To be fair to Jensen, there is a more coherent version of his argument. Instead of arguing that markets force people to be rational, one can argue that market prices will still be rational, even if many individuals are decidedly Human. This argument is certainly plausible, perhaps even compelling. It just happens to be wrong. But how and why it is wrong is a long story that we will take up in Section VI.
For the field of behavioral economics to succeed, we needed answers to these questions. And in some quarters, we still do. But now, instead of snappy one-liners, it is possible to point to studies of real people interacting at high stakes in markets—even financial markets, where the invisible handwave would be expected to be most likely to be valid.
It was with the Gauntlet in my mind that I arrived at Cornell, in rural Ithaca, New York, in the fall of 1978. Ithaca is a small town with long, snowy winters, and not much to do. It was a good place to work.
While in California I had managed to finish two papers. One expounded on the List, and the other was called “An Economic Theory of Self-Control.” Writing the papers was the easy part; getting them published was another story. The first paper, mentioned earlier, “Toward a Positive Theory of Consumer Choice,” was rejected by six or seven major journals; I have repressed the exact count. In hindsight, I am not surprised. The paper had plenty of ideas, but little hard evidence to support them. Each rejection came with a set of referee reports, with often scathing comments that I would try to incorporate in the next revision. Still, I did not seem to be making any progress.
At some point I had to get this paper published, if for no other reason than that I needed to move on. Luckily, two open-minded economists were starting a new journal called the Journal of Economic Behavior and Organization. I guessed that they were anxious to get submissions, so I sent the paper to them and they published it in the inaugural issue. I had my first behavioral economics publication, albeit in a journal no one had ever heard of.
If I were going to stay in academia and get tenure at a research-focused university like Cornell, I would have to start publishing regularly in top journals. I had returned from California with two ideas at the top of my list of topics to explore. The first was to understand the psychology of spending, saving, and other household financial behavior, what has now become known as mental accounting. The second was self-control and, more generally, choosing between now and later. The next two sections of the book take up those topics.
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* They favored this hypothesis even though Lichtenstein and Slovic (1973) had replicated their studies for real money on the floor of a casino in Las Vegas. Their dismissal of this evidence might be explained by another of their hypotheses. They also explicitly entertained the possibility that the perverse results were obtained simply because the experimenters were psychologists, who were known to deceive people in experiments. Needless to say, this hypothesis did not sit well with any psychologists who stumbled onto their paper.
II.
MENTAL ACCOUNTING:
1979–85
After our year together in California, Amos and Danny continued their collaboration and I would only see them occasionally at conferences. They were working on follow-up papers to “Prospect Theory” and I continued to think about consumer choice. There was one topic, however, that they and I were both thinking about, mostly independently. In a nutshell it is: “How do people think about money?” Early on I called this process “psychological accounting,” but in a later paper on the topic Amos and Danny changed the name to “mental accounting,” and I followed suit.
I have continued to think, write, and talk about mental accounting for the rest of my career. I still find it fascinating, exciting, and incisive; it is a lens that helps me understand the world. The next few chapters are devoted to mental accounting basics, but the topic permeates the rest of the book. Thinking about mental accounting can be contagious. You may soon find yourself blurting, “Well, that is really a mental accounting problem.”
7
Bargains and Rip-Offs
My friend Maya Bar-Hillel was shopping for a quilt to use as a comforter on her double bed. She went to the store and found one she liked that was on sale. The regular prices were $300 for a king size, $250 for a queen size, and $200 for a double. This week only, all sizes were priced at $150. Maya could not resist: she bought the king size.
To begin any discussion of mental accounting, it helps to understand the basic economic theory of the consumer. Recall from the discussion of the endowment effect that all economic decisions are made through the lens of opportunity costs. The cost of dinner and a movie tonight is not fully captured by the financial outlay—it also depends on the alternative uses of that time and money.
If you understand opportunity costs and you have a ticket to a game that you could sell for $1,000, it does not matter how much you paid for the ticket. The cost of going to the game is what you could do with that $1,000. You should only go to the game if that is the best possible way you could use that money. Is it better than one hundred movies at $10 each? Better than an upgrade to your shabby wardrobe? Better than saving the money for a rainy day or a sunny weekend? This analysis is not limited to decisions that involve money. If you spend an afternoon reading a novel, then the opportunity cost is whatever else you might have done with that time.
