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  1. 1. USA $25.95 CANADA $27.95• W h y do our headaches persist after taking a one-cent aspirin but disappear when we take a 50-cent aspirin?• Why does recalling the Ten Commandments reduce our tendency to lie, even when we couldnt possibly be caught?• W h y do we splurge on a lavish meal but cut coupons to save 25 cents on a can of soup?• W h y do we go back for second helpings at the unlimited buffet, even when our stomachs are already full?• And how did we ever start spending $4.15 on a cup of coffee when, just a few years ago, we used to pay less than a dollar? hen it comes to making decisions in our lives, we think were in control. We think were making smart, rational choices. But are we? In a series o f illuminating, often surprising experi­ments, M I T behavioral economist Dan Ariely refutes thecommon assumption that we behave in fundamentallyrational ways. Blending everyday experience with ground­breaking research, Ariely explains how expectations,emotions, social norms, and other invisible, seeminglyillogical forces skew our reasoning abilities. N o t only do we make astonishingly simple mistakesevery day, but we make the same types of mistakes, Arielydiscovers. We consistently overpay, underestimate, andprocrastinate. We fail to understand the profound effectsof our emotions on what we want, and we overvalue whatwe already own. Yet these misguided behaviors are neitherrandom nor senseless. Theyre systematic and predict­able—making us predictably irrational. From drinking coffee to losing weight, from buying acar to choosing a romantic partner, Ariely explains howto break through these systematic patterns o f thought tomake better decisions. Predictably Irrational will changethe way we interact with the world—one small decisionat a time. 0208
  2. 2. DAN ARIELY is the Alfred P. Sloan Professor o fBehavioral E c o n o m i c s at M I T , where he holds a jointappointment between M I T s Media Laboratory and theSloan School of Management. He is also a researcher at theFederal Reserve B a n k of Boston and a visiting professorat Duke University. Ariely wrote this book while he wasa fellow at the Institute for Advance Study at Princeton.His work has been featured in leading scholarly journalsand a variety of popular media outlets, including the NewYork Times, the Wall Street Journal, the WashingtonPost, the Boston Globe, Scientific American, and Science.Ariely has appeared on C N N and National Public Radio.He divides his time between Durham, North Carolina,Cambridge, Massachusetts, and the rest o f the world. A U T H O R P H O T O G R A P H COURTESY OF T H E A U T H O R JACKET DESIGN BY CHRISTINE V A N BREE Visit for exclusive information on your favorite HarperCollins authors. HARPER An Imprint ofWzr^erQoWxnsPublishers
  3. 3. Predictably Irrational—its not what you think."A marvelous book that is both thought-provoking and highly entertaining, ranging from the power o f placebos to the pleasures o f Pepsi. Ariely unmasks the subtle but powerful tricks that our minds play on us, and shows us how we can prevent being fooled." —Jerome Groopman, Recanati Chair of Medicine, Harvard Medical School, and New York Times bestselling author o f How Doctors Think" D a n Ariely is a genius at understanding human behavior: no economist does a better job of uncovering and explaining the hidden reasons for the weird ways we act, in the marketplace and out. Predictably Irrational will reshape the way you see the world, and yourself, for good." — J a m e s Surowiecki, author o f The Wisdom of Crowds"Filled with clever experiments, engaging ideas, and delightful anecdotes. D a n Ariely is a wise and amusing guide to the foibles, errors, and bloopers o f everyday decision making." — D a n i e l G i l b e r t , Professor o f Psychology, Harvard University, and New York Times bestselling author o f Stumbling on Happiness" T h i s is going to be the most influential, talked-about b o o k in years. It is so full o f daz­ zling insights—and so engaging—that once I started reading, I couldnt put it down." — D a n i e l M c F a d d e n , 2 0 0 0 N o b e l Laureate in E c o n o m i c s , M o r r i s C o x Professor o f E c o n o m i c s , University o f C a l i f o r n i a at Berkeley"Predictably Irrational is wildly original. It shows why—much more often than we usu­ ally care to admit—humans make foolish, and sometimes disastrous, mistakes. Ariely not only gives us a great read; he also makes us much wiser." — G e o r g e Akerlof, 2 0 0 1 N o b e l Laureate in E c o n o m i c s , Koshland Professor o f E c o n o m i c s , University o f C a l i f o r n i a at Berkeley" T h e most difficult part o f investing is managing your emotions. D a n explains why that is so challenging for all o f us, and how recognizing your built-in biases can help you avoid c o m m o n mistakes." — C h a r l e s Schwab, C h a i r m a n and C E O , T h e Charles S c h w a b C o r p o r a t i o n
  4. 4. predictably irrational
  5. 5. predictably irrational The Hidden Forces That Shape Our Decisions Dan Ariely HARPER An Imprint ofHarperCoMinsPublishers
  6. 6. PREDICTABLY IRRATIONAL. Copyright © 2 0 0 8 by Dan Ariely. Allrights reserved. Printed in the United States of America. N o part of thisbook may be used or reproduced in any manner whatsoever withoutwritten permission except in the case of brief quotations embodied incritical articles and reviews. For information, address HarperCollinsPublishers, 10 East 53rd Street, New York, N Y 1 0 0 2 2 .HarperCollins books may be purchased for educational, business, orsales promotional use. For information, please write: Special MarketsDepartment, HarperCollins Publishers, 10 East 53rd Street, New York,N Y 10022.Designed by Renato StanisicLibrary of Congress Cataloging-in-Publication Data is available uponrequest.ISBN: 9 7 8 - 0 - 0 6 - 1 3 5 3 2 3 - 908 09 10 11 12 WBC/RRD 10 9 8 7 6
  7. 7. To my mentors, colleagues, and students— who make research exciting
  8. 8. Contents INTRODUCTION: How an Injury Led Me to Irrationality and to the Research Described Here xi CHAPTER I The Truth about Relativity: Why Everything Is Relative—Even When It Shouldnt Be1 CHAPTER 2 The Fallacy of Supply and Demand: Why the Price of Pearls—and Everything Else— Is Up in the Air 23 CHAPTER 3 The Cost of Zero Cost: Why We Often Pay Too Much When We Pay Nothing 49
  9. 9. contents CHAPTER 4 The Cost of Social Norms: Why We Are Happy to Do Things, but Not When We Are Paid to Do Them 67 CHAPTER 5 The Influence of Arousal: Why Hot Is Much Hotter Than We Realize 89 CHAPTER 6 The Problem of Procrastination and Self-Control: Why We Cant Make Ourselves Do What We Want to Do 109 CHAPTER 7 The High Price of Ownership: Why We Overvalue What We Have 127 CHAPTER 8 Keeping Doors Open: Why Options Distract Us from Our Main Objective139 CHAPTER 9 The Effect of Expectations: Why the Mind Gets What It Expects 155 viii
  10. 10. contents CHAPTER IO The Power of Price: Why a SO-Cent Aspirin Can Do What a Penny Aspirin Cant 173 CHAPTER I I The Context of Our Character, Part I: Why We Are Dishonest, and What We Can Do about It 195 CHAPTER 12 The Context of Our Character, Part II:Why Dealing with Cash Makes Us More Honest 217 CHAPTER 13 Beer and Free Lunches:What Is Behavioral Economics, and Where Are the Free Lunches? 231 Thanks 245 List of Collaborators 249 Notes 255 Bibliography and Additional Readings 259 Index 269 ix
  11. 11. Introduction How an Injury Led Me to Irrationality and to the Research Described HereI have been told by many people that I have an unusual way of looking at the world. Over the last 20 years or so of myresearch career, its enabled me to have a lot of fun figuring outwhat really influences our decisions in daily life (as opposed towhat we think, often with great confidence, influences them). Do you know why we so often promise ourselves to diet,only to have the thought vanish when the dessert cart rollsby? Do you know why we sometimes find ourselves excitedlybuying things we dont really need? Do you know why we still have a headache after taking aone-cent aspirin, but why that same headache vanishes whenthe aspirin costs 50 cents? Do you know why people who have been asked to recallthe Ten Commandments tend to be more honest (at least im­mediately afterward) than those who havent? Or why honorcodes actually do reduce dishonesty in the workplace?
