Neo-classical economics assumes that all individuals involved in economic exchange are entirely rational, utility maximising agents.
However, behavioural economists recognise that, for most of us, decision-making is constrained by physiological and psychological forces resulting from human evolution. These limitations can help us understand and influence human behaviour.
Why humans are not rational
In our article ,‘Neo-classical vs behavioural economics’ we argued that the assumption that humans make rational buying decisions is flawed.
Behavioural economists have identified over 100 biases or psychological errors that humans are prone to when making decisions.
Here, we look at the top seven of these tendencies and consider how marketers exploit them.
Value and utility are relative
Our perception of value and utility is relative. Most of us would drive for twenty minutes to get a £100 discount on a £300 television, yet few, if any, of us would travel the same distance to save the same £100 on a £10,000 car.
Similarly, someone considering buying a watch costing £1,000 is likely to consider one costing £20,000 as far more expensive. By contrast, a person contemplating a £181,000 watch would see a £200,000 alternative in much the same price bracket.
In the real world, we judge utility in the context of the choices available to us, rather than in absolute terms. So, the best way to convince someone your £500 product is reasonably priced is to force a comparison with a £1,000 equivalent.
Loss aversion and the endowment effect
For most people, losses outweigh gains.
In one experiment, researchers offered participants a bet: if the toss of a fair coin came up tails they would lose $100, if it came up heads, they would win $125. Despite the calculated expected gains being in the gambler’s favour, few participants took the bet. The researchers had to offer winnings in excess of $200 before a majority of participants would accept the wager.
This attitude is forcing companies to think carefully about whether to position differential pricing, between channels for example, as a surcharge or as a discount. One will dissuade, the other incentivise.
The endowment effect defines the behaviour of people reluctant to give up things they’ve mentally incorporated into their possessions or lifestyles. An example is where someone has acquired highly sought-after concert tickets at face value and will not sell them, even when the resale value reaches several multiples of what they paid.
Organisations utilise this tendency by offering free trial periods or upfront discounts to tempt consumers into trying their products and services. Once the offering has become an established part of the customer’s lifestyle, the customer would prefer to start paying for it than lose it. Gym memberships are a great example of the endowment effect.
One reason fast food chains are so successful is that they promise a reliable, consistent standard of food. For decades, McDonalds was seen by American travellers as a beacon of reliability when visiting foreign countries, as they could depend on the burgers and fries tasting exactly the way they did back home. Similarly, British tourists have long had a reputation for seeking out the nearest fish and chip vendor when in Spain, even when superior local food is available.
In business, organisations are reluctant to try out new suppliers who may offer better value because of the fear of moving from a good enough arrangement
This is satisficing. Avoiding disaster is a higher priority than maximising outcomes. Rather than finding optimal solutions for a simplified world, most people seek satisfactory solutions for a complex world.
Perceptions of value are often based on pre-existing figures inside a person’s mind, even if those figures have little or nothing to do with the matter at hand.
To demonstrate this, researchers asked a large group of university students to write down the last three digits of their mobile numbers. Then, without consulting any information source, they asked the same students to guess the year Attila the Hun died. The results showed a near perfect correlation – the higher the last three digits of the phone number, the higher the estimate for the year of the ancient ruler’s death.
Retailers exploit this thinking error by constantly changing their prices and resetting consumer expectations of what a normal price is and what constitutes a discount.
In the corporate world, many managers set budgets for the forthcoming year by taking the existing budget and adjusting upwards or downwards by a small amount. The current figure is the basis and often no account is taken for any changes in the nature of the business itself or its operating environment.
Recognising the anchoring effect, many expert negotiators make an extreme first offer to reset the expectations of the other side. This way, they can make one-sided outcomes look reasonable.
The way questions or decisions are presented to us can affect the choices we make.
A food label with the claim ‘90% fat free’ looks more attractive to consumers than one saying ‘Contains 10% fat’.
Similarly, proposing a mass vaccination program where the vaccine is promoted as 99.99% safe is more likely to be successful than a campaign admitting that one child in ten thousand is likely to suffer serious complications.
A subtle form of framing can be seen in product marketing. One of the reasons for the success of the iPod was Apple’s ability to make the portability of tens of thousands of songs more important to consumers than sound quality.
Deliberately directing attention towards positive or negative attributes changes the perception of exactly the same set of facts.
Social proof and connection
When looking at ways to encourage hotel guests to reuse towels, researchers placed various messages in the bathrooms. Some offered a small daily discount, some threatened a small daily fine while others appealed to the individual’s environmental conscience.
The only message that made a consistent, measurable difference was:
‘Other guests who stay in this hotel reuse their towels, please do the same.’
In short, we like to do what others similar to us do. As inherently social animals, we take our cues from other people who we deem to be like us. Studies similar to the towel project have encouraged people to recycle more waste and cut energy consumption.
Social proof is also the main principle behind the concept of nudging, which has been much in the media recently. Telling people that others are paying their taxes or are not fare dodging has proved successful in making them comply themselves.
We can take this concept a step further by tying an individual’s actions to those of people in their close social groups. Research has shown that the most effective way to get people exercising is to provide incentives linked to their closest friends.
In short, we are tied to the actions of those with whom we have social connections.
Consistency and commitment effect
A common sales technique is to present a compelling price for a product, win the sale, then, at the last minute, find a reason to increase the price. In most cases, the customer still goes ahead with the purchase.
In the US, jury selection consultants often ask a prospective juror:
‘If you were the only person who believed in my client’s innocence, could you withstand the pressure of the rest of the jury to change your mind?’
Few self-respecting prospective jurors would answer negatively. And, having made the promise, those jurors would, if selected, be unlikely to give in to any pressure exerted by the rest of the jury.
Questions like this can initiate a cycle of compliance.
This is because we want to appear and feel like we’re right and show our conviction. Society values consistency and conviction, even when they’re wrong. The reason for this is that consistency is associated with intellectual and personal strength, rationality, honesty and stability.
To guard against the dangers in consistency and commitment effect, ask yourself:
‘Knowing what I know now, would I go back in time and make the same commitment?’
The decision-making flaws we’ve looked at here don’t make us weak and fickle creatures. We’re all products of our evolutionary biology.
Proponents of neo-classical economics, particularly those working in capital markets, suggest that while we may not always act completely rationally, nor would we fall prey to the biases exposed by behavioural economists.
They can’t, however, explain why supposedly rational capital markets go through frequent cycles of bubbles and crashes. They’ve also, to date, been unwilling to test their own decision-making abilities in rigorous, laboratory conditions.