Thank you for your interest in my book, BEHAVECON: a revealing guide to outsmarting yourself, making the best decisions, and leading the richest life.
Let me invite you to start reading a little bit.
This is Chapter 7 “Relativity and Fix Points”. Here you learn, how the mind perceives prices in relation to one another and how smart promotions can fool us into supposedly amazing deals. Enjoy, understand and lead the richest life by choosing what you really want!
Relativity and Fix Points
“A cynic is a man who knows the price of everything and the value of nothing.”
19th-century Irish writer
“He who is fixed to a star does not change his mind.”
—Leonardo da Vinci
Italian Renaissance polymath
While we looked at four ways to argue for a price above, you might have noticed that—except for the arbitrary pricing—none of them had an incontestable starting point. Even the cost plus price starts with a cost, which is itself a price that was externally determined when sourcing the item.
Even though prices serve as a proxy to facilitate trade, they are just a concept, apparently detached from the value. They are in the eye of the beholder. You decide what price is right for you. And quite naturally, sellers’ and buyers’ interests and opinions diverge.
Imagine something arbitrarily priced. How much to pay for an old Beatles record at a vintage media store? Or the Rolling Stones one? Which one is more valuable? You might agree that the Stones are certainly eight times more valuable than the old and worn childhood book of Tom Sawyer. Some store might price the Stones at $15, another at $50, or even $250 if the condition is like new. If Tom Sawyer is priced accordingly, you will subconsciously perceive it all fair.
As a rule, even though we cannot commit to a specific value, we will be pretty rigid on our relative assessment of those values. This mix of conviction and uncertainty is called coherent arbitrariness.
Where can you use this to your advantage? If you are at a garage sale, remember you are not negotiating the price of one item, but for all the items. So pick one you can negotiate down the easiest to start with. Chances are, the owner will then align other prices accordingly without much ado.
Relativity of Alternatives
Now that we have just bought some vintage records, let us go find a Blu-ray player to illustrate what role relativity plays in determining prices as well as our choices within a product category.
Say you want to buy a new Blu-ray player and do not have a clue how much one would be. (You can try this at home with anything that you do not know much about for the most significant effect.) As of this writing, Google Shopping shows a range of $74 to $234 on the first page for “Blu-ray Player.” Which one would you chose? Be honest to yourself. I guess you would probably pick one in the $100–$150 range.
Why do I guess? It is because we instinctively compare. Most people settle for the midpoint, even though some exhibit a different behavior. There are four stereotypes: affluent luxury buyers, frugal spendthrifts or tightwads, average consumers, and random pickers. Which type are you? Despite some influence by our character, the general tendency is to settle for the midpoint. This tendency even remains if the sample is changed to a premium or low-cost one on purpose or without us knowing. Look at this for some more illustration:
A search for “Blu Ray Player Denon” (a higher-profile brand) shows listings for $355 through $1,430. Ouch, that is expensive, but suddenly the $234 player seems like a pretty good deal. After all, you will own the player for a while, so why not? That is why a salesperson in a HiFi store will most certainly invite you to sit in the demo room and listen to the $15K set of speakers even if you only want a small compact stereo.
By the way, looking a little further, I found a nice Samsung for only $63, and I am sure you can even do better. Markets expand further than your eyes can see at first glance, and some research can pay off handsomely.
If you cannot believe this yet, let us look at another experiment. Imagine you see two types of beer on the shelf. A store brand—taste rated 50 out of 100—sells for $1.80, and another branded one for $2.60, rated 70 out of a 100. Which one would you buy? In an experiment at Duke University, about twice as many students bought the premium beer.
What happened after introducing a third beer at $1.60 rated 40 out of 100? Nobody wanted the new beer. However, the portion of students buying the store-brand beer at $1.80 rose from 33% before to 47%. That is how the supercheap beer actually can help the store drive business to the midprice beer.
A similar effect appeared when instead the store introduced a premium brand at $3.40 rated 75. A total of 10% of the students actually bought the premium beer, but now 90% (up from 66%) bought the brand beer and nobody bought the store-brand beer.
