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Posts Tagged ‘Behavioral economics’

Marketing Psychology: Price Framing

January 30, 2015 2 comments

Price framing is one of those topics that everyone seems to have heard of, but every person you ask will give you a different definition of what it is and how it works. Yet if you’re managing a web store with thousands of products, for example, understanding how to present prices and products in the most optimal way can make an enormous revenue difference.

Let’s take a moment to talk about how price framing works and why it has an effect on consumers.

First of all, when we talk about price framing, we’re talking about changing the context of a price presentation – without substantially changing the price itself – in order to encourage more purchases. This is the reason you’re charged $39.99 rather than $40.00 for iPhone earbuds. But that’s just the tip of the iceberg.

What Do You Mean I’m Not Being Rational?!

One of the most amazing things about how price framing works is that it shouldn’t work at all. Up until a few decades ago, economic theory took utilitarianism as a given. When making a choice whether or not to buy an iPhone, both economists and psychologists assumed that you made a rational calculation of the pros and cons of the choice, and selected the outcome that, to the best of your knowledge, would be most useful or advantageous to you.

So it shouldn’t matter at all how a price is presented to you. The price is the price, and you should make the same calculation of advantages regardless of context.

Except that the rational action theory of economics turns out to be mostly bullshit.

If rational action theory were true, your tendency to purchase a $39.99 item (when you would not have purchased a $40 item) would be based solely on the utility of the one-cent savings. I think we can all agree that something else is at work here. This is an example of how marketers have always been decades ahead of economists.

The first people who noticed that people don’t make explicitly rational outcome choices were psychologists Daniel Kahneman and the late Amos Tversky. They are the grandfathers of what’s now called behavioral economics. They discovered through controlled experiments that people use cognitive shortcuts, called biases, to help make choices. These shortcuts don’t always produce rational decisions.

For example, Kahneman and Tversky discovered that, when people are given a choice of losing $10 for sure, or having a 50-50 chance of losing $25, they tend to avoid the certain loss even though rationally speaking it’s the worse choice.

Other pioneers have significantly advanced the study of these cognitive shortcuts. Two of the most prominent are Richard Thaler (author of Nudge), and Dan Ariely (author of Predictably Irrational).

So, what affect can these biases have on consumer behavior (and specific to us, on price presentation)?

Here are three major principles that may be helpful:

1. People evaluate prices relative to a reference point

Up until recently we believed that, when evaluating a potential purchase, people made comparisons to absolutes. Is this iPhone worth the 400 units of currency that I will part with?

Well, it turns out that we evaluate purchases on relative terms. We’re looking for the value that’s reasonable. But what’s reasonable can be determined by many things.

In a Psychology Today article called “Pricing and Framing: When Are We Likely to Pay More For Products,” Dr. Gizem Saka gives us the scenario of the bread maker:

…You have two options. A standard quality break maker is for sale for $80; and a higher quality bread maker is sold at $120. You compare and contrast the two machines. You tell yourself you are not an expert maker, and you go with the $80 one.

[…]

Now when you go to the shop, you have 3 options. You can spend $80, or $120 or $475. Rationally speaking, adding an irrelevant option should not change your decision between the $80 and the $120 ones. The pros and cons did not change; quality of the bread makers remained the same, and you are making the same salary. You know that you are never going to spend $475 on a break maker…

But the thing is, now you do would feel more comfortable buying the $120 one. After all, you are not buying the most expensive alternative. You have found the middle ground, and you are probably happier, compared to someone who buys the cheaper version with only two options.

This is a form of psychological anchoring that Saka describes is widely known as the irrelevant third option, or in business terms, the loss leader. It is a super-premium product that may not be profitable in its own right but makes the next option down seem more attractive.

This is the most famous use of the principle that the attractiveness of an option will change depending on what’s presented with it. But this is only one example of the effect one can have by introducing or removing options.

2. People evaluate price differences relative to the level of the initial price.

The scientific name for this is the Weber-Fechner Law, if you want to Google it.

You will tend to be more motivated if a $20 price is lowered to $10, than if a $120 price were lowered to $110. Again, there’s no good reason for this. The economic advantage to you is the same in both scenarios.

Ernst Weber was a 19th century scientists who discovered that the stronger a stimulus is, the more change you have to make to it before we can perceive the change. If you’re carrying three pounds of stuff and I add a pound, you will notice the change much more easily than if you’re carrying 30 lbs and I add one.

