Zero Prices and Fuzzy Transactions — Dan Ariely on Irrationality

Zero Prices, Fuzzy Transactions, and the Economics of Dishonesty — Dan Ariely on Irrationality

Kisses and the price of zero

In most economics textbooks, money and prices are treated as rational entities. They are supposed to grease the wheels of demand and supply. But that isn’t the entire story. While these systems have long been a part of human life, we are only beginning to understand our relationships with them.

Consider, for example, the concept of free. Most will agree, I think, that there is something unique about the price of zero. It seems to elicit an emotional response from us when we see it. In Predictably Irrational, the behavioral economist Dan Ariely recalls running a chocolate stall that allowed customers to choose between a 15 cent Lindt truffle and a 1 cent Hershey’s Kiss. At these prices, 73 percent of patrons bought a truffle, while 27 percent bought a Kiss.

But here’s the kicker. When Ariely reduced the price of both items by 1 cent, preferences flipped. Now, 69 percent of customers preferred the free Kiss, while 31 percent went for a 10 cent truffle. The absolute change in prices, while minor, had an outsized effect on buying behavior.

While the result seems intuitive, the explanation is not clear-cut. Ariely’s suspects that it plays into our aversion towards losses. When things are free, we have nothing to lose. So we want more of it. I’d also add that people think implicitly in relative terms. In the first case, a truffle is much more expensive than a Kiss. But when Kisses are free, the deal seems inordinately better.

Free shipping at Amazon

Similar effects are found in business. Ariely points, for example, to Amazon.com and their introduction of free shipping (after some threshold amount). The deal was a major hit. Free shipping gave people an excuse to order more, and Amazon’s sales jumped immediately.

But sales did not seem to pick up in just one country—France. Are the French just different from the rest of us? Not quite. As Ariely explains, the French office had taken a different strategy. Instead of making shipping free, they charged their customers a measly franc. Somehow, the difference between free and one franc was enough to nullify the effect. But “when Amazon changed the promotion in France to include free shipping, France joined all the other countries in a dramatic sales increase.” Zero is almighty.

Placebos and the price of nothing

While we love free things, we also love paying for a whole lot of nothing. We’re not talking just about diamonds, black pearls and other gemstones. I’m referring to the placebo effect and the role that subjective beliefs have on our willingness to pay.

Ariely notes, for example, that there has been “increasing doubts about the use of arthroscopic surgery for a particular arthritic affliction of the knee.” In one study, orthopedic surgeon J.B. Moseley found that “the placebo group [experienced] relief from pain and improvements in walking to the same extent… as those who had the actual operations.”

Unsurprisingly, the study generated “a firestorm” among surgeons. As Moseley retorts, surgeons “who routinely perform arthroscopy… [were] undoubtedly embarrassed at the prospect that the placebo effect, not surgical skill, [was] responsible for patient improvement… As you might imagine, these surgeons [went] to great lengths to try to discredit [the] study.”

Beliefs and subjective reality

Now, it’s not my place to comment on the veracity of these findings. Disagreement in any case warrants further investigation and validation. But it is not at all surprising to hear about the effects of placebos in medicine and surgery. Indeed, placebos are anything but new. Ariely recalls, for instance, when 18th Century Italian physician Gerbi used worm secretions to treat toothaches. The procedure supposedly alleviated patient pain for about a year.

Placebos are a microcosm of the way beliefs and expectations can affect our subjective reality. And if the miracle is believable enough, and the patient is hopeful or desperate enough, they will pay good money for it. This explains in part why baseless supplements, healing crystals, and management consultants have so much staying power.

As Ariely writes:

“The truth is that placebos run on the power of suggestion. They are effective because people believe in them. You see your doctor and you feel better. You pop a pill and you feel better… In general, two mechanisms shape the expectations that make placebos work. One is belief—our confidence or faith in the drug, the procedure, or the caregiver… The second mechanism is conditioning. Like Pavlov’s famous dogs…, the body builds up expectancy after repeated experiences and releases various chemicals to prepare us for the future.”
Dan Ariely. (2008). Predictably Irrational.

