Predictably Irrational

Humans rarely choose things in absolute terms. We don’t have an internal value meter that tells us how much things are worth. Rather, we focus on the relative advantage of one thing over another, and estimate value accordingly.

Everything is relative, and that’s the point.

Most people don’t know what they want unless they see it in context.

• We don’t know what kind of racing bike we want until we see it in the Tour De France.
• We don’t know what kind of speaker system we like until we hear a set of speakers that sounds better than the previous one.
• We don’t know what we want to do with our lives - until we find a relative or friend who is doing just what we think we should be doing.

We not only tend to compare things with one another but also tend to focus on comparing things that are easily comparable — and avoid comparing things that cannot be compared easily.

📍 The decoy effect is the secret agent in more decisions than we could imagine.

For vacation, choosing between Rome and Paris. Tough choice! Don’t know. Offer a 3rd option: Rome without the free breakfast. Call it “-Rome”, or the decoy.

Now considering 3 options: Rome, -Rome, Paris.

The comparison with the clearly inferior option makes Rome with the free breakfast seem even better. -Rome makes Rome look so good that you judge it to be even better than the difficult-to-judge Paris.

In essence, introducing (−A), the decoy, creates a simple relative comparison with (A), and hence makes (A) look better, not just relative to (−A), but overall as well. As a consequence, the inclusion of (−A) in the set, even if no one ever selects it, makes people more likely to make (A) their final choice.

Studies even find that countries with the “happiest” people are not among those with the highest personal income. Yet we keep pushing toward a higher salary.

This is the problem of relativity — we look at our decisions in a relative way and compare them locally to the available alternative.

🖇 Related to Stumbling On Happiness and the idea of driving across town to save a few bucks for a low-priced item, but not to get “the same amount” on a car, for example. Relativism at its best.

That’s a lesson we can all learn: the more we have, the more we want. And the only cure is to break the cycle of relativity.

📍 Arbitrary coherence. (“baby duckling”). Anchoring. Imprinting.

Once prices are established in our mind, they shape not only what we are willing to pay for an item, but also how much we are willing to pay for related products. (This makes them coherent.)

Price tags themselves are not anchors. They become anchors when we contemplate buying a product or service at that particular price. That’s when the imprint is set. From then on, we are willing to accept a range of prices, but we will always refer back to the original anchor.

📍 The fallacy of supply and demand

…or as Mark Twain once noted about Tom Sawyer, “Tom had discovered a great law of human action, namely, that in order to make a man covet a thing, it is only necessary to make the thing difficult to attain.”

How did Starbucks charge more for coffee, then? If we were previously anchored to the prices at Dunkin’ Donuts, how did we move our anchor to Starbucks?

You go in the for the first time, then the second time you wonder, should you go in? The ideal decision-making process should take into account the quality of the coffee (Starbucks versus Dunkin’ Donuts); the prices at the two places; and, of course, the cost (or value) of walking a few more blocks to get to Dunkin’ Donuts. This is a complex computation — so instead, you resort to the simple approach: “I went to Starbucks before, and I enjoyed myself and the coffee, so this must be a good decision for me.” So you walk in and get another small cup of coffee.

🔖 We start to line up behind ourself: one that we call self-herding. This happens when we believe something is good (or bad) on the basis of our own previous behavior. Essentially, once we become the first person in line at the restaurant, we begin to line up behind ourself in subsequent experiences.

If anchoring is based on our initial decisions, how did Starbucks manage to become an initial decision in the first place? In other words, if we were previously anchored to the prices at Dunkin’ Donuts, how did we move our anchor to Starbucks? This is where it gets really interesting. When Howard Shultz created Starbucks, he was as intuitive a businessman as Salvador Assael. He worked diligently to separate Starbucks from other coffee shops, not through price but through ambience. Accordingly, he designed Starbucks from the very beginning to feel like a continental coffeehouse.

Starbucks did everything in its power to make the experience feel different. So different that we would not use the prices at Dunkin’ Donuts as an anchor, but instead would be open to the new anchor that Starbucks was preparing for us.