Fechner improved on this idea by figuring out the mathematical relationship between intensity and perceived change (it’s a simple logarithm, if you care).

The Weber-Fechner law is why you have a hard time paying $5.00 for a Starbucks Sugar-coma Mocha, but you have an easier time coming down $5,000 on the asking price for the house you’re selling. This is especially important when studying price elasticity – the variation in dollar amount that people are willing to pay for the same item.

3. Losses hurt more than gains give pleasure.

This is part of what’s called the Endowment Effect, for you Googlers. People tend to ascribe more value to that which they own. Therefore people try to avoid losses more than achieve gains. People want to avoid late fees more than they care to take advantage of early-bird discounts, even if the value is the same.

One working paper from a USM student described how this effect was studied on the “discount for cash” gasoline consumers in the 80’s.

It’s illegal to do so now, but it used to be that gas stations would charge you a special surcharge if you wanted to pay with a credit card (trying to recoup their extra processing fees). The credit card companies, fearing backlash insisted that any such price difference had to be termed a “cash discount” rather than a “credit surcharge.”

It turns out they were right to fear: those paying for gas by credit card had a significantly more negative reaction to the transaction if they “paid a surcharge” rather than simply missing out on a “discount.”

Further Research

Research is still young in this field, fleshing out the details of principles like these. The results are fascinating. For example, one working paper from the Harvard Business School found that it makes a big difference in preference depending on whether a price is “all-inclusive” or “partitioned.”

If you split out a price into line items, the way budget airlines are more prone to do, people will tend to prefer the deal if the secondary item is top-notch for the price (incredible in-flight service, full-service meal, etc), and oppose the deal if the secondary item is lackluster (one movie option, snackbox, etc.).

Why is this? because the secondary item is easier to evaluate compared to its price than the primary item (the plane trip itself). It’s easier to see if you’re getting a deal or not. So if your secondary items aren’t that high-quality for the money, all-inclusive is the way to go.

I’m excited to see what new principles we’ll be able to add to these three as research develops. If you have some to add (and can cite your source), please use the comments to let people know!

 

Does Advertising Content Work? Let’s Find Out…

September 30, 2013 Leave a comment
English: Portrait of Milton Friedman

English: Portrait of Milton Friedman (Photo credit: Wikipedia)

One of the great advances in economics to emerge in recent decades is the field of behavioral economics. The preceding generation of economists, including Milton Friedman and others, believed that humans were entirely rational consumers. When they made a purchase decision, it was as a result of a neat mental weighing of opportunities costs verses actual costs and other factors.

Now we are starting to understand the enormous hubris of our own assumed rationality. First Kahneman and Tversky came along and pointed out that human cognition is effected by its own limitations, and that we are susceptible to errors in judgement based on these limitations. Dan Airely noted that human irrationality follows predictable patterns. Then Richard Thaler famously pronounced that you could effect (“nudge”) social and economic outcomes by changing decision contexts. This acceptance and exploration of human irrationality and cognitive bias is giving us a richer understanding of the way we work.

So, let’s see this effect in a true marketing context. Professors Marianne Bertrand (Chicago Booth) and Dean Karlan (Yale), together with their team, designed a field experiment in South Africa. They partnered with a cash loan lender to send direct mail advertisements to potential loan customers. The customers were offered rates selected at random, but that were more favorable than the current market. Some of the mailings only represented the interest rate. Other mailings (randomly) included any of a number of psychological manipulations (in other words, “marketing”). These manipulations included elements like competitive comparisons, promotional giveaways, suggested loan uses, pictures of demographically similar people on the mailer, deadlines and other suggestive priming.

No surprise: these psychological factors, when considered as a whole, had a significant effect on loan take-up. The demand increased by as much as a 25% reduction in the interest rate. This effect should not be possible under traditional economic thought.

There were a few interesting subtleties to the results. First, the psychologically-loaded marketing was generally more effective when the interest rate is high (i.e. the loan is more expensive). In other words, as consumers were influenced more by price, they were influenced less by psychological factors.

Also, there were no subgroups of customers who were more or less susceptible to psychological factors than any other. Many have hypothesized that psychological marketing has a greater effect on the less educated and less wealthy. This does not seem to be the case.

Much of new classical research was conducted a...

