how would I choose in such a situation. I want the truffle not the kiss in both situations.
Thus the material research question is not as Dan and other BDT researchers keep cataloging, whether a group acts out of expectation, but why a group does and another group does not. The research performed fails to live up the scientific standard. It merely documents a phenomena that violates our expectations. Given that BDT has been busy in the area for 30 years, I am impatient with Thaler, Ariely for not going to the next step and offering material cognitive explanations of the phenomena. Again we must explain both choices, not just the counter intuitive choice.
My next issue with this work is that it does not address what BDT theorists already know- context matters. Again we need explanations.
My last issue is that individual violations of rationality does not imply that markets will fail in a manner similar to the individual level choices. Agent-based modeling has shown us that the dynamics are far more complex. BDT researchers are confounding levels when they assert their findings have clear implications for markets. They have not theoretical basis for their assertions, other than believing naive economists who assert that markets are merely the sum of individual actions. Agent-based models show us this is clearly incorrect.
Posted by: bee at Feb 3, 2008 1:06:14 PM
I think this is easy to understand. We often assume that prices are set in a competitive market, where "you get what you pay for". If so, the one cent candy must be really cheap to produce, or the producer couldn't make a profit. Cheap to produce goods are often low quality. But when the candy is given away free, the producer is obviously not making a profit, so there is no longer any reason to think the candy must be cheap and low quality.
Posted by: Radford Neal at Feb 3, 2008 1:35:03 PM
I think we might be in a better position to evaluate this if the study covered a range of prices for both candies between 15 and 1 cent.
Posted by: Yancey Ward at Feb 3, 2008 1:38:33 PM
"Some 69 percent of our customers (up from 27 percent before) chose the FREE! Kiss, giving up the opportunity to get the Lindt truffle for a very good price."
Okay, but how many of these "customers" were actually people who, in the control scenario would not have bought anything at all? Certainly free offers attract free-loaders who might otherwise not buy anything at all if a transaction is involved.
Posted by: Geoff Hamilton at Feb 3, 2008 1:47:43 PM
This finding is fully consistent with other research, and has major implications in the field of health care, where it is well known from the Rand Health Insurance Experiment that the reduction in quantity demanded in going from free care to a $1 copay is much greater than any subsequent reduction as the price of the copay rises.
Posted by: Mark Shroder at Feb 3, 2008 1:55:48 PM
Some clarifications:
We did conduct one of the experiments at one of the MIT cafeterias, where the offer (one of the two) was presented to the customers by the cashier at checkout. This means that all customers had purchased something and the cost of the chocolate would be added to their bill -- essentially making their marginal transaction cost 0 (or at least making the transaction cost the same across all conditions). The results in this setup were the same.
Based on this I suspect that transaction cost alone is not sufficient to explain the results.
As for the comment about why they are charging $5 for my talk, maybe it is because they are trying to get cognitive dissonance to work (people who pay might have a greater need to justify their payment and as a consequence might increase their motivation to enjoy my talk...)
BTW In the book there is a chapter about my attempts to charge people for my poetry readings...
Posted by: Dan Ariely at Feb 3, 2008 2:00:33 PM
A price of zero is not a price.
Following on from Radford Neal, a market transaction involves exchange of money for goods, and a price is a signal of the value put on a commodity within a market transaction. A one cent price is an indication that a Hershey's Kiss is worth less than two cents.
Taking a free Hershey's Kiss is not a market transaction and involves no exchange. A price of zero is not a signal of value. It's a gift and it makes no statement about the value of a Hershey's Kiss.
Just to take a dig, I guess if you're an economist you see things through economic lenses, but those other social science types do study real things you know.
Posted by: tom s. at Feb 3, 2008 2:35:33 PM
An element no one else is raising is the nature of the commodity. Chocolate is a luxury good. You don't "need" a chococlate. It's a thing that either delivers pleasure or why bother? So people may have been thinking "Well, if I'm going to bothering to have a chocolate at all, I'm gonna go for the really good stuff." But then it shifted as soon as the cheap stuff became not just cheap but free. So down to a penny taste and discernment (and hope) overwhelm price consdierations. At the end, though, the attraction of "free" overwhelms the promise of pleasure-excellence. But do we know if this holds when the good being offered is something other than a luxury-type "pleasure" good?
I dunno. I have the impression that the general rules people play by when it comes to art-pleasure-luxury goods are different than the rules people play by when it comes to necessities ... And that they're flukier and more changeable too. Pleasure and subjective experience are not just hard to predict but hard to know, and of course people can fool themselves too. (Lindts may not in fact be any good. But who's to judge? After all, many sucko movies make a fortune ...)
Haven't read the book, and I imagine it's fascinating. But is Dan really arguing that "irrationality" can be predicted? Really? If so, can I introduce him to my wife?