…more about supply and demand

Traditional economics assumes that prices of products in the market are determined by a balance between two forces: production at each price (supply) and the desires of those with purchasing power at each price (demand). The price at which these two forces meet determines the prices in the marketplace.

This is an elegant idea, but it depends centrally on the assumption that the two forces are independent and that together they produce the market price, but:

• What consumers are willing to pay can easily be manipulated, and this means that consumers don’t in fact have a good handle on their own preferences and the prices they are willing to pay for different goods and experiences.
• Anchoring comes from manufacturer’s suggested retail prices (MSRPs), advertised prices, promotions, product introductions… all of which are supply-side variables. It seems then that instead of consumers’ willingness to pay influencing market prices, the causality is somewhat reversed and it is market prices themselves that influence consumers’ willingness to pay.

What this means is that demand is not, in fact, a completely separate force from supply.

In other words, the sensitivity we show to price changes might in fact be largely a result of our memory for the prices we have paid in the past and our desire for coherence with our past decisions — not at all a reflection of our true preferences or our level of demand.

Mark Twain’ quote:

Work consists of whatever a body is obliged to do. Play consists of whatever a body is not obliged to do.

There are wealthy men who drive 4-horse passenger coaches 20-30 miles on a daily line in the summer because the privilege costs them considerable money, but if they were offered wages for the service, that would turn it into work, and they would resign.

📍 Decisions are not isolated choices

Socrates said that the unexamined life is not worth living. Perhaps it’s time to inventory the imprints and anchors in our own life. Even if they once were completely reasonable, are they still reasonable? Once the old choices are reconsidered, we can open ourselves to new decisions — and the new opportunities of a new day. That seems to make sense.

With everything you do, in fact, you should train yourself to question your repeated behaviors.

Theory says we base these decisions on our fundamental values - our likes and dislikes. But could it be that we made arbitrary decisions at some point in the past and have built our lives on them ever since, assuming the original decisions were wise?

We can actively improve on our irrational behaviors. Start by becoming aware of our vulnerabilities and train yourself to question your repeated behaviors.

If you’re planning on a purchase, ask yourself:

• How did that habit begin?
• What amount of pleasure will you be getting out of it?
• Is the pleasure as much as you thought you would get?
• Could you cut back a little and better spend the remaining money on something else?

In particular, pay attention to the first decision you make in what is going to be a long stream of decisions. When we face such a decision, it may seem this is just one decision without large consequences, but in fact the power of the first decision has a long-lasting effect that will percolate for years to come.

📍 The cost of zero

If you find a bin of free athletic socks at a department store, for instance, there’s no downside to grabbing all the socks you can. The critical issue arises when FREE! becomes a struggle between a free item and another item — a struggle in which the presence of FREE! leads us to make a bad decision.

“FREE!” makes us do irrational things.

Most transactions have an upside and a downside, but when something is FREE! we forget the downside, FREE! gives us such an emotional charge that we perceive what is being offered as immensely more valuable than it really is.

🧪 Experiment: a table set up in a busy area, offering chocolate:

• Lindt truffle = 27 cents. Hershey’s Kiss = 2 cent. Result? 75% chose truffle, 25% chose kiss.
• Lindt truffle = 15 cents. Hershey’s Kiss = 1 cent. Result? 73% chose truffle, 27% chose kiss.
• Lindt truffle = 14 cents. Hershey’s Kiss = free. Result? 31% chose truffle, 69% chose kiss.

I think it’s because humans are intrinsically afraid of loss. The real allure of FREE! is tied to this fear. There’s no visible possibility of loss when we choose a FREE! item (it’s free). But suppose we choose the item that’s not free. Now there’s a risk of having made a poor decision—the possibility of a loss. And so, given the choice, we go for what is free.

📍 The cost of social norms

We live in two worlds: one characterized by social exchanges and the other characterized by market exchanges. And we apply different norms to these two kinds of relationships. Moreover, introducing market norms into social exchanges, as we have seen, violates the social norms and hurts the relationships.