I recently wondered why my supermarket suddenly had two store brands of yoghurt. That’s why.
Or consider the full screenshot from the previously referenced e-mail service Sanebox.
Source: http://www.sanebox.com/pricing retrieved May 19, 2012.
What would you chose? After doing some math, you will see that the savings for the yearly offer are a meager $4.40 over the monthly one. If you ever decide to cancel this service, waiting for the end of the term will most certainly eat up all those savings. And in a time where about half the couples get a divorce, an e-mail service is not for life.
Introducing a third alternative that few or nobody really wants can drive demand toward a specific alternative that a shop wants to move. In general, we can always see a reversion to the middle if there are multiple options. The effect that comes into play here is extremeness aversion. Extended surveys of daily shopping items have shown that, in case of uncertainty about a fair price, we tend to avoid the extremely cheap or extremely expensive alternatives. We shy away from the best or worst quality, from the smallest or largest variant. Feels odd once you know how this middle can be influenced, doesn’t it? So next time you see three options, think twice before settling for the middle. It most likely has the highest margin for the store, but how well does it really fit you?
Pricing is relative, and you have to choose what to compare. If you are looking for something cheap that day, resist looking at anything expensive in the same store. Selecting the comparison group is as important as choosing the eventual item for purchase.
In another case, a clever HiFi salesperson might lure you into his store with a $150 Blu-ray player that, upon inspection, looks really crappy—already from the outside. Then you will be shown a $170 player that looks terrific. Are you going to ask if there is a cheaper one? Probably not. The $150 decoy completely blinded you. Even if you see the $63 player in the showroom, you will most likely assume that it does not have the picture quality or another key feature that the $170 player has, and you will gladly believe without even asking.
Let us expand on this with a further experiment: MIT students are said to be pretty intelligent. So look at the experiment that was conducted among MIT’s Sloan MBA students with the real-world offer of the Economist magazine. They could select any of the following subscription options:
- online-only for $59
- print and web for $125
- print-only for 125$
As one would expect, nobody picked the print-only option. Puh! A total of 16% picked online-only and 84% picked the combo. At the same time in the next classroom, participants were given the choice without the print-only option. Should it matter? It does—a great deal. Here, 68% picked the online-only subscription and 32% the combo. Introducing the decoy (print-only) made the average Sloan MBA student spend $34.32 more than he would otherwise have. Do not worry—at Berkeley they would not have fared any better.
“How is this possible?” You might wonder. We understand that the offers print versus online are not easy to compare, so we put a lot of conscious effort into our decision. But it’s easy to compare print including online versus print-only—especially if they come blatantly at the same price. So our brain once more goes haywire, and we pick the combo, forgetting about the cheaper option altogether. This is an example of the contrast effect induced by the decoy. We prefer an item that is clearly better than another, ignoring how it compares to all the other possible options.
This comes into play in many scenarios of complex purchases. Imagine buying a new laptop. There are so many variants. Instead of comparing them all, you might just pick one that is significantly and evidently superior to one other model. A clever salesperson will show you just those.
|Side Note about TV Quality|
|Could you really see enough of the difference between the premium TV and the middle-class TV? Actually, a TV set’s performance is usually not the limit, but the media. So in the store you see the most brilliant media that drives the sets to the max (and you will find TV sets that they do not want to sell as much, less carefully adjusted.) At home, with your highly compressed cable TV and DVDs whose quality is often limited by the recording of the original motion pictures, the inferior set can be as brilliant as it ever gets—for your eyes and your purse.|
Anchoring means fixating our mind on something, especially a number. It happens by merely thinking about one. Once the anchor is set, your mind builds pricing expectations relative to that number for whatever you are purchasing right now. This works whether the number given is reasonable or far from it! For evidence, look at experiments where people were asked to note the last digits of their social security number (which are completely random) on a sheet of paper and then requested to bid for a random product. In that case, we see that higher social security numbers mean proportionally higher bids.
It is still being discussed how carefully one has to think about a number for the subconscious to acknowledge it as anchor. However, indications are that anchors are set fairly fast, as the above-mentioned example illustrates.