  12. 12. introduction By the end of this book, youll know the answers to theseand many other questions that have implications for yourpersonal life, for your business life, and for the way you lookat the world. Understanding the answer to the question aboutaspirin, for example, has implications not only for your choiceof drugs, but for one of the biggest issues facing our society:the cost and effectiveness of health insurance. Understandingthe impact of the Ten Commandments in curbing dishonestymight help prevent the next Enron-like fraud. And under­standing the dynamics of impulsive eating has implicationsfor every other impulsive decision in our lives—includingwhy its so hard to save money for a rainy day. My goal, by the end of this book, is to help you funda­mentally rethink what makes you and the people around youtick. I hope to lead you there by presenting a wide range ofscientific experiments, findings, and anecdotes that are inmany cases quite amusing. Once you see how systematic cer­tain mistakes are—how we repeat them again and again—Ithink you will begin to learn how to avoid some of them. But before I tell you about my curious, practical, enter­taining (and in some cases even delicious) research on eating,shopping, love, money, procrastination, beer, honesty, andother areas of life, I feel it is important that I tell you aboutthe origins of my somewhat unorthodox worldview—andtherefore of this book. Tragically, my introduction to thisarena started with an accident many years ago that was any­thing but amusing.O N WHAT W O U L D otherwise have been a normal Friday after­noon in the life of an eighteen-year-old Israeli, everythingchanged irreversibly in a matter of a few seconds. An explo- xii
  13. 13. introductionsion of a large magnesium flare, the kind used to illuminatebattlefields at night, left 70 percent of my body covered withthird-degree burns. The next three years found me wrapped in bandages in ahospital and then emerging into public only occasionally,dressed in a tight synthetic suit and mask that made me looklike a crooked version of Spider-Man. Without the ability toparticipate in the same daily activities as my friends and fam­ily, I felt partially separated from society and as a conse­quence started to observe the very activities that were oncemy daily routine as if I were an outsider. As if I had comefrom a different culture (or planet), I started reflecting on thegoals of different behaviors, mine and those of others. Forexample, I started wondering why I loved one girl but notanother, why my daily routine was designed to be comfort­able for the physicians but not for me, why I loved going rockclimbing but not studying history, why I cared so much aboutwhat other people thought of me, and mostly what it is aboutlife that motivates people and causes us to behave as we do. During the years in the hospital following my accident, I hadextensive experience with different types of pain and a greatdeal of time between treatments and operations to reflect on it.Initially, my daily agony was largely played out in the "bath," aprocedure in which I was soaked in disinfectant solution, thebandages were removed, and the dead particles of skin werescraped off. When the skin is intact, disinfectants create a low-level sting, and in general the bandages come off easily. Butwhen there is little or no skin—as in my case because of myextensive burns—the disinfectant stings unbearably, the ban­dages stick to the flesh, and removing them (often tearing them)hurts like nothing else I can describe. Early on in the burn department I started talking to the xiii
  14. 14. introductionnurses who administered my daily bath, in order to under­stand their approach to my treatment. The nurses wouldroutinely grab hold of a bandage and rip it off as fast as pos­sible, creating a relatively short burst of pain; they would re­peat this process for an hour or so until they had removedevery one of the bandages. Once this process was over I wascovered with ointment and with new bandages, in order torepeat the process again the next day. The nurses, I quickly learned, had theorized that a vigor­ous tug at the bandages, which caused a sharp spike of pain,was preferable (to the patient) to a slow pulling of the wrap­pings, which might not lead to such a severe spike of pain butwould extend the treatment, and therefore be more painfuloverall. T h e nurses had also concluded that there was no dif­ference between two possible methods: starting at the mostpainful part of the body and working their way to the leastpainful part; or starting at the least painful part and advanc­ing to the most excruciating areas. As someone who had actually experienced the pain of thebandage removal process, I did not share their beliefs (whichhad never been scientifically tested). Moreover, their theoriesgave no consideration to the amount of fear that the patientfelt anticipating the treatment; to the difficulties of dealingwith fluctuations of pain over time; to the unpredictability ofnot knowing when the pain will start and ease off; or to thebenefits of being comforted with the possibility that the painwould be reduced over time. But, given my helpless position,I had little influence over the way I was treated. As soon as I was able to leave the hospital for a prolongedperiod (I would still return for occasional operations andtreatments for another five years), I began studying at TelAviv University. During my first semester, I took a class that xiv
  15. 15. introductionprofoundly changed my outlook on research and largely de­termined my future. This was a class on the physiology ofthe brain, taught by professor Hanan Frenk. In addition to thefascinating material Professor Frenk presented about the work­ings of the brain, what struck me most about this class washis attitude to questions and alternative theories. Many times,when I raised my hand in class or stopped by his office tosuggest a different interpretation of some results he had pre­sented, he replied that my theory was indeed a possibility(somewhat unlikely, but a possibility nevertheless)—and wouldthen challenge me to propose an empirical test to distinguishit from the conventional theory. Coming up with such tests was not easy, but the idea thatscience is an empirical endeavor in which all the participants,including a new student like myself, could come up with al­ternative theories, as long as they found empirical ways totest these theories, opened up a new world to me. On one ofmy visits to Professor Frenks office, I proposed a theory ex­plaining how a certain stage of epilepsy developed, and in­cluded an idea for how one might test it in rats. Professor Frenk liked the idea, and for the next threemonths I operated on about 50 rats, implanting catheters intheir spinal cords and giving them different substances tocreate and reduce their epileptic seizures. One of the practi­cal problems with this approach was that the movements ofmy hands were very limited, because of my injury, and as aconsequence it was very difficult for me to operate on therats. Luckily for me, my best friend, Ron Weisberg (an avidvegetarian and animal lover), agreed to come with me to thelab for several weekends and help me with the procedures—atrue test of friendship if ever there was one. In the end, it turned out that my theory was wrong, but xv
  16. 16. introductionthis did not diminish my enthusiasm. I was able to learnsomething about my theory, after all, and even though thetheory was wrong, it was good to know this with high cer­tainty. I always had many questions about how things workand how people behave, and my new understanding—thatscience provides the tools and opportunities to examine any­thing I found interesting—lured me into the study of howpeople behave. With these new tools, I focused much of my initial effortson understanding how we experience pain. For obvious rea­sons I was most concerned with such situations as the bathtreatment, in which pain must be delivered to a patient over along period of time. Was it possible to reduce the overall ag­ony of such pain? Over the next few years I was able to carryout a set of laboratory experiments on myself, my friends,and volunteers—using physical pain induced by heat, coldwater, pressure, loud sounds, and even the psychological painof losing money in the stock market—to probe for the an­swers. By the time I had finished, I realized that the nurses in theburn unit were kind and generous individuals (well, therewas one exception) with a lot of experience in soaking andremoving bandages, but they still didnt have the right theoryabout what would minimize their patients pain. How couldthey be so wrong, I wondered, considering their vast experi­ence? Since I knew these nurses personally, I knew that theirbehavior was not due to maliciousness, stupidity, or neglect.Rather, they were most likely the victims of inherent biases intheir perceptions of their patients pain—biases that appar­ently were not altered even by their vast experience. For these reasons, I was particularly excited when I re­turned to the burn department one morning and presented xvi
  17. 17. introductionmy results, in the hope of influencing the bandage removalprocedures for other patients. It turns out, I told the nursesand physicians, that people feel less pain if treatments (suchas removing bandages in a bath) are carried out with lowerintensity and longer duration than if the same goal isachieved through high intensity and a shorter duration. Inother words, I would have suffered less if they had pulledthe bandages off slowly rather than with their quick-pullmethod. The nurses were genuinely surprised by my conclusions,but I was equally surprised by what Etty, my favorite nurse,had to say. She admitted that their understanding had beenlacking and that they should change their methods. But shealso pointed out that a discussion of the pain inflicted in thebath treatment should also take into account the psychologi­cal pain that the nurses experienced when their patientsscreamed in agony. Pulling the bandages quickly might bemore understandable, she explained, if it were indeed thenurses way of shortening their own torment (and their facesoften did reveal that they were suffering). In the end, though,we all agreed that the procedures should be changed, andindeed, some of the nurses followed my recommendations. My recommendations never changed the bandage removalprocess on a greater scale (as far as I know), but the episodeleft a special impression on me. If the nurses, with all their ex­perience, misunderstood what constituted reality for the pa­tients they cared so much about, perhaps other people similarlymisunderstand the consequences of their behaviors and, forthat reason, repeatedly make the wrong decisions. I decided toexpand my scope of research, from pain to the examination ofcases in which individuals make repeated mistakes—withoutbeing able to learn much from their experiences. xvii