Thinking like that is a right and proper normative theory of consumer choice. It’s what Econs do, and in principle we should all strive to think this way most of the time. Still, anyone who tried to make every decision in this manner would be paralyzed. How can I possibly know which of the nearly infinite ways to use $1,000 will make me happiest? The problem is too complex for anyone to solve, and it is unrealistic to think that the typical consumer engages in this type of thinking. Few people think in a way that even approximates this type of analysis. For the $1,000 ticket problem, many people will consider only a few alternatives. I could watch the game on television and use the money to go visit my daughter in Providence. Would that be better? But figuring out the best alternative use of the money is not something I or anyone is capable of thinking about—not even close.*
What do people do instead? I was unsure about how to study this and other aspects of consumer decision-making, so I hired a student to interview local families to see what we could learn about what real people do. I concentrated on lower-middle-class households because spending decisions are much more important when your budget is tight.
The interviews were designed to give the participants plenty of time to talk about whatever they wanted. (We paid them a fixed amount to participate but some talked for hours.) The target respondent was the person in the household who handled the money. In married couples, more often than not this responsibility fell to the wife. The purpose of the interviews was not to collect data for an academic paper. I simply hoped to get an overall impression of how people thought about managing their household’s finances. Adam Smith famously visited a pin factory to see how manufacturing worked. This was my pin factory. The interviews grounded me in reality and greatly influenced everything I later wrote about mental accounting.
The first question to deal with was one I had been pondering since the days of the List. “When is a cost a loss?” Although it had long been on my mind, my “discovery” of prospect theory heightened that interest. Recall that the value function displays loss aversion: when starting from zero, it is steeper going down than going up. Losses hurt about twice as much as gains make us feel good. This raises the question: if you pay $5 for a sandwich, do you feel like you just lost $5? For routine transactions, the answer is clearly no. For one thing, thinking that way would make you miserable. Because losses are weighed about twice as heavily as gains, even trading a ten-dollar bill for two fives would be viewed as a loss with this sort of accounting. “Losing” each of the five-dollar bills would be more painful than the pleasure associated with receiving the $10. So what does happen when you make a purchase? And what in the
world was Maya thinking when she bought that gigantic quilt?
Eventually I settled on a formulation that involves two kinds of utility: acquisition utility and transaction utility. Acquisition utility is based on standard economic theory and is equivalent to what economists call “consumer surplus.” As the name suggests, it is the surplus remaining after we measure the utility of the object gained and then subtract the opportunity cost of what has to be given up. For an Econ, acquisition utility is the end of the story. A purchase will produce an abundance of acquisition utility only if a consumer values something much more than the marketplace does. If you are very thirsty, then a one-dollar bottle of water is a utility windfall. And for an Econ who owns a double bed, the acquisition utility of a quilt that fits the bed would be greater than one that hangs two feet over the side in every direction.
Humans, on the other hand, also weigh another aspect of the purchase: the perceived quality of the deal. That is what transaction utility captures. It is defined as the difference between the price actually paid for the object and the price one would normally expect to pay, the reference price. Suppose you are at a sporting event and you buy a sandwich identical to the one you usually have at lunch, but it costs triple the price. The sandwich is fine but the deal stinks. It produces negative transaction utility, a “rip-off.” In contrast, if the price is below the reference price, then transaction utility is positive, a “bargain,” like Maya’s extra-large quilt selling for the same price as a smaller one.
Here is a survey question that illustrates the concept. Two groups of students in an executive MBA program who reported being regular beer drinkers were asked one of the two versions of the scenario shown below. The variations appear in parentheses and brackets.
You are lying on the beach on a hot day. All you have to drink is ice water. For the last hour you have been thinking about how much you would enjoy a nice cold bottle of your favorite brand of beer. A companion gets up to go make a phone call and offers to bring back a beer from the only nearby place where beer is sold (a fancy resort hotel) [a small, rundown grocery store]. He says that the beer might be expensive so asks how much you are willing to pay for the beer. He says he will buy the beer if it costs as much or less than what you state. But if it costs more than the price you state, he will not buy it. You trust your friend, and there is no possibility of bargaining with the (bartender) [store owner]. What price will you tell him?
There are several things to notice about this example, which was fine-tuned to deal with the objections I anticipated hearing from economists. Crucially, the consumption act is identical in the two situations. The respondent gets to drink one bottle of his favorite brand of beer on the beach. He never enters or even sees the establishment from which the beer has been purchased, and thus does not consume any ambience, positive or negative. Also, by ruling out any negotiation with the seller, the respondents have no reason to disguise their true preferences. In economists’ lingo, the situation is incentive compatible.
With those provisos out of the way, we can proceed to the punch line. People are willing to pay more for the beer if it was purchased from the resort than from the convenience store. The median† answers, adjusted for inflation, were $7.25 and $4.10.