• Social norms: friendly requests that people make of one another. “Could you help me move this couch?” Social norms are wrapped up in our social nature and our need for community. They are usually warm and fuzzy. Instant paybacks are not required.
• Market norms: the exchanges are sharp-edged: wages, prices, rents, interest, costs-and-benefits. Market relationships are not necessarily mean or evil - they also include self-reliance, inventiveness, and individualism - but they do imply comparable benefits and prompt payments.

When you are in the domain of market norms, you get what you pay for - that’s just the way it is.

Once market norms enter our considerations (aka. there is a monetary transaction involved), the social norms depart.

Using gifts is not seen as market norms. No one is offended by a small gift, because even small gifts keep us in the social exchange world and away from market norms.

🔖 Takeaway: when you’re in a restaurant with a date, for heaven’s sake don’t mention the price of the selections. Yes, they’re printed clearly on the menu. Yes, this might be an opportunity to impress your date with the caliber of the restaurant. But if you rub it in, you’ll be likely to shift your relationship from the social to the market norm.

Brilliant example to illustrate how social norms work 👇

A fine was imposed to parents that picked up their kids late. Once the fine was imposed, the day care center had inadvertently replaced the social norms with market norms. Now that the parents were paying for their tardiness, they interpreted the situation in terms of market norms. In other words, since they were being fined, they could decide for themselves whether to be late or not, and they frequently chose to be late. Needless to say, this was not what the day care center intended.

Once the fine was removed, the behavior of the parents didn’t change. They continued to pick up their kids late. In fact, when the fine was removed, there was a slight increase in the number of tardy pickups (after all, both the social norms and the fine had been removed).

🔖 Takeaway: when a social norm collides with a market norm, the social norm goes away for a long time. In other words, social relationships are not easy to reestablish. Once the bloom is off the rose — once a social norm is trumped by a market norm — it will rarely return.

📍 Social norms applied to education

Cash will take you only so far — social norms are the forces that can make a difference in the long run. Instead of focusing the attention of the teachers, parents, and kids on test scores, salaries, and competition, it might be better to instill in all of us a sense of purpose, mission, and pride in education. To do this we certainly can’t take the path of market norms. The Beatles proclaimed some time ago that you “Can’t Buy Me Love” and this also applies to the love of learning — you can’t buy it; and if you try, you might chase it away.

We should probably first rethink school curricula, and link them in more obvious ways to social goals (elimination of poverty and crime, elevation of human rights…), technological goals (boosting energy conservation, space exploration, nanotechnology…), and medical goals (cures for cancer, diabetes, obesity…) that we care about as a society. This way the students, teachers, and parents might see the larger point in education and become more enthusiastic and motivated about it.

Money is very often the most expensive way to motivate people. Social norms are not only cheaper, but often more effective as well.

So what good is money? In ancient times, money made trading easier: you didn’t have to sling a goose over your back when you went to market, or decide what section of the goose was equivalent to a head of lettuce. In modern times money has even more benefits, as it allows us to specialize, borrow, and save. But money has also taken on a life of its own. As we have seen, it can remove the best in human interactions.

📍 The influence of arousal

Our experiment at Berkeley revealed not just the old story that we are all like Jekyll and Hyde, but also something new — that every one of us, regardless of how “good” we are, underpredicts the effect of passion on our behavior. In every case, the participants in our experiment got it wrong. Even the most brilliant and rational person, in the heat of passion, seems to be absolutely and completely divorced from the person he thought he was.

When you are in one state, and try to predict your behavior in another state, you’ll get it wrong.

We all systematically underpredict the degree to which arousal completely negates our superego, and the way emotions can take control of our behavior.

📍 Procrastination and self-control

Procrastination (from the Latin pro, meaning for; and eras, meaning tomorrow) is rooted in the same kind of problem as arousal: when we promise to save our money, we are in a cool state. When we promise to exercise and watch our diet, again we’re cool.