  18. 18. introductionT H I S J O U R N E Y INTO the many ways in which we are all ir­rational, then, is what this book is about. T h e disciplinethat allows me to play with this subject matter is calledbehavioral economics, or judgment and decision making(JDM). Behavioral economics is a relatively new field, one thatdraws on aspects of both psychology and economics. It hasled me to study everything from our reluctance to save forretirement to our inability to think clearly during sexualarousal. Its not just the behavior that I have tried to under­stand, though, but also the decision-making processes behindsuch behavior—yours, mine, and everybody elses. BeforeI go on, let me try to explain, briefly, what behavioral eco­nomics is all about and how it is different from standardeconomics. Let me start out with a bit of Shakespeare: What a piece of work is a man! how noble in reason! how infinite in faculty! in form and moving how express and admirable! in action how like an angel! in apprehension how like a god! The beauty of the world, the paragon of animals. —from Act II, scene 2 , of Hamlet The predominant view of human nature, largely sharedby economists, policy makers, nonprofessionals, and every­day Joes, is the one reflected in this quotation. O f course,this view is largely correct. Our minds and bodies are capableof amazing acts. We can see a ball thrown from a distance,instantly calculate its trajectory and impact, and then moveour body and hands in order to catch it. We can learn newlanguages with ease, particularly as young children. We canmaster chess. We can recognize thousands of faces without xviii
  19. 19. introductionconfusing them. We can produce music, literature, technol­ogy, and art—and the list goes on and on. Shakespeare is not alone in his appreciation for the hu­man mind. In fact, we all think of ourselves along the lines ofShakespeares depiction (although we do realize that ourneighbors, spouses, and bosses do not always live up to thisstandard). Within the domain of science, these assumptionsabout our ability for perfect reasoning have found their wayinto economics. In economics, this very basic idea, called ra­tionality^ provides the foundation for economic theories, pre­dictions, and recommendations. From this perspective, and to the extent that we all believein human rationality, we are all economists. I dont mean thateach of us can intuitively develop complex game-theoreticalmodels or understand the generalized axiom of revealed pref­erence (GARP); rather, I mean that we hold the basic beliefsabout human nature on which economics is built. In this book,when I mention the rational economic model, I refer to thebasic assumption that most economists and many of us holdabout human nature—the simple and compelling idea that weare capable of making the right decisions for ourselves. Although a feeling of awe at the capability of humans isclearly justified, there is a large difference between a deepsense of admiration and the assumption that our reasoningabilities are perfect. In fact, this book is about human irratio­nality—about our distance from perfection. I believe thatrecognizing where we depart from the ideal is an importantpart of the quest to truly understand ourselves, and one thatpromises many practical benefits. Understanding irrational­ity is important for our everyday actions and decisions, andfor understanding how we design our environment and thechoices it presents to us. xix
  20. 20. introduction My further observation is that we are not only irrational,but predictably irrational—that our irrationality happensthe same way, again and again. Whether we are acting asconsumers, businesspeople, or policy makers, understandinghow we are predictably irrational provides a starting pointfor improving our decision making and changing the way welive for the better. This leads me to the real "rub" (as Shakespeare mighthave called it) between conventional economics and behav­ioral economics. In conventional economics, the assumptionthat we are all rational implies that, in everyday life, we com­pute the value of all the options we face and then follow thebest possible path of action. What if we make a mistake anddo something irrational? Here, too, traditional economicshas an answer: "market forces" will sweep down on us andswiftly set us back on the path of righteousness and rational­ity. On the basis of these assumptions, in fact, generations ofeconomists since Adam Smith have been able to develop far-reaching conclusions about everything from taxation andhealth-care policies to the pricing of goods and services. But, as you will see in this book, we are really far less ra­tional than standard economic theory assumes. Moreover,these irrational behaviors of ours are neither random norsenseless. They are systematic, and since we repeat themagain and again, predictable. So, wouldnt it make sense tomodify standard economics, to move it away from naivepsychology (which often fails the tests of reason, introspec­tion, and—most important—empirical scrutiny)? This isexactly what the emerging field of behavioral economics,and this book as a small part of that enterprise, is trying toaccomplish. xx
  21. 21. introductionAs YOU W I L L see in the pages ahead, each of the chapters inthis book is based on a few experiments I carried out over theyears with some terrific colleagues (at the end of the book, Ihave included short biographies of my amazing collabora­tors) . Why experiments ? Life is complex, with multiple forcessimultaneously exerting their influences on us, and this com­plexity makes it difficult to figure out exactly how each ofthese forces shapes our behavior. For social scientists, experi­ments are like microscopes or strobe lights. They help us slowhuman behavior to a frame-by-frame narration of events,isolate individual forces, and examine those forces carefullyand in more detail. They let us test directly and unambigu­ously what makes us tick. There is one other point I want to emphasize about ex­periments. If the lessons learned in any experiment werelimited to the exact environment of the experiment, theirvalue would be limited. Instead, I would like you to thinkabout experiments as an illustration of a general principle,providing insight into how we think and how we makedecisions—not only in the context of a particular experi­ment but, by extrapolation, in many contexts of life. In each chapter, then, I have taken a step in extrapolatingthe findings from the experiments to other contexts, attempt­ing to describe some of their possible implications for life,business, and public policy. The implications I have drawnare, of course, just a partial list. To get real value from this, and from social science in gen­eral, it is important that you, the reader, spend some timethinking about how the principles of human behavior identi­fied in the experiments apply to your life. My suggestion toyou is to pause at the end of each chapter and consider xxi
  22. 22. introductionwhether the principles revealed in the experiments mightmake your life better or worse, and more importantly whatyou could do differently, given your new understanding ofhuman nature. This is where the real adventure lies. And now for the journey. xxii
  23. 23. predictably irrational
  24. 24. C H A P T E R 1 The Truth about Relativity Why Everything Is Relative—Even When It Shouldnt Be ne day while browsing the World Wide Web (obviously for work—not just wasting time), I stumbled on the fol­lowing ad, on the Web site of a magazine, the Economist. SUBSCRIPTIONS OPINION Welcome to WORLD The Economist Subscription Centre BUSINESS Pick the type of subscription you want to buy FINANCE & ECONOMICS or renew. SCIENCE & TECHNOLOGY PEOPLE • subscription - US $59.00 BOOKS & ARTS One-year subscription to M A R K E T S & DATA Includes online access to all articles from The Economist since 1997. DIVERSIONS • Print subscription - US $125.00 One-year subscription to the print edition of The Economist. • Print & web subscription - US $125.00 One-year subscription to the print edition of The Economist and online access to all articles from The Economist since 1997.
  25. 25. predictably irrational I read these offers one at a time. The first offer—the Inter­net subscription for $59—seemed reasonable. The secondoption—the $125 print subscription—seemed a bit expen­sive, but still reasonable. But then I read the third option: a print and Internet sub­scription for $125.1 read it twice before my eye ran back to theprevious options. Who would want to buy the print optionalone, I wondered, when both the Internet and the print sub­scriptions were offered for the same price? Now, the print-onlyoption may have been a typographical error, but I suspect thatthe clever people at the Economists London offices (and theyare clever—and quite mischievous in a British sort of way) wereactually manipulating me. I am pretty certain that they wantedme to skip the Internet-only option (which they assumed wouldbe my choice, since I was reading the advertisement on the Web)and jump to the more expensive option: Internet and print. But how could they manipulate me? I suspect its becausethe Economists marketing wizards (and I could just picturethem in their school ties and blazers) knew something impor­tant about human behavior: humans rarely choose things inabsolute terms. We dont have an internal value meter thattells us how much things are worth. Rather, we focus on therelative advantage of one thing over another, and estimatevalue accordingly. (For instance, we dont know how much asix-cylinder car is worth, but we can assume its more expen­sive than the four-cylinder model.) In the case of the Economist, I may not have known whetherthe Internet-only subscription at $59 was a better deal than theprint-only option at $125. But I certainly knew that the print-and-Internet option for $125 was better than the print-onlyoption at $125. In fact, you could reasonably deduce that inthe combination package, the Internet subscription is free! "Its 2