The University of Chicago, home to Professors Richard Thaler and Marianne Bertrand. (Photo credit: Wikipedia)

Finally, the psychologically-loaded marketing did not seem to attract a poorer class of borrowers. Normally to increase demand for loans one lowers the interest rate, but in so doing one risks attracting borrowers who are less likely to repay. Therefore there is a certain market equilibrium that exists regardless of the present interest rate. Psychologically-loaded marketing increased demand for loans without changing the risk profile of the borrowing pool. That is, it changed the equilibrium of the market on its own. This means that psychological marketing could be seen as its own competitive dimension, particularly in areas of low price sensitivity.

Me For a Member: Cognitive Dissonance and Rationalization

February 28, 2013 5 comments

“I would never belong to any club that would have me for a member.”Groucho Marx

Grouchoicon

Grouchoicon (Photo credit: Wikipedia)

A group of mediocre, boring people get together and decide that they want to form a club that features strong barriers to entry; very few other people can get in without a rigorous acceptance process. We outsiders see only the near impossibility of joining this group and start thinking: “Hey, the members of this group must be cooler than they seem.”

I want to point you in the direction of the excellent PsyBlog, the blog to which this one aspires. I search through PsyBlog from time to time when I’m coming up on deadline and desperate for inspiration. I found this gem detailing a 1959 Stanford sociology study that went down in history. I’ll summarize it, but I strongly suggest reading their excellent briefing to get the full flavor.

A student is asked to take part in an experiment having to do with comparing expectations to reality. He is told that he will be assigned a task, and will set about performing the task with no preset expectations. Another similar group of participants, he is told, will have to complete the same task, but will be told about the nature of the task beforehand.

The task is assigned, and the student goes at it. The task is mind-numbingly boring. Something like moving pegs around a board for a half hour.

As the participant finished and is about to leave, the experimenter throws in a curveball: there’s another student coming in who will participate next, and she is part of the group that’s supposed to be told about the experiment beforehand. The person who is supposed to brief this new participant has not turned up. The experimenter asked if our student, before he leaves, will brief the next student and tell her that the experiment task was really interesting. There’s a dollar in it for him if he does (this is 1959). Our student goes and tells the next student that the task was, indeed, very interesting (even though it was not). The experimenter returns, gives the promised dollar, and states incidentally that other participants have, in fact, found the task to be interesting.

One last step: our student is ushered into another room and interviewed about the experiment. Inexplicably, he tells his interviewer that parts of the task really were kind of interesting. It couldn’t have been all that boring after all, could it?

After the experiment is over, the student confers with a friend and finds out that she went through almost the exact same process. One difference: she was given $20 to tell the other student how interesting the experiment was.

Our guy says, “It really was kind of interesting, don’t you think? I rated it high.”

His friend says, “What are you kidding? It was so boring! I rated it the lowest I could. How could you have thought that was interesting?”

So why would the person paid only $1.00 to lie about a boring task actually start to believe it was interesting, whereas the person paid $20 to do the same thing accurately remembered how boring the task really was? Read more…

This Time Is Different

September 29, 2012 Leave a comment

Cover of "This Time Is Different: Eight C...I would like to bring your attention to an excellent book: This Time Is Different: Eight Centuries of Financial Folly. It’s written by two econometricians: Carmen Reinhart of the University of Maryland, and her research partner at Harvard, Kenneth Rogoff. Anyone who enjoys reading book-length academic treatises should not miss this. I mean that in the most genuine and unironic way.

Reinhart and Rogoff have spent years compiling one of the most comprehensive econometric databases in existence dealing with financial crises (typically in the form of sovereign or bank debt defaults). The data incorporates not only modern databases, but also older primary sources like the League of Nations archives, and individual researcher data going back as far as the 1300’s. The results of their massive undertaking are posted online for public consumption. It is truly an impressive achievement.

Once the data was compiled, the researchers used it to examine the nature of financial crises throughout history. The authors are quick to point out that this type of data-driven approach is rather novel in economics. Similar to psychology, the study of economics is classically theory-driven. Practitioners in the field most typically form elegant and impressive theories based on a short swath of experience, and then selectively cite data that validates the theory. This study, by contrast, first assembles a complete data set, and then looks at it dispassionately for patterns that would suggest an inference.

As the title of the book suggests, there are commonalities between financial crises. The core source of commonality between such events seems to be the mistaken notion that “this time is different.” Economic actors either have delusional estimates of the creditworthiness of some debtors, or they believe that some new technology or debt instrument all but eliminates credit risk, or that current rosy financial trends will continue indefinitely (or at least that they have the special knowledge to allow them to exit the market before all the other investors). Whatever the specific belief, they all share this common theme. Our authors submit to us that it is precisely our notion of “this time is different” that is the very reason why this time is no different from any other. Read more…

How Debt Screws With Our Heads, Part 2: Distortion and Bias

November 23, 2011 2 comments

This is Part 2 of a 2-part article on the human cognition of risk and debt. Part 1 can be found here.

