I have just finished reading Predictably Irrational, a book by Dan Ariely on why economic thinking is flawed due to its failure to include behavioural economic concepts. In economics the actions of people are summed up by Homo Economicus, an imaginary figure that is completely rational and bases all its actions upon these rational foundations. Obviously not all humans are as rational as Homo Economicus, and this causes inconsistencies in economic models.

Dan Ariely argues that if we use findings from behavioural economics (a branch of economics that incorporates psychology) and mould these into our economic models, then we will improve our models and will thus have a better understanding of how the economy actually works.

The book is split into chapters, and is quite an easy read. I have summarised some basic findings below:

1. Theory of (economic) relativity – people are more likely to take action when they can compare an entity with something else.

Look at this picture:

Which light blue circles looks biggest, the one on the left, or the one on the right? The answer is that they are both the same, but it appears that the circle on the left is bigger, because it is relatively bigger than the circles which we can immediately compare it with.

This is the essence of the theory on relativity – we compare something based on the things which are similar to it and which we have access to. In the image example, the shapes are all similar (i.e. they are circles) and they are in the same area, so we have easy access to compare.

An example given in the book, is that the homemade bread baking machine industry started off with one brand of breadmaker. Sales were dismal. People had nothing to compare this breadmaker with, they saw the price £x, but couldn’t compare it with anything else. They weren’t sure how much they would value a breadmaker, and therefore didnt purchase a breadmaker. However, when another brand of breadmaker was released (by the same firm) sales skyrocketed. Now consumers, had 2 products which they could compare between. They can compare based on quality and on price, and hence may decide to buy the breadmaker.

Another example, is when an estate agent shows you some properties in an area. They may decide to show you 2 Victorian homes, the cheaper of which needs some renovation, but the other is slightly more expensive, but is ready to move into; and a modern home. Typically people are likely to end up buying the more expensive Victorian home. This is because they are able to compare the 2 Victorian homes – and hence the modern home is eliminated from the buyers mind, because he can’t easily compare it with anything else, unless of course he goes off and looks at houses without his estate agent. Now the decision lies between the two Victorian homes. Because the consumer can compare between the two he is likely to go for the finished home as this appears better, even if it is slightly more expensive.

In conclusion, what does this tell us? That when running a business it might be a good idea to have things to compare with. As consumers it tells us to be careful what we compare a product with. Clever firms will try and influence our buying habits to make us buy the most expensive product, by displaying substitutes which guide us towards the more expensive product. For example, the Economist had a purchasing choice on their website of:

£50 for online only

£130 for paper copy only

£130 for paper copy AND online copy

Obviously nobody is going to pick the paper copy only option, as they may as well have the online edition also for the same price. This wasn’t a mistake however, it was manipulation on the firms behalf to influence the decision of consumers. When consumers were presented with the choice of only online, or only online AND paper, (at the same price as above) about 25% went for the online. However when the middle option was inserted this fell to about 5%. Why? Because of relativity. People can easily compare the paper copy AND online copy with the paper copy. It is a much better deal. This leads them to ignore the online only copy, as they can’t easily compare it with anything else. And unless they went onto the site looking to purchase the magazine solely electronically, then they opted for the more expensive dual package – clever marketing, eh!

Therefore consumers should be careful with what they compare goods with. Remember that a firm will always want you to spend as much money as possible, and they can influence your views, taking advantage of your irrationality. If you yourself are running an enterprise then it may be an idea to present some alternatives to your consumers to influence their habits. Lets say you are selling home baked treats at a community fete. You have Fairy Cakes (£1) and Brownies (50p) on sale. Consumers can’t easily compare the difference between the 2 goods because they are quite different. Therefore they only purchase one of either goods. However if you through in a slice of Sponge-Cake (£2) then they can compare this with the Fairy Cakes, and are therefore more likely to buy either the Sponge or the Fairy cake. They disregard the brownies because they can’t easily compare this with anything else, but hey, the Brownies would only sell for 50p, so you’d rather sell Sponge-Cakes!

2. Expectations – knowledge presented before an event changes the outcome of the event (i.e. how it is experienced), whereas knowledge after an event doesn’t affect the memory of the event, nor future examples.

The test given for this, is that a group of students are given a free beer, some are given an ordinary beer, others are given beer laced with vinegar. After drinking either beer they are then able to buy the same beer. The experimenters also asked the testers what they thought of the beer. When students aren’t told what the beer they are drinking is, they tend to like what they have drunk and buy the same beer. However, when students are told beforehand they consistently tend to dislike the vinegary beer, and choose not to buy if after the experiment.

Furthermore, if a tester is given the vinegary beer, and then got told this after they have drunk it and were offered to purchase the vinegary bar, they typically did! This shows that expectations of the vinegary drink being horrible made the beer actually taste horrible.

So how can this be used in reality? Well, businesses can try to influence expectations so that consumers aren’t effected negatively by expectations. This could mean limiting information given to customers if it is likely to conjure a negative stereotype (i.e. dont tell them that the beer has vinegar in it), or to try and set good expectations about the product by building a successful brand.

Another interesting point based in this chapter, was that stereotypes can affect the way people act, even when they dont fit within the stereotyped group! In a test, a group of students were primed (they were made suggestable without realising it, this can be done by making participants do a word puzzle with certain words in it to prime them. They think they are just doing the word puzzle, but subconsciously they are thinking about the words and the associations which such words) to make them think of old people. They were then asked to walk down a corridor (to leave the building). Students who were primed with stereotypes of old people (bingo, Florida, pensions etc) walked down the corridor more slowly, than students who hadn’t been primed. This shows how much expectations and stereotypes can influence are behaviour and are thoughts.

3. Anchoring – this is the theory that humans can be primed to a certain number when paying for something, and also that the first number presented when bargaining becomes a fixed anchor throughout the bargaining process. This shows that the first price we see is the most important. Therefore when you are bidding for a product, make sure that the first price you say is fairly low (this anchors the whole price down and means you are likely to get a better deal), but not too low that the other party looses interest. Setting a low starting points means that any bidding can’t be raised to high.

We base our purchasing habits on an anchor which could have been set years a go.

4. The free effect – is the theory that we enjoy things which have a cost of £0 much more than we should making us irrational. People prefer receiving something for free compared to a low price even if they aren’t getting as good a deal. This would imply to marketers that rather than make things a lower price they should offer more BOGOF (Buy one get one free) or X% Free deals in order to gain more custom.

5. Social and Market Norms – Ariely talked about the differences between social and market norms and the effects these had on people. Social norms are situations which arise in normal life and market norms are those which arise when payment is involved.

He concluded that people do more work for free if they believed it was a ‘favour’ or for charity. For example when a charity asked for help painting walls in deprived neighbourhoods offering a low fee for doing so they received no response, but when they took away this payment they had lots of volunteers! The reason for this is that the charity mixed social and market norms, people get a greater feeling from doing something for free (i.e. helping charities) than they do if they are being made a measly wage. People struggle to make this low wage still seem like charity.