  26. 26. the truth about relativitya bloody steal—go for it, governor! " I could almost hear themshout from the riverbanks of the Thames. And I have to admit,if I had been inclined to subscribe I probably would have takenthe package deal myself. (Later, when I tested the offer on alarge number of participants, the vast majority preferred theInternet-and-print deal.) So what was going on here? Let me start with a funda­mental observation: most people dont know what they wantunless they see it in context. We dont know what kind ofracing bike we want—until we see a champ in the Tour deFrance ratcheting the gears on a particular model. We dontknow what kind of speaker system we like—until we hear aset of speakers that sounds better than the previous one. Wedont even know what we want to do with our lives—untilwe find a relative or a friend who is doing just what we thinkwe should be doing. Everything is relative, and thats thepoint. Like an airplane pilot landing in the dark, we wantrunway lights on either side of us, guiding us to the placewhere we can touch down our wheels. In the case of the Economist, the decision between the Internet-only and print-only options would take a bit of thinking. Think­ing is difficult and sometimes unpleasant. So the Economistsmarketers offered us a no-brainer: relative to the print-only op­tion, the print-and-Internet option looks clearly superior. The geniuses at the Economist arent the only ones who un­derstand the importance of relativity. Take Sam, the televisionsalesman. He plays the same general type of trick on us whenhe decides which televisions to put together on display: 36-inch Panasonic for $690 42-inch Toshiba for $850 50-inch Philips for $1,480 3
  27. 27. predictably irrational Which one would you choose? In this case, Sam knowsthat customers find it difficult to compute the value of differ­ent options. (Who really knows if the Panasonic at $690 is abetter deal than the Philips at $1,480?) But Sam also knowsthat given three choices, most people will take the middlechoice (as in landing your plane between the runway lights).So guess which television Sam prices as the middle option?Thats right—the one he wants to sell! Of course, Sam is not alone in his cleverness. The NewYork Times ran a story recently about Gregg Rapp, a restau­rant consultant, who gets paid to work out the pricing formenus. He knows, for instance, how lamb sold this year asopposed to last year; whether lamb did better paired withsquash or with risotto; and whether orders decreased whenthe price of the main course was hiked from $39 to $41. One thing Rapp has learned is that high-priced entrées onthe menu boost revenue for the restaurant—even if no onebuys them. Why? Because even though people generally wontbuy the most expensive dish on the menu, they will order thesecond most expensive dish. Thus, by creating an expensivedish, a restaurateur can lure customers into ordering the sec­ond most expensive choice (which can be cleverly engineered 1to deliver a higher profit margin).So LETS RUN through the Economists sleight of hand inslow motion. As you recall, the choices were:1. Internet-only subscription for $59.2. Print-only subscription for $125.3. Print-and-Internet subscription for $125. 4
  28. 28. the t r u t h a b o u t r e l a t i v i t y When I gave these options to 100 students at M I T s SloanSchool of Management, they opted as follows:1. Internet-only subscription for $59—16 students2. Print-only subscription for $125—zero students3. Print-and-Internet subscription for $ 1 2 5 — 8 4 students So far these Sloan M B A s are smart cookies. They allsaw the advantage in the print-and-Internet offer over theprint-only offer. But were they influenced by the mere pres­ence of the print-only option (which I will henceforth, andfor good reason, call the "decoy"). In other words, supposethat I removed the decoy so that the choices would be theones seen in the figure below: SUBSCRIPTIONS OPINION Welcome to WORLD The Economist Subscription Centre BUSINESS Pick the type of subscription you want to buy FINANCE & ECONOMICS or renew. SCIENCE & TECHNOLOGY PEOPLE • subscription - US $59.00 BOOKS & ARTS One-year subscription to M A R K E T S & DATA Includes online access to all articles from The Economist since 1997. DIVERSIONS • Print & web subscription - US $125.00 One-year subscription to the print edition of The Economist and online access to all articles from The Economist since 1997. 5
  29. 29. predictably irrational Would the students respond as before (16 for the Internetonly and 84 for the combination)? Certainly they would react the same way, wouldnt they?After all, the option I took out was one that no one selected,so it should make no difference. Right? Au contraire! This time, 68 of the students chose theInternet-only option for $59, up from 16 before. And only 32chose the combination subscription for $125, down from 84 1before/ " SUBSCRIPTIONS r.ntnomKuom SUBSCRIPTIONS OPINION Welcome to Welcome to Dn C e n t r e •;:V.•• The Economist Subscript! The Economist Subscription Centre you want to buy Pick t h e t y p e of subscription FINANCE I ECONOMICS Pick t h e type of subscription you want to buy SCIENCE & TECHNOLOGY SCIENCE & TECHNOLOGY • E c o n o m i s t . c o m s u b s c r i p t i o n - US $ 5 9 . 0 0 • E c o n o m i s t . c o m s u b s c r i p t i o n - US $ 5 9 . 0 0 O n e - y e a r subscription to E c o n o m i s t . c o m . BOOKS I ARTS One-year subscription to MARKETS S DAT) Includes online a c c e s s t o all articles from VAftKE-ISS.lV.T.1. Includes online a c c e s s t o all articles from The Economist since 1 9 9 7 The Economist since 1 9 9 7 . • P r i n t s u b s c r i p t i o n - US $ 1 2 5 . 0 0 • P r i n t & w e b s u b s c r i p t i o n - US $ 1 2 5 . 0 0 O n e - y e a r subscription to t h e print edition One-year subscription t o t h e print edition of The Economist. of The Economist and online a c c e s s to all (0> articles from The Economist since 1 9 9 7 . • P r i n t & w e b s u b s c r i p t i o n - US $ 1 2 5 . 0 0 O n e - y e a r subscription to t h e print edition of The Economist and online a c c e s s to all articles from The Economist since 1 9 9 7 . What could have possibly changed their minds? Nothingrational, I assure you. It was the mere presence of the decoythat sent 84 of them to the print-and-Internet option (and 16to the Internet-only option). And the absence of the decoyhad them choosing differently, with 32 for print-and-Internetand 68 for Internet-only. This is not only irrational but predictably irrational aswell. Why? Im glad you asked. As a convention in this book, every time I mention that conditions are different fromeach other, it is always a statistically significant difference. I refer the interested readerto the end of this book for a list of the original academic papers and additional readings. 6
  30. 30. the t r u t h a b o u t relativityL E T ME O F F E R you this visual demonstration of relativity. As you can see, the middle circle cant seem to stay the samesize. When placed among the larger circles, it gets smaller.When placed among the smaller circles, it grows bigger. Themiddle circle is the same size in both positions, of course, but itappears to change depending on what we place next to it. This might be a mere curiosity, but for the fact that itmirrors the way the mind is wired: we are always looking atthe things around us in relation to others. We cant help it.This holds true not only for physical things—toasters, bicy­cles, puppies, restaurant entrées, and spouses—but for expe­riences such as vacations and educational options, and forephemeral things as well: emotions, attitudes, and points ofview. We always compare jobs with jobs, vacations with vaca­tions, lovers with lovers, and wines with wines. All thisrelativity reminds me of a line from the film CrocodileDundee, when a street hoodlum pulls a switchblade againstour hero, Paul Hogan. "You call that a knife?" says Hogan 7
  31. 31. predictably irrationalincredulously, withdrawing a bowie blade from the back ofhis boot. "Now this" he says with a sly grin, "is a knife."R E L A T I V I T Y IS (RELATIVELY) easy to understand. But theresone aspect of relativity that consistently trips us up. Its this:we not only tend to compare things with one another butalso tend to focus on comparing things that are easilycomparable—and avoid comparing things that cannot becompared easily. That may be a confusing thought, so let me give you anexample. Suppose youre shopping for a house in a new town.Your real estate agent guides you to three houses, all of whichinterest you. One of them is a contemporary, and two are colo­nials. All three cost about the same; they are all equally desir­able; and the only difference is that one of the colonials (the"decoy") needs a new roof and the owner has knocked a fewthousand dollars off the price to cover the additional expense. So which one will you choose? The chances are good that you will not choose the con­temporary and you will not choose the colonial that needsthe new roof, but you will choose the other colonial. Why?Heres the rationale (which is actually quite irrational). Welike to make decisions based on comparisons. In the case ofthe three houses, we dont know much about the contempo­rary (we dont have another house to compare it with), sothat house goes on the sidelines. But we do know that one ofthe colonials is better than the other one. That is, the colo­nial with the good roof is better than the one with the badroof. Therefore, we will reason that it is better overall and gofor the colonial with the good roof, spurning the contempo­rary and the colonial that needs a new roof. 8
  32. 32. the truth about relativity To better understand how relativity works, consider thefollowing illustration: A -A B Attribute 2 In the left side of this illustration we see two options,each of which is better on a different attribute. Option (A)is better on attribute 1—lets say quality. Option (B) is bet­ter on attribute 2—lets say beauty. Obviously these are twovery different options and the choice between them is notsimple. Now consider what happens if we add another op­tion, called (-A) (see the right side of the illustration). Thisoption is clearly worse than option (A), but it is also verysimilar to it, making the comparison between them easy,and suggesting that (A) is not only better than (—A) but alsobetter than ( B ) . In essence, introducing (-A), the decoy, creates a simple rela­tive comparison with (A), and hence makes (A) look better, notjust relative to (-A), but overall as well. As a consequence, theinclusion of (-A) in the set, even if no one ever selects it, makespeople more likely to make (A) their final choice. Does this selection process sound familiar? Remember thepitch put together by the Economist} T h e marketers thereknew that we didnt know whether we wanted an Internetsubscription or a print subscription. But they figured that, of 9