But then the lava flow of hot emotion comes rushing in:

• Just when we promise to save, we see a new car, a mountain bike, or a pair of shoes that we must have.
• Just when we plan to exercise regularly, we find a reason to sit all day in front of the television.
• And as for the diet? I’ll take that slice of chocolate cake and begin the diet in earnest tomorrow.

🖋 This idea is related to the asynchrony found in positive feedback loops during the habit-forming process. If you commit to exercise more, the benefits of exercising won’t show up in the short-term, but instead, eating that cookie has an instant gratification (and seemingly no penalty) that we end up giving in.

Giving up on our long-term goals for immediate gratification, my friends, is procrastination.

Students did their assignments best when forced to obey a schedule, instead of letting them choose for themselves (since procrastination takes over). If this lesson is applied to society, government could force required health exams the way we get tickets for jaywalking or having seat belts unsecured.

What if the doctor asked you if you would like to pay this $100 deposit for the test? Would you accept this self-imposed challenge? And if you did, would it make you more likely to show up for the procedure?

📍 Bundling activities: the lesson to learn from Ford’s experience is that bundling our medical tests (and procedures) so that people remember to do them is far smarter than adhering to an erratic series of health commands that people are unwilling to follow.

Thoreau wrote, “Simplify! Simplify!” And, indeed, simplification is one mark of real genius.

🔖 The self-control credit card: customers decide in advance how much money they wanted to spend in each category, per store, per time-frame. For example: $20 on coffee per week, or $600 on clothes every 6 months, or no candy between 2pm and 6pm. If they surpass their limit, cardholders select their penalties. The card could be rejected, or they could tax themselves and send the tax to Habitat for Humanity, a friend, or long-term savings. Or it could email your spouse.

📍 The price of ownership

On the basis of Jack Knetsch, Dick Thaler, and Daniel Kahneman’s research on the “endowment effect,” we predicted that when we own something we begin to value it more than other people do.

🎲 Bunch of people wait in line for football tickets. They’re handed out on a lottery system. Some get them, others don’t, but they all waited the same time. […] It was an emotional chasm that was formed, between those who now imagined the glory of the game, and those who imagined what else they could buy with the price of the ticket. And it was an empirical chasm as well—the average selling price (about $2,400) was separated by a factor of about 14 from the average buyer’s offer (about $175).

🔖 Adam Smith wrote, “Every man [and woman] … lives by exchanging, or becomes in some measure a merchant, and the society itself grows to be what is properly a commercial society.”

• We focus on what we may lose, rather than what we may gain. When we price our beloved VW, therefore, we think more about what we will lose (the use of the bus) than what we will gain (money to buy something else).
• We assume other people will see the transaction from the same perspective as we do. We somehow expect the buyer of our VW to share our feelings, emotions, and memories. Or we expect the buyer of our house to appreciate how the sunlight filters through the kitchen windows.

It’s as hard for the buyer to imagine the seller’s point of view as it is for the seller to imagine the buyer’s.

📍 The Ikea effect (aka. escalation of commitment): the more work you put into something, the more ownership you begin to feel for it. Think about the last time you assembled some furniture. Figuring out which piece goes where and which screw fits into which hole boosts the feeling of ownership.

“Virtual ownership,” of course, is one mainspring of the advertising industry. We see a happy couple driving down the California coastline in a BMW convertible, and we imagine ourselves there. We get a catalog of hiking clothing from Patagonia, see a polyester fleece pullover, and—poof—we start thinking of it as ours. The trap is set, and we willingly walk in. We become partial owners even before we own anything.

Similarly, we can start to feel ownership during a bidding on eBay.

Ownership changes perspective. Moving backwards to our pre-ownership state is a loss we cannot abide. While moving up in life, we indulge ourselves with the fantasy that we can always ratchet ourselves back if need be, but in reality, we can’t.

🖇 Related to Mark Manson’s brilliant post on minimalism where he points out that “there are two psychological factors at play in owning a bunch of stuff and both lower the overall quality of life: identity investment and loss aversion”.