Basketball and the price of ownership

Prices manifest themselves in another peculiar but predictable way: the endowment effect. This is the idea that we begin to value the things we own more than strangers will. This is important to understand because ownership “pervades our lives, and in a strange way, shapes many of the things we do.”

One example can be found in college basketball. To attend some high-profile college games in the United States, students sign up to participate in a lottery in hopes of winning a ticket to the game. What’s curious, Ariely notes, is how the perceived value of these tickets change after the lottery is completed.

When Ariely asked participating students who did not win a ticket how much they would pay to attend the game, the average buyer’s offer was around $175. But when Ariely asked lottery winners (ticket holders) how much they were willing to sell their tickets for, the average selling price was around $2,400—a whopping fourteen-fold difference.

Now given the randomness of a lottery, it is strange to find such discrepancies in willingness to buy and sell. Ownership seemed to skew results. As Ariely sees it, “we fall in love with what we already have”, “focus on what we may lose, rather than what we may gain”, and assume wrongly that others will see its value in the same light.

In the context of college basketball, non-ticket holders thought about what a couple hundred dollars might get them. Meanwhile, ticket winners began to imagine themselves at the event, and saw the sale as a deprivation of that experience. Ownership changed their frame of reference and contributed to the higher selling price quoted.

Subprime values and bidding wars

The endowment effect can be found elsewhere. During the subprime crisis, the American economy and real estate market stagnated. Rising foreclosures and falling housing prices made global headlines. Yet “two out of three homeowners believed that the value of their own home had increased or stayed the same” during this period, Ariely reports. The majority wrongly believed that their homes were more immune to market forces than their neighbors and countrymen.

“The more work you put into something, the more ownership you begin to feel for it… In the same way that we think our own kids are more wonderful and special than our friends’ and neighbors’ children (regardless of whether our children deserve such esteem), we overvalue everything that we own.”
Dan Ariely. (2008). Predictably Irrational.

Sometimes, the bias takes root well before we own anything. Have you ever overpaid in the final minutes of an online auction in fear of losing an item that you have not yet won? Many people do. As Ariely explains, bidders are in a “vulnerable position” when they see themselves as “virtual owners”. It feeds our aversiveness to losses. Perhaps it is safer then to set your limit in advance before your emotions take over in the dying seconds.

Ownership is everywhere

Of course, ownership applies not only to things but to ideas too. The more time we spend with a startup, sports team, or political party, the more entrenched we become in their positions; and the more it takes to change our position. The ownership of ideas is also more complex because our identity, status, and self-image is often intertwined with it. Cults, dogma, and ideology are sometimes undying because of this.

Ariely himself tries “to view all transactions as if [he] were a nonowner” — to put “some distance between [himself] and the item [or idea] of interest”. I’m reminded, likewise, of the Silicon Valley expression: “strong opinions, weakly held”. Even right now as we speak, we cannot be certain that our current beliefs are correct. But we should be willing to revise and update our mental models as credible evidence comes to light.

The examples we’ve discussed so far speak about the fuzzy nature of prices, monies, and value. Our behavior shapes and is shaped by the economic systems we interact with. A lot of this comes into focus when we recognize the two worlds in which we live: “one where social norms prevail, and the other where market norms make the rules.”

Indeed, why don’t we pay our parents for every meal they prepare, or every nappy they’ve changed, or every other little thing they’ve done for us, in cold cash? Why is it rude to tip my grandparents for the divine feasts they make on Christmas day?

There are countless social and market norms that crisscross our lives. While we would struggle to list them all on paper, we somehow know what to do. Some domains, like housing and education, exist in both camps—they become emotional goods in the marketplace. Some families will pay any price if it allows their child to attend a ‘good’ university.

Capitalists and childcare

Sometimes, the fuzziness of norms can affect behavior in surprising ways. Let us take, for example, Uri Gneezy and Aldo Rustichini’s study of Israeli day care centers. The centers wanted to reduce parental tardiness, and so instituted a fine on parents that failed to pick up their children on time. This sounds like a rational deterrent, right?

Well, not quite. To the center’s surprise, the number of late parents rose substantially. Before, most parents tried to arrive on time out of guilt and respect to the educators that cared for their children. But when the fines were imposed, the norms changed. Parents began to think that lateness was okay. They could simply pay the fine. The centers had put a price on time.