In our last post, we talked about the loss-aversion mechanisms of the brain, and how they send us emotional signals that help us avoid unwise risk. We also noted that there were about ten or twelve cognitive biases that tend to interfere with that mechanism, keeping it from kicking-in when it should. Here are a few of the major cognitive distortions that disable our ability to objectively conceptualize the risks of debt:

Aversion to Sure Loss: “If I don’t take this risk, I can’t get back where I should be.”

Loss aversion can hurt us as well as help us, because if we feel that we are “down,” we tend to take increasingly risky behaviors to try and get “back even.” This was proven out in a serious of famous choice problems conducted by Tversky and Kahneman.

Aversion to Sure Loss is related to another bias called Social Anchoring. Social Anchoring is the idea that if you don’t take on this risk, everyone else will pass you by. Both biases make you feel like you might be “behind” by comparison. One World Bank policy working paper pointed out how the directors of the Big 5 investment banks were concerned not about the nature of the investments they took on, but about beating one another’s returns.

In his paper, How Psychological Pitfalls Generated the Global Financial Crisis, Professor Hersh Shefrin tells how UBS, trailing its competitors in 2006, got itself deep into the subprime mortgages that led to its downfall. Their decisions seemed to have less to do with the prudence of the investment than with their trailing position in the industry. They made the decision from what’s called “the domain of losses,” the same psychological sensation we feel when we’ve lost $200 at the blackjack table, and we “know we can get it back.”

Present Bias: “I’ll just sacrifice something later on to make room for this new debt.”

Present Bias says that we value the present more than we value the future. Sure, it’s okay to eat cake now; you’ll do more exercise next week to make up for it. Sure we can afford the flatscreen; we’ll give up something else for the next couple months. Read more…

How Debt Screws With Our Heads, Part 1: Pleasure and Pain

November 21, 2011 2 comments

This is Part 1 of a 2-part article on the human cognition of risk and debt. The second part can be found here.

RiskIn her textbook Neuroeconomics and the Firm, Angela A. Stanton quotes psychiatrist and former trader Richard Peterson, who tells us the story of Lee:

Lee [was] a 53-year-old partner in an accounting firm, who lost part of his Orbitofrontal Cortex (OFC) as a result of surgery to remove a tumor…

After a successful operation, Lee was able to return to work and function normally except for his terrible investment decisions. He bought several expensive vacation time shares, bought penny stocks based on faxed and emailed promotional material and could not keep up his mortgage payments. The loss of his OFC took away an important part of Lee’s functional ‘loss avoidance’ system. Previously a conservative investor, he was now unable to feel ‘risk.’ Lee explained that he knew he should feel uncertain and afraid, but his highly speculative investments did not feel ‘risky’ to him.

America is a nation engorged on debt. Many of us need ten years or more to pay off hefty student loans. Many others of us never fully recover from getting too deep into credit card debt. Still others of us took mortgage debt on terms we couldn’t afford because we planned on refinancing before it became a problem.

Market theory tells us that supply and demand forces will place a rational value on debt risk. A debtor fitting such-and-such a profile, with so much collateral, borrowing for so long a time equals a precise interest cost. Of course the future is not completely foreseeable, and there’s always a risk that the borrower will not be able to pay the loan back. But the market has baked that possibility into the cost of the loan…that’s the whole point. Therefore – as far as the market is concerned – debt is a knowable, quantifiable entity.

And yet, every major financial crisis in the history of the United States has been either precipitated or exacerbated by over-leveraging. Investors and banks have borrowed to finance investments since Aristotle’s time. Yet we find ourselves living through more and more periods of financial turmoil, usually kicked off by over-leveraged or unwisely-leveraged professional investors.

Preceding the 1929 crash, investors were buying stocks on as much as 90% margin (nine dollars of loan to every one dollar of capital). Starting in 1975, the maximum debt-to-equity ratio for investment banks was 12-1 (it could borrow up to 12 times its own net worth to play the market). When the rule was relaxed in 2004, those ratios went up to 30-1 and even 40-1. At the time of its crash, the Swiss bank UBS was leveraged at 60-1. The Long Term Capital Management hedge fund, at its 1998 bailout, had an effective leverage ratio of 250-1. These outlandish leverage rates were a major contributing factor to the 2007 financial crisis.