  33. 33. predictably irrationalthe three options, the print-and-Internet combination wouldbe the offer we would take. Heres another example of the decoy effect. Suppose youare planning a honeymoon in Europe. Youve already decidedto go to one of the major romantic cities and have narrowedyour choices to Rome and Paris, your two favorites. Thetravel agent presents you with the vacation packages for eachcity, which includes airfare, hotel accommodations, sightsee­ing tours, and a free breakfast every morning. Which wouldyou select? For most people, the decision between a week in Romeand a week in Paris is not effortless. Rome has the Coliseum;Paris, the Louvre. Both have a romantic ambience, fabulousfood, and fashionable shopping. Its not an easy call. But sup­pose you were offered a third option: Rome without the freebreakfast, called - R o m e or the decoy. If you were to consider these three options (Paris, Rome,- R o m e ) , you would immediately recognize that whereasRome with the free breakfast is about as appealing as Pariswith the free breakfast, the inferior option, which is Romewithout the free breakfast, is a step down. The comparisonbetween the clearly inferior option (-Rome) makes Romewith the free breakfast seem even better. In fact, - R o m emakes Rome with the free breakfast look so good that youjudge it to be even better than the diffkult-to-compare op­tion, Paris with the free breakfast.O N C E YOU SEE the decoy effect in action, you realize that it isthe secret agent in more decisions than we could imagine. It evenhelps us decide whom to date—and, ultimately, whom to marry.Let me describe an experiment that explored just this subject. 10
  34. 34. trie t r u t h a b o u t r e l a t i v i t y As students hurried around M I T one cold weekday, I askedsome of them whether they would allow me to take their pic­tures for a study. In some cases, I got disapproving looks. Afew students walked away. But most of them were happy toparticipate, and before long, the card in my digital camerawas filled with images of smiling students. I returned to myoffice and printed 60 of them—30 of women and 30 of men. The following week I made an unusual request of 25 of myundergraduates. I asked them to pair the 30 photographs ofmen and the 30 of women by physical attractiveness (matchingthe men with other men, and the women with other women).That is, I had them pair the Brad Pitts and the George Cloo-neys of M I T , as well as the Woody Aliens and the Danny De-Vitos (sorry, Woody and Danny). Out of these 30 pairs, Iselected the six pairs—three female pairs and three malepairs—that my students seemed to agree were most alike. Now, like Dr. Frankenstein himself, I set about givingthese faces my special treatment. Using Photoshop, I mutatedthe pictures just a bit, creating a slightly but noticeably lessattractive version of each of them. I found that just the slight­est movement of the nose threw off the symmetry. Using an­other tool, I enlarged one eye, eliminated some of the hair,and added traces of acne. No flashes of lightning illuminated my laboratory; norwas there a baying of the hounds on the moor. But this wasstill a good day for science. By the time I was through, I hadthe M I T equivalent of George Clooney in his prime (A) andthe M I T equivalent of Brad Pitt in his prime (B), and also aGeorge Clooney with a slightly drooping eye and thickernose (-A, the decoy) and a less symmetrical version of BradPitt ( - B , another decoy). I followed the same procedure forthe less attractive pairs. I had the M I T equivalent of Woody 11
  35. 35. predictably irrationalAllen with his usual lopsided grin (A) and Woody Allen withan unnervingly misplaced eye (—A), as well as Danny DeVito(B) and a slightly disfigured version of Danny DeVito ( - B ) . For each of the 12 photographs, in fact, I now had a regu­lar version as well as an inferior ( - ) decoy version. (See theillustration for an example of the two conditions used in thestudy.) It was now time for the main part of the experiment. Itook all the sets of pictures and made my way over to the stu­dent union. Approaching one student after another, I askedeach to participate. When the students agreed, I handed thema sheet with three pictures (as in the illustration here). Someof them had the regular picture (A), the decoy of that picture(—A), and the other regular picture (B). Others had the regu­lar picture (B), the decoy of that picture (—B), and the otherregular picture (A). For example, a set might include a regular Clooney (A), adecoy Clooney (—A), and a regular Pitt (B); or a regular Pitt(B), a decoy Pitt (—B), and a regular Clooney (A). After se­lecting a sheet with either male or female pictures, accordingto their preferences, I asked the students to circle the peoplethey would pick to go on a date with, if they had a choice. Allthis took quite a while, and when I was done, I had distrib­uted 6 0 0 sheets. What was my motive in all this? Simply to determine if theexistence of the distorted picture (-A or - B ) would push myparticipants to choose the similar but undistorted picture. Inother words, would a slightly less attractive George Clooney(-A) push the participants to choose the perfect George Cloo­ney over the perfect Brad Pitt? There were no pictures of Brad Pitt or George Clooney inmy experiment, of course. Pictures (A) and (B) showed ordi- 12
  36. 36. the t r u t h a b o u t relativity
  37. 37. predictably irrationalnary students. But do you remember how the existence of acolonial-style house needing a new roof might push you tochoose a perfect colonial over a contemporary house—simplybecause the decoy colonial would give you something againstwhich to compare the regular colonial? And in the Econo­mists ad, didnt the print-only option for $125 push people totake the print-and-Internet option for $125? Similarly, wouldthe existence of a less perfect person (-A or - B ) push peopleto choose the perfect one (A or B ) , simply because the decoyoption served as a point of comparison? It did. Whenever I handed out a sheet that had a regularpicture, its inferior version, and another regular picture, theparticipants said they would prefer to date the "regular"person—the one who was similar, but clearly superior, to thedistorted version—over the other, undistorted person on thesheet. This was not just a close call—it happened 75 percentof the time. To explain the decoy effect further, let me tell you some­thing about bread-making machines. When Williams-Sonomafirst introduced a home "bread bakery" machine (for $275),most consumers were not interested. What was a home bread-making machine, anyway? Was it good or bad? Did one reallyneed home-baked bread? Why not just buy a fancy coffee-maker sitting nearby instead? Flustered by poor sales, themanufacturer of the bread machine brought in a marketingresearch firm, which suggested a fix: introduce an additionalmodel of the bread maker, one that was not only larger butpriced about 50 percent higher than the initial machine. Now sales began to rise (along with many loaves of bread),though it was not the large bread maker that was being sold.Why? Simply because consumers now had two models of breadmakers to choose from. Since one was clearly larger and much 14
  38. 38. the t r u t h a b o u t relativitymore expensive than the other, people didnt have to maketheir decision in a vacuum. They could say: "Well, I dontknow much about bread makers, but I do know that if I wereto buy one, Id rather have the smaller one for less money." 2And thats when bread makers began to fly off the shelves. OK for bread makers. But lets take a look at the decoyeffect in a completely different situation. What if you aresingle, and hope to appeal to as many attractive potentialdating partners as possible at an upcoming singles event? Myadvice would be to bring a friend who has your basic physicalcharacteristics (similar coloring, body type, facial features),but is slightly less attractive (—you). Why? Because the folks you want to attract will have ahard time evaluating you with no comparables around. How­ever, if you are compared with a "-you," the decoy friendwill do a lot to make you look better, not just in comparisonwith the decoy but also in general, and in comparison withall the other people around. It may sound irrational (and Icant guarantee this), but the chances are good that you willget some extra attention. O f course, dont just stop at looks.If great conversation will win the day, be sure to pick a friendfor the singles event who cant match your smooth deliveryand rapier wit. By comparison, youll sound great. Now that you know this secret, be careful: when a similarbut better-looking friend of the same sex asks you to accompanyhim or her for a night out, you might wonder whether you havebeen invited along for your company or merely as a decoy.R E L A T I V I T Y HELPS US make decisions in life. But it can alsomake us downright miserable. Why? Because jealousy andenvy spring from comparing our lot in life with that of others. 15
  39. 39. predictably irrational It was for good reason, after all, that the Ten Command­ments admonished, "Neither shall you desire your neighborshouse nor field, or male or female slave, or donkey or any­thing that belongs to your neighbor." This might just be thetoughest commandment to follow, considering that by ourvery nature we are wired to compare. Modern life makes this weakness even more pronounced.A few years ago, for instance, I met with one of the top execu­tives of one of the big investment companies. Over the courseof our conversation he mentioned that one of his employeeshad recently come to him to complain about his salary. "How long have you been with the firm?" the executiveasked the young man. "Three years. I came straight from college," was theanswer. "And when you joined us, how much did you expect to bemaking in three years?" "I was hoping to be making about a hundred thousand." The executive eyed him curiously. "And now you are making almost three hundred thou­sand, so how can you possibly complain?" he asked. "Well," the young man stammered, "its just that a coupleof the guys at the desks next to me, theyre not any betterthan I am, and they are making three hundred ten." The executive shook his head. An ironic aspect of this story is that in 1993, federal secu­rities regulators forced companies, for the first time, to revealdetails about the pay and perks of their top executives. Theidea was that once pay was in the open, boards would be re­luctant to give executives outrageous salaries and benefits.This, it was hoped, would stop the rise in executive compen­sation, which neither regulation, legislation, nor shareholder 16