📍 Keeping doors open

We might not always be aware of it, but in every case we give something up for those options. We end up with a computer that has more functions than we need, or a stereo with an unnecessarily expensive warranty.

Once they saw their options shrinking, our MIT students could not stay focused. Pecking like barnyard hens at every door, they sought to make more money, and ended up making far less.

What my friend (and also the donkey and Congress) failed to do when focusing on the similarities and minor differences between two things was to take into account the consequences of not deciding. The donkey failed to consider starving, Congress failed to consider the lives lost while it debated highway legislation, and my friend failed to consider all the great pictures he was missing, not to mention the time he was spending at Best Buy.

More important, they all failed to take into consideration the relatively minor differences that would have come with either one of the decisions.

📍 The effect of expectations

Students who got beer with drops of vinegar liked it. But if they were told in advance it had vinegar, they didn’t. Students who were told about the vinegar after tasting the beer liked it much better — as much as the ones who didn’t know it had vinegar at all.

If you tell people up front that something might be distasteful, the odds are good that they will end up agreeing with you — not because their experience tells them so but because of their expectations.

Same with coffee: when presented with test-taste coffee in styrofoam cups, people said it tasted cheap. When the same coffee was presented in nice cups, saucers and spoons, they said it tasted expensive. And they’d be willing to pay more for it.

🔖 Stereotypes: asians good at math, women worse at math. This means that Asian-American women could be influenced by both notions. In fact, they are. Asian women were asked to take a math exam.

• Half were asked questions about being Asian first (priming their thoughts for race-related issues), and they did better on the test.
• Half were asked questions about being a woman first (priming their thoughts for gender-related issues), and they did worse on the test.

🖇 Related to Priming - Wikipedia effect, not just states of mind prime behavior or decisions, but also actions and emotions can be primed by events of which we are not even aware.

🎲 John Bargh and the “Florida effect” involves two stages of priming. First, the set of words primes thoughts of old age, though the word “old” is never mentioned; second, these thoughts prime behavior, walking slowly, which is associative with old age.

Tasting beer without knowing about the vinegar, or learning about the vinegar after the beer was tasted, allowed the true flavor to come out. The same approach should be used to settle arguments — this type of “blind” condition might help us better recognize the truth.

When stripping away our preconceptions and our previous knowledge is not possible, perhaps we can at least acknowledge that we are all biased. If we acknowledge that we are trapped within our perspective, which partially blinds us to the truth, we may be able to accept the idea that conflicts generally require a neutral third party — who has not been tainted with our expectations — to set down the rules and regulations.

📍 The power of price

The more we understand the connection between brain and body, the more things that once seemed clear-cut become ambiguous. Nowhere is this as apparent as with the placebo.

When given a placebo pill, told it was a pain pill, almost all people felt the pain-relieving effects when told it was very expensive. But when told it was only 10 cents, only half felt the effects.

For people with recent pain-medicine experience, it was even more extreme. They had recently learned first-hand that you get what you pay for.

📍 Cost-benefit calculation framework for “classic” type of dishonesty:

• How much money is in the till (the reward)
• Who might be around to stop them (chances of getting caught or how difficult it’ll be to get it done)
• What punishment they may face if caught

📍 Second type of dishonesty: the kind committed by people who generally consider themselves honest — the men and women who have “borrowed” a pen from a conference site, taken an extra splash of soda from the soft drink dispenser, exaggerated the cost of their television on their property loss report…

Cheating is often one step removed from cash. Taking a red pencil from work is easy. Taking 10 cents from the petty cash drawer in order to buy a pencil is not so easy.

Smith’s theory had a darker corollary: since people engage in a cost-benefit analysis with regard to honesty, they can also engage in a cost-benefit analysis to be dishonest. According to this perspective, individuals are honest only to the extent that suits them (including their desire to please others).

This means that even when we have no chance of getting caught, we still don’t become wildly dishonest.