These results show that people are willing to pay different prices for the same beer, consumed at the same spot on the beach, depending on where it was bought. Why do the respondents care where the beer was bought? One reason is expectations. People expect prices to be higher at a fancy hotel, in part because the costs are quite obviously higher. Paying seven dollars for a beer at a resort is annoying but expected; paying that at a bodega is an outrage! This is the essence of transaction utility.
Econs do not experience transaction utility. For them, the purchase location is another supposedly irrelevant factor, or SIF. It is not that Econs are immune to bargains. If someone was selling beers on the beach for ten cents, then even an Econ would be happy, but that happiness would be fully captured by the acquisition utility. Those who enjoy transaction utility are getting pleasure (or pain) from the terms of the deal per se.
Since transaction utility can be either positive or negative—that is, there can be both great deals and awful gouges—it can both prevent purchases that are welfare-enhancing and induce purchases that are a waste of money. The beer on the beach example illustrates a case where someone can be dissuaded from making a worthwhile purchase. Suppose Dennis says he would only pay $4 for the beer from the bodega, but $7 from the hotel. His friend Tom could make Dennis happier if bought the beer at the store for $5 but told Dennis he had bought it from the hotel. Dennis would get to drink his beer thinking the deal was fine. It is only his distaste for overpaying that stops him from agreeing to this transaction without Tom’s subterfuge.
For those who are at least living comfortably, negative transaction utility can prevent our consuming special experiences that will provide a lifetime of happy memories, and the amount by which the item was overpriced will long be forgotten. Good deals, on the other hand, can lure all of us into making purchases of objects of little value. Everyone has items in their closets that are rarely worn but were “must buys” simply because the deal was too good, and of course somewhere in the garage or attic is our version of Maya’s quilt.
Because consumers think this way, sellers have an incentive to manipulate the perceived reference price and create the illusion of a “deal.” One example that has been used for decades is announcing a largely fictional “suggested retail price,” which actually just serves as a misleading suggested reference price. In America, some products always seem to be on sale, such as rugs and mattresses, and at some retailers, men’s suits. Goods that are marketed this way share two characteristics: they are bought infrequently and quality is difficult to assess. The infrequent purchases help because consumers often do not notice that there is always a sale going on. Most of us are pleasantly surprised that when we wander in to buy a new mattress, there happens to be a sale this week. And when the quality of a product, like a mattress, is hard to assess, the suggested retail price can do double duty. It can simultaneously suggest that quality is high (thus increasing perceived acquisition utility) and imply that there is transaction utility to be had because the product is “on sale.”
Shoppers can get hooked on the thrill derived from transaction utility. If a retailer known for frequent discounting tries to wean their customers away from expecting great deals, it can struggle. Several retailers have tried over the years to entice customers with something called “everyday low pricing,” but these experiments usually fail.‡ Getting a great deal is more fun than saving a small and largely invisible amount on each item.
Macy’s and JC Penney are just two U.S. retailers to have notably tried—and failed—to wean their customers off their addiction to frequent sales. In an image makeover undertaken in 2006–07, Macy’s leadership specifically targeted coupons as a price reduction device, and wanted to reduce their usage. Macy’s saw coupons as a threat, linking the brand too closely to less prestigious retailers such as JC Penney or Kohl’s. After taking over several other department store chains across the country and rebranding them all as Macy’s, they cut the use of coupons by 30% in the spring of 2007, compared to the prior spring. This did not go over well with customers. Sales plummeted, and Macy’s quickly promised to return to its previous glut of coupons by the holiday season of that same year.
JC Penney similarly eschewed coupons for a brief period in 2012 in pursuit of an everyday low price strategy. Noting that less than 1% of revenues came from full-price transactions, CEO Ron Johnson in a surprisingly candid press release announced an end to what he dubbed “fake prices”—the mythical suggested retail price—and the start of a simpler pricing scheme. In addition to abolishing traditional sales via coupons, the new scheme did away with prices ending in .99, rounding them up to the nearest dollar. JC Penney claimed the end price consumers paid was effectively the same, after all these changes.
Sharp readers (and shoppers) might wonder about large-format discount retailers such as Walmart and Costco. These retailers successfully operate under an everyday low pricing strategy, sometimes without explicit reference to an original higher price. But they have not eliminated transaction utility; just the opposite. They have convinced their customers that the entire shopping experience is an orgy of bargain hunting, and go out of their way to reinforce that image. Along with providing genuinely low prices, Walmart also offers a variation on the old ploy of guaranteeing that they have the lowest prices available by allowing shoppers to scan their receipts into a “savings catcher” app that promises to give a refund to anyone if there is a lower price available. Unless Macy’s and JC Penney wanted to give up all pretensions of offering an upscale shopping experience, they could not compete with these true low-cost providers in providing transaction utility to their customers.
Misbehaving: The Making of Behavioral Economics Page 7
