Sunday, July 20, 2008

Dan Ariely’s Predictably Irrational

Dan Ariely is a Duke University professor specializing in behavioral economics. In Predictably Irrational, he explains his field like so:

According to the assumptions of standard economics, all human decisions are rational and informed, motivated by an accurate concept of the worth of all goods and services and the amount of happiness (utility) of all decisions are likely to produce....Behavioral economists, on the other hand, believe that people are susceptible to irrelevant influences from their immediate environment (which we call context effects), irrelevant emotions, shortsightedness, and other forms of irrationality.

Ariely provides many real-world examples of economic irrationality. For example, here’s an anecdote about a restaurant consultant who learned that...

...high-priced entrees 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. Thus, by creating an expensive dish, a restaurateur can lure customers into ordering the second most expensive choice (which can be cleverly engineered to deliver a higher profit margin).

While a book of such anecdotes would make for good reading, Ariely’s academic work is about going beyond the anecdote to the experiment. Thus, much of the book covers controlled experiments (often by Ariely) designed to test people’s rationality in decision-making. And to Ariely’s credit, he still makes it a good read.

Among the experiments Ariely describes:

  • Seeing if people who knew they were starting an auction from an arbitrary price (the last two digits of their social security number) would nevertheless bid relative to that price. Without knowing others’ bids, each participant made a single “best offer” bid, which could be either up or down from his or her social-security-number starting point. “In the end, we could see that students with social security numbers ending in the upper 20 percent placed bids that were 216 to 346 percent higher than those of the students with social security numbers ending in the lowest 20 percent.”
  • Exploring the distorting effect of free pricing. Given a choice between a single ultrafancy chocolate for 15 cents (well below normal price) and a single Hershey’s Kiss for 1 cent, 73% chose the ultrafancy chocolate. But when the price of each was reduced 1 cent—to 14 cents and “FREE!”, respectively—69% chose the Kiss. Note that it was one chocolate per person, so everyone faced an either/or choice, and the relative price difference was unchanged at 14 cents. “According to standard economic theory (simple cost-benefit analysis), then, the price reduction should not lead to any change in the behavior of our customers....And yet here we were, with people pressing up to the table to grab our Hershey’s Kisses, not because they made a reasoned cost-benefit analysis before elbowing their way in, but simply because the Kisses were FREE!”
  • Testing whether people value items more highly after buying them. Because of high demand and limited supply, Duke ran a lottery to determine who could buy tickets to Duke basketball games. After a lottery, Ariely and another researcher called more than 100 students who either won or lost in the lottery. “In general, the students who did not own a ticket were willing to pay around $170 for one....Those who owned a ticket, on the other hand, demanded about $2,400 for it.” In other words, there was initially a single group of students, “all hungry for a basketball ticket before the lottery drawing; and then, bang—in an instance after the drawing, they were divided into two groups—ticket owners and non-ticket owners. It was an emotional chasm that was formed, between those who now imagined the glory of the game, and those who imagined what else they could buy with the price of the ticket.”

Having found that people can indeed be predictably irrational, Ariely makes the move from descriptive to prescriptive:

The good news is that these [irrationalities] also provide opportunities for improvement. If we all make systematic mistakes in our decisions, then why not develop new strategies, tools, and methods to help us make better decisions and improve our overall well-being?

Among the new strategies he mentions is Save More Tomorrow, a program designed by behavioral-economics proponents Richard Thaler (University of Chicago) and Shlomo Benartzi (UCLA):

When new employees join a company, in addition to the regular decisions they are asked to make about what percentage of their paycheck to invest in their company’s retirement plan, they are also asked what percentage of their future salary raises they would be willing to invest in their retirement plan. It is difficult to sacrifice consumption today for saving in the distant future, but it is psychologically easier to sacrifice consumption in the future, and even easier to give up a percentage of a salary increase that one does not yet have.

Save More Tomorrow is a poster child for behavioral economics because it famously succeeded in a real-world test at an actual company, nearly quadrupling savings rates. Aiming for a similar real-world win, Ariely tried to sell the credit-card industry on the concept of a “self-control credit card,” where the consumer could self-restrict spending by category. There were no takers, but he is still holding out hope.

I’ve gone on at length about Predictably Irrational because I thought it was well worth my, and probably your, time. It’s a great combination of data-driven insight, real-world application, and well-told stories—by one of the principles in the field, no less.

Here’s the link to the book at Amazon, which has an excerpt and some author videos. See also Ariely’s Predictably Irrational site.

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