Monday, September 27, 2010

Takeaways from Predictably Irrational, Part I

Continuing my survey of popular economics books, I recently finished Dan Ariely's Predictably Irrational: The  Hidden Forces That Shape Our Decisions. You can read Dan's current writing at his blog. Here is first of my takeaways from the book, focusing mostly on understanding value:

The best way to see what's wrong with your culture is to ask someone who is outside of it. Sadly, everyone we know is in our culture.

Dan Ariely's original interest came from a traumatic experience he in a burn ward. The story, as well as some of his experiments, can be heard in his TED Talk.

Figuring out how much we value things can be difficult, so often we compare it to other similar items to create a "relative value". Although this can be helpful, it often does not match our real value. This is shown perfectly in Jeff Monday's visual comparison (earlier dating example).

Because of this valuation problem, often we don't know what we want until we see it in context. Perhaps this is what advertising does. We see a iPhone being used and understand better how it can help us in our everyday life. Here are my earlier thoughts on advertising.

Another way we try to deal with the complexity of valuing things, is stick to our past decisions. This means our first impression matters a lot. Habits are like peer pressure, but with ourselves. Sometimes our original impression isn't based on any real information. Here's an example from the book on how just writing your Social Security number can impact how much you are willing to pay.

A psychological flaw of supply and demand: The price at which we demand a product is influenced by the original price we see it being supplied. The two are not completely independent from each other.

One of the most basic economic assumptions, the law of demand, states that as price goes up, consumers buy less. How much of that is not based on rational trade offs, but instead on the memory of the initial price paid?

As a business, one way to get people away from their past decisions is to create a new category. Give them a product they've never had to decide on before and they'll have "relative value".

If that's how we buy products, maybe it's also how we pick careers. We have an uncle who's an electrician who then inspires (or more accurately models) us to be one too. This can help explain why generational poverty is so hard to escape.

I've posted about money's diminishing effect on happiness. Here's a quote from H.L. Mencken to clarify: "a wealthy man is one who earns $100 a year more than his wife's sister's husband." To make it easier, just live in a poor neighborhood.

Something I've been wondering for a long time: Is the famous Tom Sawyer whitewashing story actually possible? Can you convince people something is fun if they naturally wouldn't think so?

Another possible irrationality is our unbalanced tastes for gain and loss. Getting $5 brings a certain amount of happiness, but losing $5 hurts more. In economics this is called loss aversion.

This fear of loss makes us prone to prefer things that have no perceived possibility of loss. This i why we are attracted to the word "free". This attraction isn't always rational. In one experiment participants were offered a high quality candy for 16¢ and a low quality for 1¢. On average, a slight majority preferred to the nicer, more expensive candy. Next participants were offered a high quality candy for 15¢ and a low quality for free. Even though the price difference was the same, now a majority of people choose the lower quality candy.

4 comments:

  1. "One of the most basic economic assumptions, the law of demand, states that as price goes up, consumers buy less. How much of that is not based on rational trade offs, but instead on the memory of the initial price paid?"

    You could look at long-run price elasticity versus short run price elasticity. If people reacted based only on memory, then the reduction of purchases would not last. But in fact we observe the opposite, long-run elasticities are higher implying that people don't get used to the price increases, they adjust more as they go.

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  2. Great point Bryan. I'll put this in my email I'm forming to the author.

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  3. If you're interested in more on the last point you should read (or listen to) Free by Chris Anderson. Appropriately, the audiobook version is free.

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