Sigmund Freud explained it this way. He said that as we grow up in society, we internalize the social virtues. This internalization leads to the development of the superego. In general, the superego is pleased when we comply with society’s ethics, and unhappy when we don’t. This is why we stop our car at four AM when we see a red light, even if we know that no one is around.

We care about honesty and we want to be honest. The problem is that our internal honesty monitor is active only when we contemplate big transgressions, like grabbing an entire box of pens from the conference hall. For the little transgressions, like taking a single pen or two pens, we don’t even consider how these actions would reflect on our honesty and so our superego stays asleep.

Cheating is a lot easier when it’s a step removed from money.

Do you think that the architects of Enron’s collapse would have stolen money from the purses of old women? Certainly, they took millions of dollars in pension monies from a lot of old women. But do you think they would have hit a woman with a blackjack and pulled the cash from her fingers? You may disagree, but my inclination is to say no.

At a college dorm, we put 10 cans of coke in shared fridges, and they all disappeared. We put 10 $1-bills on a plate and they all stayed.

Students given a chance to cheat under ordinary circumstances cheated, on average, by 2.7 questions. But when they were given the same chance to cheat with non-monetary currency, their cheating increased to 5.9. What a difference there is in cheating for money versus cheating for something that is a step away from cash!

🔖 Students primed with the Ten Commandments were primed to cheat less: people cheat when they have a chance to do so, but they don’t cheat as much as they could. Moreover, once they begin thinking about honesty — recalling the Ten Commandments — they stop cheating completely. In other words, when we are removed from any benchmarks of ethical thought, we tend to stray into dishonesty. But if we are reminded of morality at the moment we are tempted, then we are much more likely to be honest.

None of this makes logical sense, but when the medium of exchange is non-monetary, our ability to rationalize increases by leaps and bounds.

How we can control our tendency to cheat when we are brought to our senses only by the sight of cash — and what we can do now that cash is going away.

📍 Free lunches

When people order out loud in a restaurant, they choose differently than when they order privately. It varies from culture to culture, though — in Hong Kong, people felt they had to order the same thing as their companions.

People who ordered out loud were also not has happy with their selections afterwards.

🔖 What we found was a correlation between the tendency to order alcoholic beverages that were different from what other people at the table had chosen and a personality trait called “need for uniqueness”: sometimes we are willing to sacrifice the pleasure from a particular consumption experience in order to project a certain image to others.

We are all far less rational in our decision making than standard economic theory assumes. Our irrational behaviors are neither random nor senseless—they are systematic and predictable. We all make the same types of mistakes over and over, because of the basic wiring of our brains.

• Standard economics: all human decisions are rational and informed, motivated by an accurate concept of the worth of all goods and services and the amount of happiness (utility) all decisions are likely to produce. Under this set of assumptions, everyone in the marketplace is trying to maximize profit and striving to optimize his experiences. As a consequence, economic theory asserts that there are no free lunches — if there were any, someone would have already found them and extracted all their value.
• Behavioral economics: people are susceptible to irrelevant influences from their immediate environment (context effects), irrelevant emotions, shortsightedness, and other forms of irrationality.

The good news is that these mistakes also provide opportunities for improvement. If we all make systematic mistakes in our decisions, then why not develop new strategies, tools, and methods to help us make better decisions and improve our overall well-being? That’s exactly the meaning of free lunches from the perspective of behavioral economics.

We usually think of ourselves as sitting in the driver’s seat, with ultimate control over the decisions we make and the direction our life takes; but, alas, this perception has more to do with our desires — with how we want to view ourselves — than with reality.

Our visual and decision environments are filtered to us courtesy of our eyes, our ears, our senses of smell and touch, and the master of it all, our brain. By the time we comprehend and digest information, it is not necessarily a true reflection of reality. Instead, it is our representation of reality, and this is the input we base our decisions on. In essence we are limited to the tools nature has given us, and the natural way in which we make decisions is limited by the quality and accuracy of these tools.