We meet a variety of anchors in real life. Walk along Chicago’s Michigan Avenue and the surrounding streets. You can find a $14,000 Ralph Lauren handbag in the window. Or if you are interested in watches, you might have heard of the Hublot “$5 million,” the latest model that was introduced into the market at a price tag of $4.75 million. Not only is the watch covered in diamonds to the extent of hiding any visible metal—18K white gold by the way—but also its name calls out how expensive it is. Hardly anyone in his right mind would buy this watch, or the Ralph Lauren bag. But if an amazing watch or bag costs this much, how much then is fair for an everyday bag or watch? Or for something else in the store, like a sweater, a belt, or a keychain? Probably much more than you would have otherwise considered.
The $5 million watch might never be sold, or only a few times, same with the $14,000 handbag; but the keychains, belts, and other accessories account for a substantial portion of those companies’ sales. Voila, the anchor at work. That is why everything on Michigan Avenue is more expensive than anywhere else in the city. When you buy a “regular” $2,500 purse, your subconscious will think, Wow, I saved over $10K. That is the idea. As publicist William Poundstone pointedly wrote, “items that don’t sell can change what does.”
Next time you see someone wearing a pair of Chanel sunglasses, remember they are basically a sign screaming, I have volunteered to be mugged for the better part of the price tag. But hey, they are beautiful!
This is not limited to luxury items: “These effects of context on choice can naturally be used in sales tactics. For example, Williams- Sonoma, a mail-order business located in San Francisco, used to offer a bread-baking appliance priced at $279. They later added a second bread-baking appliance, similar to the first but somewhat larger, and priced at $429—more than 50% higher than the original appliance. Not surprisingly, Williams- Sonoma did not sell many units of the new item. However, the sales of the less expensive appliance almost doubled.”
The same happened when we introduced a premium maintenance package at one of my previous jobs. We should not have been surprised to see sales of our regular package take off, while the premium one did not sell at all. These types of anchors make consumers reframe their decision from “Do I need this?” to “Which one do I need?” So remember, not buying is always an option too.
If you feel that luxury is not your world, join me in looking at the most basic human need: hunger. Whether at an Applebee’s, Red Lobster, or a gourmet temple, in the way described above, high-priced entrees act as anchor and raise the revenues for the restaurant, even if nobody buys them. As a matter of fact, people often buy the second most expensive dish on the menu. Think about this when you enter Daniel Boulud’s, a NYC restaurant. He offers a burger for a whopping $150 stuffed with double truffles. Other even pricier ones come with Kobe beef, more truffles, and gold flakes. Nobody in his right mind would ever buy this. What it does, in any case, it makes the $50 steak look like a great deal.
Well, one might say there is still some reason out there—one $175 burger outfit had to file for bankruptcy recently. Maybe enough people caught onto the concept and started out by finding the cheapest item on the menu and working their way up. Anchoring works both ways. It’s your call at which end of the table you choose to take a seat.
When a sailor sets anchor, it will hold for a long time. Eventually, it will nudge and gradually move. It will never let go entirely unless the chain breaks. Our subconscious anchors behave similarly. An anchor we once set will influence us over a series of decisions and only gradually lose its effect. Over time, it will go away entirely, but significant effects have been shown after a week or even later as we will see.
Imagine moving from LA to Pittsburgh, most likely you will spend the same amount for housing (or only slightly less) and afford a much more luxurious space as the average Pittsburgher on your income level would. On the other hand, you would squeeze yourself into a smaller studio if you moved the other direction. In both ways, your past housing cost serves as an anchor. Recently, I moved from Ann Arbor, Michigan, to Cologne, Germany, and, knowing this, was able to shave a third of my monthly rent without even slightly compromising on my standard of living. Had I just looked for something in my well-acquainted price range, I am sure I wouldn’t have had any problems spending more money. But to what benefit?
Such a long-range effect works only for anchors that you have become very accustomed to. No need to worry that test-driving a $100K car once makes you overpay for cars your entire life.