  40. 40. the truth about relativitypressure had been able to stop. And indeed, it needed to stop:in 1976 the average C E O was paid 36 times as much as theaverage worker. By 1993, the average C E O was paid 131times as much. But guess what happened. Once salaries became publicinformation, the media regularly ran special stories rankingCEOs by pay. Rather than suppressing the executive perks,the publicity had CEOs in America comparing their pay withthat of everyone else. In response, executives salaries sky­rocketed. The trend was further "helped" by compensationconsulting firms (scathingly dubbed "Ratchet, Ratchet, andBingo" by the investor Warren Buffett) that advised theirCEO clients to demand outrageous raises. The result? Nowthe average C E O makes about 369 times as much as the aver­age worker—about three times the salary before executivecompensation went public. Keeping that in mind, I had a few questions for the execu­tive I met with. "What would happen," I ventured, " i f the information inyour salary database became known throughout the com­pany?" The executive looked at me with alarm. "We could getover a lot of things here—insider trading, financial scandals,and the like—but if everyone knew everyone elses salary, itwould be a true catastrophe. All but the highest-paid indi­vidual would feel underpaid—and I wouldnt be surprised ifthey went out and looked for another job." Isnt this odd? It has been shown repeatedly that the linkbetween amount of salary and happiness is not as strong asone would expect it to be (in fact, it is rather weak). Studieseven find that countries with the "happiest" people are notamong those with the highest personal income. Yet we keep 17
  41. 41. predictably irrationalpushing toward a higher salary. Much of that can be blamedon sheer envy. As H. L. Mencken, the twentieth-centuryjournalist, satirist, social critic, cynic, and freethinker noted,a mans satisfaction with his salary depends on (are you readyfor this?) whether he makes more than his wifes sisters hus­band. Why the wifes sisters husband? Because (and I have afeeling that Menckens wife kept him fully informed of hersisters husbands salary) this is a comparison that is salientand readily available.* All this extravagance in C E O s pay has had a damagingeffect on society. Instead of causing shame, every new out­rage in compensation encourages other CEOs to demandeven more. "In the Web World," according to a headline inthe New York Times, the "Rich Now Envy the Superrich." In another news story, a physician explained that he hadgraduated from Harvard with the dream of someday receiv­ing a Nobel Prize for cancer research. This was his goal. Thiswas his dream. But a few years later, he realized that severalof his colleagues were making more as medical investmentadvisers at Wall Street firms than he was making in medi­cine. He had previously been happy with his income, buthearing of his friends yachts and vacation homes, he sud­denly felt very poor. So he took another route with his 3career—the route of Wall Street. By the time he arrived athis twentieth class reunion, he was making 10 times whatmost of his peers were making in medicine. You can almostsee him, standing in the middle of the room at the reunion,drink in hand—a large circle of influence with smaller circlesgathering around him. He had not won the Nobel Prize, but* N o w t h a t you k n o w this f a c t , a n d a s s u m i n g t h a t you a r e not m a r r i e d , t a k e this intoa c c o u n t when you s e a r c h for a soul m a t e . L o o k for s o m e o n e w h o s e sibling is m a r r i e d toa p r o d u c t i v i t y - c h a l l e n g e d individual. 18
  42. 42. the truth a b o u t relativityhe had relinquished his dreams for a Wall Street salary, for achance to stop feeling "poor." Is it any wonder that familypractice physicians, who make an average of $160,000 a year,are in short supply?*CAN WE DO anything about this problem of relativity? The good news is that we can sometimes control the "cir­cles" around us, moving toward smaller circles that boostour relative happiness. If we are at our class reunion, andtheres a "big circle" in the middle of the room with a drinkin his hand, boasting of his big salary, we can consciouslytake several steps away and talk with someone else. If we arethinking of buying a new house, we can be selective aboutthe open houses we go to, skipping the houses that are aboveour means. If we are thinking about buying a new car, wecan focus on the models that we can afford, and so on. We can also change our focus from narrow to broad. Letme explain with an example from a study conducted by twobrilliant researchers, Amos Tversky and Daniel Kahneman.Suppose you have two errands to run today. The first is tobuy a new pen, and the second is to buy a suit for work. At anoffice supply store, you find a nice pen for $25. You are set tobuy it, when you remember that the same pen is on sale for$18 at another store 15 minutes away. What would you do?Do you decide to take the 15-minute trip to save the $7? Mostpeople faced with this dilemma say that they would take thetrip to save the $7. Now you are on your second task: youre shopping for*Of c o u r s e , physicians have o t h e r p r o b l e m s as well, including i n s u r a n c e f o r m s ,b u r e a u c r a c y , and t h r e a t s of lawsuits for m a l p r a c t i c e . 19
  43. 43. predictably irrationalyour suit. You find a luxurious gray pinstripe suit for $455and decide to buy it, but then another customer whispers inyour ear that the exact same suit is on sale for only $448 atanother store, just 15 minutes away. Do you make this sec­ond 15-minute trip? In this case, most people say that theywould not. But what is going on here? Is 15 minutes of your timeworth $7, or isnt it? In reality, of course, $7 is $7—no matterhow you count it. T h e only question you should ask yourselfin these cases is whether the trip across town, and the 15 ex­tra minutes it would take, is worth the extra $7 you wouldsave. Whether the amount from which this $7 will be saved is$10 or $10,000 should be irrelevant. This is the problem of relativity—we look at our decisionsin a relative way and compare them locally to the availablealternative. We compare the relative advantage of the cheappen with the expensive one, and this contrast makes it obvi­ous to us that we should spend the extra time to save the $7.At the same time, the relative advantage of the cheaper suit isvery small, so we spend the extra $7. This is also why it is so easy for a person to add $200 to a$5,000 catering bill for a soup entrée, when the same personwill clip coupons to save 25 cents on a one-dollar can of con­densed soup. Similarly, we find it easy to spend $3,000 to up­grade to leather seats when we buy a new $25,000 car, butdifficult to spend the same amount on a new leather sofa (eventhough we know we will spend more time at home on the sofathan in the car). Yet if we just thought about this in a broaderperspective, we could better assess what we could do with the$3,000 that we are considering spending on upgrading the carseats. Would we perhaps be better off spending it on books,clothes, or a vacation? Thinking broadly like this is not easy, 20
  44. 44. the t r u t h about relativitybecause making relative judgments is the natural way we think.Can you get a handle on it? I know someone who can. He is James Hong, cofounder of the ratingand dating site. (James, his business partner Jim Young,Leonard Lee, George Loewenstein, and I recently worked ona research project examining how ones own "attractiveness"affects ones view of the "attractiveness" of others.) For sure, James has made a lot of money, and he sees evenmore money all around him. One of his good friends, in fact,is a founder of PayPal and is worth tens of millions. But Hongknows how to make the circles of comparison in his lifesmaller, not larger. In his case, he started by selling his 4Porsche Boxster and buying a Toyota Prius in its place. "I dont want to live the life of a Boxster," he told the NewYork Times, "because when you get a Boxster you wish youhad a 911, and you know what people who have 911s wishthey had? They wish they had a Ferrari." Thats a lesson we can all learn: the more we have, themore we want. And the only cure is to break the cycle of rela­tivity. 21
  45. 45. CHAPTER 2 The Fallacy of Supply and Demand Why the Price of Pearls—and Everything Else— Is Up in the AirA t the onset of World War II, an Italian diamond dealer, James Assael, fled Europe for Cuba. There, he found anew livelihood: the American army needed waterproofwatches, and Assael, through his contacts in Switzerland,was able to fill the demand. When the war ended, Assaels deal with the U.S. govern­ment dried up, and he was left with thousands of Swisswatches. The Japanese needed watches, of course. But theydidnt have any money. They did have pearls, though—manythousands of them. Before long, Assael had taught his sonhow to barter Swiss watches for Japanese pearls. The busi­ness blossomed, and shortly thereafter, the son, Salvador As­sael, became known as the "pearl king." The pearl king had moored his yacht at Saint-Tropez oneday in 1973, when a dashing young Frenchman, Jean-Claude
  46. 46. predictably irrationalBrouillet, came aboard from an adjacent yacht. Brouillethad just sold his air-freight business and with the proceedshad purchased an atoll in French Polynesia—a blue-lagooned paradise for himself and his young Tahitian wife.Brouillet explained that its turquoise waters abounded withblack-lipped oysters, Finctada mar gar iti fera. And from theblack lips of those oysters came something of note: blackpearls. At the time there was no market for Tahitian black pearls,and little demand. But Brouillet persuaded Assael to go intobusiness with him. Together they would harvest black pearlsand sell them to the world. At first, Assaels marketing effortsfailed. The pearls were gunmetal gray, about the size of mus­ket balls, and he returned to Polynesia without having made asingle sale. Assael could have dropped the black pearls alto­gether or sold them at a low price to a discount store. Hecould have tried to push them to consumers by bundling themtogether with a few white pearls. But instead Assael waited ayear, until the operation had produced some better speci­mens, and then brought them to an old friend, Harry Win­ston, the legendary gemstone dealer. Winston agreed to putthem in the window of his store on Fifth Avenue, with an out­rageously high price tag attached. Assael, meanwhile, com­missioned a full-page advertisement that ran in the glossiestof magazines. There, a string of Tahitian black pearls glowed,set among a spray of diamonds, rubies, and emeralds. The pearls, which had shortly before been the privatebusiness of a cluster of black-lipped oysters, hanging on arope in the Polynesian sea, were soon parading through Man­hattan on the arched necks of the citys most prosperous di­vas. Assael had taken something of dubious worth and madeit fabulously fine. Or, as Mark Twain once noted about Tom 24