Besides, isn't it of the nature of irrationality to be unpredictable, except maybe in a uselessly general, "shit happens" kind of way?
Plus; Wouldn't you think Hollywood could do a better job of knowing what's going to be a hit if "predictable" were any part of the game? William Goldman: "Nobody knows anything." Decades of experience, and that's the best generalization anyone's ever come up with where what's-gonna-work-in-showbiz is concerned.
Or is that just a catchy title?
Posted by: Michael Blowhard at Feb 3, 2008 2:41:00 PM
Go ahead and introduce me to your wife ....
Yes, much like the mistakes we make with visual illusions we also fall for decision illusions in repeatable and predictable ways.
Posted by: Dan Ariely at Feb 3, 2008 2:54:08 PM
Whatever the merits of the book (and I am very optimistic based on his promise of poetry recitals), Ariely has some darn good brain teasers on his (not the book's) web site under "riddles."
Posted by: burger flipper at Feb 3, 2008 2:58:03 PM
A point my wife made: We are conditioned in our culture to accept free items as a gift. A gift of a free piece of candy reminds us of a time when grandparents or others would hand us such a gift. If a free item is perceived on some level as a gift we will feel good, and as long as the gift is not seen as a bad thing, many will respond by reflex and simply take the item.
If people perceive that the cashier is giving out the candy as a gift, social conventions may explain most of the increase in consumption. People are polite to us and we are polite back.
I am not sure what this proves about anything.
Posted by: DanC at Feb 3, 2008 2:59:27 PM
To Michael B.
Predictability has nothing to see with rationality. We can predict very well the behavior of a planet, meteorit, whatever... plants or animals also. No rationality involved.
We could indeed end up with a better theory of human behavior that is completely orthogonal to rationality (and which appears in many cases to be "irrational").
Posted by: arcop at Feb 3, 2008 4:09:31 PM
"If people perceive that the cashier is giving out the candy as a gift, social conventions may explain most of the increase in consumption. People are polite to us and we are polite back."
Free is different from too-good-to-be-true for a cynical reason, too. There is a common cynical reflex that I, at least, took for granted without thinking about it until one day I talked with a foreign graduate student who had fallen for a telephone scam along the lines of "give us this $25 finder's fee up front and you will [modulo some fine print somewhere] get a free $4400 Hawaiian vacation!" I can refuse such offers by wise-in-practice habit, without having to be nearly as intelligent as I knew that graduate student was.
I'm not sure how rational it is to to apply the same cynical rule when the price is so small that it could hardly tempt a rational crook, but it doesn't seem terribly unwise to apply it whenever you don't immediately understand what's going on.
If the $1 medical insurance deductible story is true, though, that seems to bypass this family of explanations and demonstrate that there truly is psychological magic at $0.
Posted by: William Newman at Feb 3, 2008 4:48:29 PM
tom s.,
Sorry, zero can be a price. In standard economic theory, if a good is in excess supply, its price is zero. It is only a matter of definition that one "must" have exchange for their to be a definable price.
Regarding the curios nature of the number zero, my late mathematician father was once asked by a young woman in a public lecture if zero is a real number. He replied, "one of the finest, my dear, one of the finest."
And, as for change, I must tell a story involving my (Russian) wife when we visited Moscow in August 1992 during the peak of a hyperinflation. Kopecks are officially worth 1/100 of a rouble, but the value of a kopeck had fallen well below that of the copper in them, so they were being melted down and were becoming scarce. OTOH, in the old days, public pay phones cost two kopecks to use, and did not provide change and had not been replaced yet. When my wife wanted to make a phone call on such a phone, she had to pay three roubles to obtain two kopecks to make the call.
Posted by: Barkley Rosser at Feb 3, 2008 4:50:03 PM
Dan -- Thanks for the answer. Just curious: Are you relying at all on the work of the British neuropsychologist Richard Gregory? He's great. I have the impression he's kind of the dean of optical illusions seen as a gateway to the nature of perception and the brain. As an arts guy, I got more out of reading "Eye and Brain" and a few of his other books than I did out of all the standard-issue art theory that artsies are usually steered to.
Anyway, looking forward to your book. Nice website, btw.
Posted by: Michael Blowhard at Feb 3, 2008 5:44:13 PM
"Many people don't carry change with them [...]"
Man, I feel old-school
Posted by: odograph at Feb 3, 2008 6:01:26 PM
So people are irrational because they don't behave according to certain models when presented with highly subjective choices? Huh. Maybe rationality is just a tool, and not a standard of measurement.
Posted by: Grant at Feb 3, 2008 6:47:21 PM
Michael -- I am a big fan of Richard Gregory. Another 2 people you might want to look at are
http://web.mit.edu/~bcs/people/adelson.shtml
and
http://www.purveslab.net/main/
Posted by: Dan Ariely at Feb 3, 2008 8:46:25 PM