What’s worse, when the fine system was revoked, behaviors did not revert. The tardiness stayed. Pricing had eroded the social norms shared between parents and educators. The result is a reminder that human behavior is more complicated than rational models suggest. But at least the centers made some money in the interim, no?

The economics of dishonesty

Fuzzy norms may also reveal something about the economics of dishonesty. To see this in action, Ariely used his students as guinea pigs. When he gave quizzes to his students, he handed them out under different environments. The first batch, his control group, would receive no opportunity to cheat. The second, however, had a chance if they wanted to. He’d ask them to transcribe their answers to another sheet, on which the correct answers were conveniently printed.

How would you behave if you were a part of the second group? Would your behavior change if your final grade or a lot of money was on the line? While the control group in Ariely’s experiment got an average score of 66 percent, the group with an opportunity to cheat fared a little better. They managed an average score of 72 percent instead. More importantly, the discrepancy was not attributable to a few cheaters who sought to get a perfect score on their test. The study “discovered that the majority of people cheated, and that they cheated just a little bit.”

Thou shalt not cheat

Now, Ariely didn’t stop there, and ran a similar setup with a twist. He introduced a third group. Like the second batch, this group had an opportunity to cheat. But they were asked first to recall the Ten Commandments before commencing the test.

This time around, the control group solved about three problems correctly on average. The second group, which had an opportunity to cheat, averaged four correct solutions. Curiously, the third group, who attempted to recall the Ten Commandments beforehand, fared only as well as the control group. They exhibited no signs of cheating.

What’s interesting, of course, is that few students can recite the Commandments in its entirety. But “mere contemplation of moral benchmarks” was enough to deter cheating. The results together highlight how easy it is for ordinary folk to push the boundaries when opportunity presents itself; and how easy it is for nudges to work their magic.

Coca cola and cash

But there’s another dimension to keep in mind when it comes to dishonesty: just how far removed people are from their acts. Ariely saw this in action when he left cans of coke and plates of cash in the communal fridges in his college dormitories. While students did not hesitate to swipe the cans when nobody was looking, the cash remained untouched. Maybe cash-grabbing felt a tad too much like stealing to them?

Indeed, many employees will take stationary from their workplace. But many of them would feel uneasy about stealing an equivalent amount of cash, I suspect. The degree of removal may help to explain the magnitude of white collar crimes we see at scale. As Ariely writes, “cheating is a lot easier when it’s a step removed from money.”

It is easy to rationalize or ignore the consequences when you’re far removed from the problem, and your salary depends on it. When it came to the global financial crisis, “the opaque nature of… complex financial products allowed bankers to see what they wanted to see, and to be dishonest to a larger degree”, Ariely writes. And when everybody in your neighborhood behaves the same way, it’s hard to see otherwise.

“Much of the dishonesty we see involves cheating that is one step removed from cash. Companies cheat with their accounting practices; executives cheat by using backdated stock options; lobbyists cheat by underwriting parties for politicians; drug companies cheat by sending doctors and their wives off on posh vacations… Do you think that the architects of Enron’s collapse… would have stolen money from the purses of old women?”.
Dan Ariely. (2008). Predictably Irrational.

Special attention

In light of all this, isn’t economic and social behavior peculiar? People grow obsessed when prices fall to zero. Yet, at the same time, they are happy to pay a premium for healing crystals, placebos, and the things they think they own. But pricing models depend on norms. They apply in some places and not in others. And if the situation is sufficiently removed from the consequences, as we saw with cola and cash, people are happy to push and erode the social rules that hold this fuzzy system together. Indeed, our relationship with prices and money deserves special attention.

Sources and further reading

Ariely, Dan. (2008). Predictably Irrational: The Hidden Forces That Shape Our Decisions.
MacKenzie, Donald., & Millo, Yuval. (2003). Constructing a Market, Performing Theory.
Kahneman, Daniel & Tversky, Amos. (1979). Prospect Theory: An Analysis of Decision under Risk.
Raworth, Kate. (2017). Doughnut Economics: Seven Ways to Think Like a 21st-Century Economist.