With all these anchor effects that make us arrive at subpar decisions, by now you probably think that that is why you always knew to rely on expert help. You had an appraiser for the last property you bought, and you have taken a car mechanic friend with you when you got your last pre-owned vehicle. Bad news. Anchors work with professionals too.
Look at the following study about a staged lawsuit: Four groups of mock jurors were asked to award damages in a case where the defendant had been found liable. They were all told that the defense had suggested 50K, but the plaintiff’s attorney’s suggestions were varied from 100K to 700K for each group of jurors. The outcome ranged from $90,333 to a staggering $421,538. While the jurors always found the plaintiff’s demand too high, they nonetheless increased their award almost in a linear way. This effect is even continuous—though in a mitigated manner—when outrageous demands (in the billions) are put forward. A boomerang effect, where they would award lower amounts in response to crazy amounts, cannot be found. Now you might counter that the jurors weren’t professionals but ordinary people working in a professional environment.
Therefore, look at this example of true experts. It indicates that experts are only slightly less influenced by anchors than amateurs. The study resulted in the following appraisal estimates for one and the same property presented to four groups of amateur prospect homeowners and real estate experts. The four pairs of groups were each told a different current listing price. In fact, the actual current listing price was $134,900 based on a prior appraisal of $135,000. The figures below show the average appraisals of several subjects for each listing price.
|Listing Price||Amateur appraisal||% amateur appraisal varies from listing||Expert appraisal||% expert appraisal varies from listing|
Source: Norcraft, G. B., and M. A. Neale (1987), p. 93
While we see that the experts appraised generally lower and were less influenced by the listing price, we note that they are still influenced, which they should not be! Being objective is their whole value proposition. The two big outliers were amateur group 4 and expert group 2. Nobody can tell in advance what an appraisal will be worth. Coincidence one might say, but possibly a costly one for you, if you rely on the expert.
The bad news is, there is no way around an anchor. Even if you know that an anchor has been placed, you will still be influenced by it. All you can do is use this knowledge in your favor and aggressively set the anchor yourself. If you cannot set the anchor for the other party, then at least firmly set the anchor for yourself by defining your target in advance. That way, your anchor is in your mind before someone else can speak up and set his or her anchor. As soon as someone else sets an anchor, try to brush it away without giving it credibility; or if you cannot do that anymore, start considering the opposite. Find arguments why the anchor is wrong and name them all to mitigate the effect.
Setting an anchor works in many cases even with extreme figures. Remember this when asking for a salary raise, a discount, or just about anything. You will not want to insult the other party to the point of no deal though. So instead of making your outrageous demand, just make the other party think about a number that skews the table in your favor. Asking for 50% raise will be considered outrageous, but naming the sales divided by the number of employees—if that is several times higher than your compensation—will make your boss anchor without being offended. A figure like that is memorable and feels somewhat fair. Good luck taking it from here.
Also, next time before calling an expert, make your own guess first, and then consider the cost of an expert and see if he or she will likely get you to your target price. Paying a little more instead of paying the expert might be a better deal for you.
Key Points to Remember
- Our sense of prices is coherent and arbitrary. We do not have an innate sense for the right price, but we do have a sense for prices relative to another. Therefore, always start negotiating the easiest item first, and then the others can drop in unison.
- Reversion to the middle/extremeness aversion: We usually settle for the midpoint when selecting out of a group. Therefore, the composition of the group deserves a lot of focus.
- Stores work with decoys, inferior products at a high price point that are meant to discourage us from going even cheaper. So look cheaper!
- In a confusing sample of offers, the contrast effect makes us prefer an item that is clearly better than another, ignoring how it compares to all the other possible options. Structuring the various offers and evaluating them in more detail will help you make a better call.
- Whatever arbitrary number we hear, it sets an anchor in our mind and makes us compare prices we are considering with that particular number. Therefore, the anchor can drive prices into any direction. As anchors even work on professionals and have an effect over time, your only working strategy is to make sure your anchor is set before you go shopping. Then once you negotiate, name your price first.
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