So if the major aspects of debt risks are so quantifiable – if you can know the terms and rationally determine the risks to which you will be exposed – why does debt consistently get us into so much trouble? Read more…

Rational Markets and Irrational Traders

September 30, 2011 2 comments

“Traders and rodents…seem to have something in common.”The Economist

Image of the human head with the brain. The ar...

Image via Wikipedia

If you’re in the current cool-crowd of psychology, you are probably a cognitive psychologist. Interest in, and funding for, cognitive psychology has greatly increased over the last fifteen to twenty years. This is due in part to popular authors like Gladwell and Daniel Pink bringing public awareness to new discoveries about how the mind forms conclusions. This has popularized cognitive and neurological perspectives in other fields of study as well.

One very interesting field that has surfed on the wave of cognitive psychology is behavioral economics. Behavioral economics studies the cognitive and emotional – that is to say the irrational – decision factors of an area that has been traditionally understood as completely rational.

Market participants like consumers, investors and bankers typically think of themselves as analysts. They’re job is to study information and make an informed decisions as to whether a certain product of instrument is worth of investment. Understanding their function in this way, participants are quick to credit their own powers when transactions turn out favorably.

Two recent articles from The Economist paint a more interesting picture: one of influential market actors as hormone-drenched, delusional, cognitively disconnected impulse-actors who have a biased understanding of their own abilities and track record.

The first article is “Raging Hormones.” It details the work of a Cambridge neuroscientist named John Coates who studies the biochemistry of market traders. According to the article, Coates’ work “suggests that hormones drive investment decisions to a far greater extent than economists or bank executives realize.”

Cortisol, in 3D

One example of this is the fluctuation in serum cortisol levels in equity traders’ blood. In a recent post, I discussed the roles of adrenaline and cortisol in the bloodstream, and their roles in dealing with stress triggers. While conducting experiments on a London trading floor, Coates saw cortisol levels in traders saliva jump as much as 500% over the course of a day. In fact, it rose in direct correlation with the market’s current implied volatility. Cortisol is the hormone that’s part of a primal early warning system; among other things, it causes feelings of dread. When it enters the blood, it would cause an irrational tendency towards risk aversion. Chronic high levels can lead to paranoia.

Another article, “The Irrationality of Politics,” uses the principles of behavioral economics to explain voter preferences, as those preferences arise from the same kind of economic irrationality. The article highlights three principles within behavioral economics that apply just as much to politics as they do to market trading:

Loss Aversion There’s a longstanding axiom called “prospect theory” which holds that people are more sensitive to losing what they already have than they are to the prospect of new gains. For example, in a recent election, many well-off voters withdrew their support for a conservative candidate who wanted to get rid of certain short term tax credits, even though a conservative government would be the most likely to cut the voters’ overall taxes in the long run. The votors simply did not want to feel the acute sting of immediate loss. Prospect theory is generally healthy for us because the principle keeps us from taking too much financial risk.

Cognitive Dissonance

Cognitive Dissonance It is possible for people, and entire electorates, to hold two different and contradicting views on an issue depending on how that issue is framed. This article cites the issue of inheritance (“death”) tax. Pollsters noticed that the voters responded positively to the idea of raising the tax threshold, because they view the tax as an inherently unfair one. However, the electorate also responds positively to attacks on the idea of raising that same threshold, as a give-away to the rich during recessionary times. There are many market-related examples of cognitive dissonance, and they usually come about as issues get more complex. For example, during the height of the housing bubble, CDO tranches filled with toxic subprime mortgages continued to receive triple-A ratings, leading to a huge amount of dissonance in terms of the value of those securities. That dissonance was a major contributor to the market’s bubble and subsequent downfall.

Instant Judgement – As this article calls it, the “Gladwellian Blink Test.” Malcolm Gladwell wrote in his famous book Blink about the rapid mental processing and judgement that takes place at the instant of introduction to something new. Psychologists believe that much voter and market decision making is based on this kind of rapid, subconscious processing, and that the process that we call rational decision-making merely serves to reverse-justify the instant judgement to which we have anchored ourselves.

Many economic assumptions, including the assumption of Market Discipline, are based off of the concept of the free market as a series of fundamentally rational transactions. As we now look back at the reasons why market discipline failed to head off The Great Recession, we must ask ourselves whether this principle is capable of mitigating systemic risk given what we are learning about how the market actually makes its decisions.