Logical Pricing is Bad for Business

A few years ago, I read Dan Ariely’s Predictably Irrational, and it forever changed the way I look at how people (including me) make decisions. We are not rational thinkers. We are irrational. But our irrationality is predictable.

We are especially irrational in the way we judge prices. One example Ariely shares is of an experiment where people are asked to write down the last two digits of their social security numbers on a piece of paper, after which they were asked how much they would pay for a variety of items. The people with the highest 20% of social security numbers said they would pay an average of $56 for a cordless keyboard, and the people with the lowest 20% of social security numbers said they would pay only $16 for the same keyboard.

Did writing down the last two digits of their social security numbers affect the prices respondents were willing to pay? Yes. Is it rational? No. Is it predictable that seemingly irrelevant factors influence people’s economic decisions? Yes.

Now I am in the middle of an amazing book by Daniel Kahneman, a nobel laureate who taught and influenced Ariely. Along with his partner, the late Amos Twersky, Kahneman can be credited with seeding the field of behavioral economics, which challenges the traditional idea of humans as rational economic actors. Kahneman’s book,Thinking, Fast and Slow, is a wild, enlightening, provocative tour of the irrational ways we think and make decisions.

Kahneman tells of judges officiating at parole hearings, where the default decision is denial, and only 35% of the time do the judges see the logic in granting parole. Analysis showed that the judges granted about 65% of parole requests shortly after eating and barely any requests once it had been two hours since their last meal.

The implications of Thinking, Fast and Slow for business are enormous. If judges will unwittingly send people back to jail just because they are hungry, how logical do you expect your customers to be? Is it illogical for your customer to infer that you won’t be able to deliver his shipments on time just because it took you two days to return a phone call? Yes. Will he make that illogical inference? Yes. Sorry, this is the world you do business in.

Kahneman’s book really has me thinking about how fickle pricing is. He tells of controlled experiments where experienced real estate agents who, when asked to estimate the price at which a house will sell, are influenced by the seller’s asking price. Have a high asking price, and the agents will estimate high. Have a low asking price, and the agents will estimate low. These effects are called “anchors,” and we are all vulnerable to them. Just yesterday I walked into a store to look at patio furniture. The first price I saw was much higher than I expected, but, as hard as I fought against it, this price raised the eventual price I was willing to pay. Maybe the store manager had read Kahneman’s book and placed a high-priced product near the entrance to create a high anchor.

Consider this example from Kahneman and its implication for pricing: Baseball card collectors were asked to estimate the value of two different card sets. The first set contained rare cards of five different Hall of Fame players. The second set contained the same five cards, but also included three cards of much lesser value. Logically, the eight-card set is worth more, because it contains the five valuable cards plus three extras, and collectors who were shown both sets side by side rated the eight-card set higher. But when seeing the sets separately, the eight-card set was valued lower. Even though the eight-card set contained the entire five-card set, and is, logically, more valuable, the lesser cards brought down the perceived average value of the cards enough to impact the overall value of the set.

The next time you are frustrated by your customers’ reactions to your prices, think of that example. You may think that including a few extras will, inevitably, help your customers see additional value, but it’s possible that those extras will actually bring down the perceived value. (Maybe throwing in the free “Wonder Wisk” with the Ginsu Knives isn’t such a good idea after all.)

I can’t recommend Thinking, Fast and Slow enough, and I also encourage you to read Ariely’s books. You will learn why your customers can be so frustrating and why your irrational brother-in-law is such a raving lunatic when it comes to his political views (which are the opposite of your views). But you will also learn how to deal with this irrationality. You will be much more adept at engaging your customers… and your brother-in-law.

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