  47. 47. the fallacy of supply and d e m a n dSawyer, "Tom had discovered a great law of human action,namely, that in order to make a man covet a thing, it is onlynecessary to make the thing difficult to attain."How DID THE pearl king do it? How did he persuade thecream of society to become passionate about Tahitian blackpearls—and pay him royally for them? In order to answerthis question, I need to explain something about baby geese. A few decades ago, the naturalist Konrad Lorenz discov­ered that goslings, upon breaking out of their eggs, becomeattached to the first moving object they encounter (which isgenerally their mother). Lorenz knew this because in one ex­periment he became the first thing they saw, and they fol­lowed him loyally from then on through adolescence. Withthat, Lorenz demonstrated not only that goslings make ini­tial decisions based on whats available in their environment,but that they stick with a decision once it has been made.Lorenz called this natural phenomenon imprinting. Is the human brain, then, wired like that of a gosling? Doour first impressions and decisions become imprinted? And ifso, how does this imprinting play out in our lives? When weencounter a new product, for instance, do we accept the firstprice that comes before our eyes ? And more importantly, doesthat price (which in academic lingo we call an anchor) have along-term effect on our willingness to pay for the productfrom then on ? It seems that whats good for the goose is good for hu­mans as well. And this includes anchoring. From the begin­ning, for instance, Assael "anchored" his pearls to the finestgems in the world—and the prices followed forever after.Similarly, once we buy a new product at a particular price, 25
  48. 48. predictably irrationalwe become anchored to that price. But how exactly does thiswork? Why do we accept anchors? Consider this: if I asked you for the last two digits of yoursocial security number (mine are 7 9 ) , then asked you whetheryou would pay this number in dollars (for me this would be$79) for a particular bottle of Côtes du Rhône 1998, wouldthe mere suggestion of that number influence how much youwould be willing to spend on wine? Sounds preposterous,doesnt it? Well, wait until you see what happened to a groupof M B A students at M I T a few years ago."Now HERE WE have a nice Côtes du Rhône Jaboulet Paral­lel," said Drazen Prelec, a professor at M I T s Sloan Schoolof Management, as he lifted a bottle admiringly. "Its a1998." At the time, sitting before him were the 55 students fromhis marketing research class. On this day, Drazen, GeorgeLoewenstein (a professor at Carnegie Mellon University), andI would have an unusual request for this group of future mar­keting pros. We would ask them to jot down the last two dig­its of their social security numbers and tell us whether theywould pay this amount for a number of products, includingthe bottle of wine. Then, we would ask them to actually bidon these items in an auction. What were we trying to prove? T h e existence of what wecalled arbitrary coherence. The basic idea of arbitrary coher­ence is this: although initial prices (such as the price of As­sads pearls) are "arbitrary," once those prices are establishedin our minds they will shape not only present prices but alsofuture prices (this makes them "coherent"). So, would think­ing about ones social security number be enough to create 26
  49. 49. the fallacy of supply and d e m a n dan anchor? And would that initial anchor have a long-terminfluence? Thats what we wanted to see. "For those of you who dont know much about wines,"Drazen continued, "this bottle received eighty-six pointsfrom Wine Spectator. It has the flavor of red berry, mocha,and black chocolate; its a medium-bodied, medium-intensity,nicely balanced red, and it makes for delightful drinking." Drazen held up another bottle. This was a HermitageJaboulet La Chapelle, 1996, with a 92-point rating from theWine Advocate magazine. "The finest La Chapelle since1990," Drazen intoned, while the students looked up curi­ously. "Only 8,100 cases made . . ." In turn, Drazen held up four other items: a cordless track­ball (TrackMan Marble F X by Logitech) ; a cordless keyboardand mouse (iTouch by Logitech); a design book (The PerfectPackage: How to Add Value through Graphic Design); and aone-pound box of Belgian chocolates by Neuhaus. Drazen passed out forms that listed all the items. "Now Iwant you to write the last two digits of your social securitynumber at the top of the page," he instructed. "And thenwrite them again next to each of the items in the form of aprice. In other words, if the last two digits are twenty-three,write twenty-three dollars." "Now when youre finished with that," he added, "I wantyou to indicate on your sheets—with a simple yes or no—whether you would pay that amount for each of the products." When the students had finished answering yes or no toeach item, Drazen asked them to write down the maximumamount they were willing to pay for each of the products(their bids). Once they had written down their bids, the stu­dents passed the sheets up to me and I entered their responsesinto my laptop and announced the winners. One by one the 27
  50. 50. predictably irrationalstudent who had made the highest bid for each of the productswould step up to the front of the class, pay for the product,*and take it with them. The students enjoyed this class exercise, but when I askedthem if they felt that writing down the last two digits of theirsocial security numbers had influenced their final bids, theyquickly dismissed my suggestion. No way! When I got back to my office, I analyzed the data. Did thedigits from the social security numbers serve as anchors? Re­markably, they did: the students with the highest-ending socialsecurity digits (from 80 to 99) bid highest, while those with thelowest-ending numbers (1 to 20) bid lowest. The top 20 per­cent, for instance, bid an average of $56 for the cordless key­board; the bottom 20 percent bid an average of $16. In the end,we could see that students with social security numbers endingin the upper 20 percent placed bids that were 216 to 346 percenthigher than those of the students with social security numbersending in the lowest 20 percent (see table on the facing page). Now if the last two digits of your social security number area high number I know what you must be thinking: "Ive beenpaying too much for everything my entire life!" This is not thecase, however. Social security numbers were the anchor in thisexperiment only because we requested them. We could have justas well asked for the current temperature or the manufacturerssuggested retail price (MSRP). Any question, in fact, wouldhave created the anchor. Does that seem rational? Of coursenot. But thats the way we are—goslings, after all.*:: T h e price t h e highest bidder paid for an item w a s based not on his o w n bid, but on thato f t h e s e c o n d highest bidder. T h i s is called a s e c o n d price a u c t i o n . W i l l i a m Vickreyreceived the N o b e l prize in e c o n o m i c s for d e m o n s t r a t i n g t h a t this t y p e of a u c t i o nc r e a t e s the c o n d i t i o n s w h e r e it is in peoples best interest to bid the m a x i m u m a m o u n tthey a r e willing t o pay for e a c h item (this is also the general logic behind the auctionsystem on e B a y ) .f W h e n Ive tried this kind o f e x p e r i m e n t on e x e c u t i v e s a n d m a n a g e r s (at the M I T E x e c u - 28
  51. 51. the fallacy of supply and d e m a n dAverage prices paid for the various products for each of the five groups offinal digits in social security numbers, and the correlations between thesedigits and the bids submitted in the auction. Range of last two digits of SS numberProducts 00-19 20-39 40-59 60-79 8 0 - 9 9 Correlations*Cordless trackball $8.64 $11.82 $13.45 $21.18 $26.18 0.42Cordless keyboard $16.09 $26.82 $29.27 $34.55 $55.64 0.52Design book $12.82 $16.18 $15.82 $19.27 $30.00 0.32Neuhaus chocolates $9.55 $10.64 $12.45 $13.27 $20.64 0.421998 Côtes du Rhône $8.64 $14.45 $12.55 $15.45 $27.91 0.331996 Hermitage $11.73 $22.45 $18.09 $24.55 $37.55 0.33•Correlation is a statistical measure of how much the movement of two variables is related. Therange of possible correlations is between - 1 and + 1 , where a correlation of 0 means that the changein value of one variable has no bearing on the change in value of the other variable. The data had one more interesting aspect. Although thewillingness to pay for these items was arbitrary, there was alsoa logical, coherent aspect to it. When we looked at the bids forthe two pairs of related items (the two wines and the two com­puter components), their relative prices seemed incredibly logi­cal. Everyone was willing to pay more for the keyboard thanfor the trackball—and also pay more for the 1996 Hermitagethan for the 1998 Côtes du Rhône. The significance of this isthat once the participants were willing to pay a certain pricefor one product, their willingness to pay for other items in thesame product category was judged relative to that first price(the anchor).tive E d u c a t i o n P r o g r a m ) , Ive had similar success m a k i n g their social s e c u r i t y n u m b e r sinfluence the prices they w e r e willing t o pay for c h o c o l a t e s , b o o k s , a n d o t h e r p r o d u c t s . 29
  52. 52. predictably irrational This, then, is what we call arbitrary coherence. Initialprices are largely "arbitrary" and can be influenced by re­sponses to random questions; but once those prices are estab­lished in our minds, they shape not only what we are willingto pay for an item, but also how much we are willing to payfor related products (this makes them coherent). Now I need to add one important clarification to the storyIve just told. In life we are bombarded by prices. We see themanufacturers suggested retail price (MSRP) for cars, lawnmowers, and coffeemakers. We get the real estate agentsspiel on local housing prices. But price tags by themselves arenot necessarily anchors. They become anchors when we con­template buying a product or service at that particular price.Thats when the imprint is set. From then on, we are willingto accept a range of prices—but as with the pull of a bungeecord, we always refer back to the original anchor. Thus thefirst anchor influences not only the immediate buying deci­sion but many others that follow. We might see a 57-inch L C D high-definition television onsale for $3,000, for instance. The price tag is not the anchor.But if we decide to buy it (or seriously contemplate buying it) atthat price, then the decision becomes our anchor henceforth interms of L C D television sets. Thats our peg in the ground,and from then on—whether we shop for another set or merelyhave a conversation at a backyard cookout—all other high-definition televisions are judged relative to that price. Anchoring influences all kinds of purchases. Uri Simon-sohn (a professor at the University of Pennsylvania) and GeorgeLoewenstein, for example, found that people who move to anew city generally remain anchored to the prices they paid forhousing in their former city. In their study they found thatpeople who move from inexpensive markets (say, Lubbock, 30
  53. 53. the fallacy of supply and d e m a n dTexas) to moderately priced cities (say, Pittsburgh) dont in­crease their spending to fit the new market.* Rather, thesepeople spend an amount similar to what they were used to inthe previous market, even if this means having to squeezethemselves and their families into smaller or less comfortablehomes. Likewise, transplants from more expensive cities sinkthe same dollars into their new housing situation as they didin the past. People who move from Los Angeles to Pittsburgh,in other words, dont generally downsize their spending muchonce they hit Pennsylvania: they spend an amount similar towhat they used to spend in Los Angeles. It seems that we get used to the particularities of ourhousing markets and dont readily change. T h e only way outof this box, in fact, is to rent a home in the new location for ayear or so. That way, we adjust to the new environment—and, after a while, we are able to make a purchase that alignswith the local market.So WE ANCHOR ourselves to initial prices. But do we hopfrom one anchor price to another (flip-flopping, if you will),continually changing our willingness to pay? Or does thefirst anchor we encounter become our anchor for a long timeand for many decisions? To answer this question, we decidedto conduct another experiment—one in which we attemptedto lure our participants from old anchors to new ones. For this experiment we enlisted some undergraduate stu­dents, some graduate students, and some investment bankerswho had come to the campus to recruit new employees fortheir firms. Once the experiment started we presented our* T h e result w a s not due t o w e a l t h , t a x e s , o r o t h e r financial r e a s o n s . 31
  54. 54. predictably irrationalparticipants with three different sounds, and following each,asked them if they would be willing to get paid a particularamount of money (which served as the price anchor) for hear­ing those sounds again. One sound was a 30-second high-pitched 3,000-hertz sound, somewhat like someone screamingin a high-pitched voice. Another was a 30-second full-spectrum noise (also called white noise), which is similar tothe noise a television set makes when there is no reception.The third was a 30-second oscillation between high-pitchedand low-pitched sounds. (I am not sure if the bankers under­stood exactly what they were about to experience, but maybeeven our annoying sounds were less annoying than talkingabout investment banking.) We used sounds because there is no existing market for an­noying sounds (so the participants couldnt use a market priceas a way to think about the value of these sounds). We alsoused annoying sounds, specifically, because no one likes suchsounds (if we had used classical music, some would have likedit better than others). As for the sounds themselves, I selectedthem after creating hundreds of sounds, choosing these threebecause they were, in my opinion, equally annoying. We placed our participants in front of computer screens atthe lab, and had them clamp headphones over their ears. As the room quieted down, the first group saw this mes­sage appear in front of them: "In a few moments we are go­ing to play a new unpleasant tone over your headset. We areinterested in how annoying you find it. Immediately after youhear the tone, we will ask you whether, hypothetically, youwould be willing to repeat the same experience in exchangefor a payment of 10 cents." The second group got the samemessage, only with an offer of 90 cents rather than 10 cents. Would the anchor prices make a difference? To find out, 32
  55. 55. the fallacy of supply and d e m a n dwe turned on the sound—in this case the irritating 30-second,3,000-hertz squeal. Some of our participants grimaced. Oth­ers rolled their eyes. When the screeching ended, each participant was pre­sented with the anchoring question, phrased as a hypotheti­cal choice: Would the participant be willing, hypothetically,to repeat the experience for a cash payment (which was 10cents for the first group and 90 cents for the second group) ?After answering this anchoring question, the participantswere asked to indicate on the computer screen the lowest pricethey would demand to listen to the sound again. This decisionwas real, by the way, as it would determine whether theywould hear the sound again—and get paid for doing so.* Soon after the participants entered their prices, theylearned the outcome. Participants whose price was suffi­ciently low "won" the sound, had the (unpleasant) opportu­nity to hear it again, and got paid for doing so. The participantswhose price was too high did not listen to the sound andwere not paid for this part of the experiment. What was the point of all this? We wanted to find outwhether the first prices that we suggested (10 cents and 90cents) had served as an anchor. And indeed they had. Thosewho first faced the hypothetical decision about whether tolisten to the sound for 10 cents needed much less money to bewilling to listen to this sound again (33 cents on average)relative to those who first faced the hypothetical decisionabout whether to listen to the sound for 90 cents—this sec­ond group demanded more than twice the compensation (73T o ensure that the bids we got were indeed the lowest prices for w h i c h the p a r t i c i p a n t swould listen to the a n n o y i n g s o u n d s , we used the " B e c k e r - D e G r o o t - M a r s c h a kp r o c e d u r e . " T h i s is an auction-like p r o c e d u r e , in w h i c h e a c h of the p a r t i c i p a n t s bidsagainst a price r a n d o m l y d r a w n by a c o m p u t e r . 33
  56. 56. predictably irrationalcents on average) for the same annoying experience. Do yousee the difference that the suggested price had?B U T THIS WAS only the start of our exploration. We alsowanted to know how influential the anchor would be in fu­ture decisions. Suppose we gave the participants an opportu­nity to drop this anchor and run for another? Would they doit? To put it in terms of goslings, would they swim across thepond after their original imprint and then, midway, swingtheir allegiance to a new mother goose? In terms of goslings,I think you know that they would stick with the originalmom. But what about humans? The next two phases of theexperiment would enable us to answer these questions. In the second phase of the experiment, we took partici­pants from the previous 10-cents and 90-cents groups andtreated them to 30 seconds of a white, wooshing noise. "Hy-pothetically, would you listen to this sound again for 50cents?" we asked them at the end. The respondents pressed abutton on their computers to indicate yes or no. "OK, how much would you need to be paid for this?" weasked. Our participants typed in their lowest price; the com­puter did its thing; and, depending on their bids, some partici­pants listened to the sound again and got paid and some didnot. When we compared the prices, the 10-cents group offeredmuch lower bids than the 90-cents group. This means that al­though both groups had been equally exposed to the suggested50 cents, as their focal anchoring response (to "Hypotheti-cally, would you listen to this sound again for 50 cents?"), thefirst anchor in this annoying sound category (which was 10cents for some and 90 cents for others) predominated. Why? Perhaps the participants in the 10-cents group said 34
  57. 57. the fallacy of supply and d e m a n dsomething like the following to themselves: "Well, I listenedpreviously to that annoying sound for a low amount. Thissound is not much different. So if I said a low amount for theprevious one, I guess I could bear this sound for about thesame price." Those who were in the 90-cents group used thesame type of logic, but because their starting point was dif­ferent, so was their ending point. These individuals toldthemselves, "Well, I listened previously to that annoyingsound for a high amount. This sound is not much different.So since I said a high amount for the previous one, I guess Icould bear this sound for about the same price." Indeed, theeffect of the first anchor held—indicating that anchors havean enduring effect for present prices as well as for futureprices. There was one more step to this experiment. This time wehad our participants listen to the oscillating sound that roseand fell in pitch for 30 seconds. We asked our 10-cents group,"Hypothetically, would you listen to this sound again for 90cents?" Then we asked our 90-cents group, "Would you lis­ten to this sound again for 10 cents?" Having flipped ouranchors, we would now see which one, the local anchor orthe first anchor, exerted the greatest influence. Once again, the participants typed in yes or no. Then weasked them for real bids: "How much would it take for youto listen to this again?" At this point, they had a history withthree anchors: the first one they encountered in the experi­ment (either 10 cents or 90 cents), the second one (50 cents),and the most recent one (either 90 cents or 10 cents). Whichone of these would have the largest influence on the pricethey demanded to listen to the sound? Again, it was as if our participants minds told them, " I f Ilistened to the first sound for x cents, and listened to the 35
  58. 58. predictably irrationalsecond sound for x cents as well, then I can surely do this onefor x cents, too!" And thats what they did. Those who hadfirst encountered the 10-cent anchor accepted low prices,even after 90 cents was suggested as the anchor. On the otherhand, those who had first encountered the 90-cent anchorkept on demanding much higher prices, regardless of the an­chors that followed. What did we show? That our first decisions resonate overa long sequence of decisions. First impressions are important,whether they involve remembering that our first DVD playercost much more than such players cost today (and realizingthat, in comparison, the current prices are a steal) or remem­bering that gas was once a dollar a gallon, which makes ev­ery trip to the gas station a painful experience. In all thesecases the random, and not so random, anchors that we en­countered along the way and were swayed by remain with uslong after the initial decision itself.Now THAT W E know we behave like goslings, it is importantto understand the process by which our first decisions trans­late into long-term habits. To illustrate this process, considerthis example. Youre walking past a restaurant, and you seetwo people standing in line, waiting to get in. "This must bea good restaurant," you think to yourself. "People are stand­ing in line." So you stand behind these people. Another per­son walks by. He sees three people standing in line andthinks, "This must be a fantastic restaurant," and joins theline. Others join. We call this type of behavior herding. Ithappens when we assume that something is good (or bad) onthe basis of other peoples previous behavior, and our ownactions follow suit. 36