Contents

Predictably Irrational

The Upside of Irrationality

The (Honest) Truth About Dishonesty

About the Author

Copyright

About the Publisher

Dedication

To my mentors, colleagues, and students—

who make research exciting

Contents

DEDICATION

INTRODUCTION

How an Injury Led Me to Irrationality and to the Research Described Here

CHAPTER 1 - The Truth about Relativity

Why Everything Is Relative—Even When It Shouldn’t Be

CHAPTER 2 - The Fallacy of Supply and Demand

Why the Price of Pearls—and Everything Else—Is Up in the Air

CHAPTER 3 - The Cost of Zero Cost

Why We Often Pay Too Much When We Pay Nothing

CHAPTER 4 - The Cost of Social Norms

Why We Are Happy to Do Things, but Not When We Are Paid to Do Them

CHAPTER 5 - The Power of a Free Cookie

CHAPTER 6 - The Influence of Arousal

Why Hot Is Much Hotter Than We Realize

CHAPTER 7 - The Problem of Procrastination and Self-Control

Why We Can’t Make Ourselves Do What We Want to Do

CHAPTER 8 - The High Price of Ownership

Why We Overvalue What We Have

CHAPTER 9 - Keeping Doors Open

Why Options Distract Us from Our Main Objective

CHAPTER 10 - The Effect of Expectations

Why the Mind Gets What It Expects

CHAPTER 11 - The Power of Price

Why a 50-Cent Aspirin Can Do What a Penny Aspirin Can’t

CHAPTER 12 - The Cycle of Distrust

CHAPTER 13 - The Context of Our Character, Part I

Why We Are Dishonest, and What We Can Do about It

CHAPTER 14 - The Context of Our Character, Part II

Why Dealing with Cash Makes Us More Honest

CHAPTER 15 - Beer and Free Lunches

What Is Behavioral Economics, and Where Are the Free Lunches?

THANKS

LIST OF COLLABORATORS

NOTES

BIBLIOGRAPHY AND ADDITIONAL READINGS

PRAISE FOR PREDICTABLY IRRATIONAL

Introduction

How an Injury Led Me to Irrationality and

to the Research Described Here

I have been told by many people that I have an unusual way of looking at the world. Over the last 20 years or so of my research career, it’s enabled me to have a lot of fun figuring out what really influences our decisions in daily life (as opposed to what we think, often with great confidence, influences them).

Do you know why we so often promise ourselves to diet, only to have the thought vanish when the dessert cart rolls by?

Do you know why we sometimes find ourselves excitedly buying things we don’t really need?

Do you know why we still have a headache after taking a one-cent aspirin, but why that same headache vanishes when the aspirin costs 50 cents?

Do you know why people who have been asked to recall the Ten Commandments tend to be more honest (at least immediately afterward) than those who haven’t? Or why honor codes actually do reduce dishonesty in the workplace?

By the end of this book, you’ll know the answers to these and many other questions that have implications for your personal life, for your business life, and for the way you look at the world. Understanding the answer to the question about aspirin, for example, has implications not only for your choice of drugs, but for one of the biggest issues facing our society: the cost and effectiveness of health insurance. Understanding the impact of the Ten Commandments in curbing dishonesty might help prevent the next Enron-like fraud. And understanding the dynamics of impulsive eating has implications for every other impulsive decision in our lives—including why it’s so hard to save money for a rainy day.

My goal, by the end of this book, is to help you fundamentally rethink what makes you and the people around you tick. I hope to lead you there by presenting a wide range of scientific experiments, findings, and anecdotes that are in many cases quite amusing. Once you see how systematic certain mistakes are—how we repeat them again and again—I think you will begin to learn how to avoid some of them.

But before I tell you about my curious, practical, entertaining (and in some cases even delicious) research on eating, shopping, love, money, procrastination, beer, honesty, and other areas of life, I feel it is important that I tell you about the origins of my somewhat unorthodox worldview—and therefore of this book. Tragically, my introduction to this arena started with an accident many years ago that was anything but amusing.

ON WHAT WOULD otherwise have been a normal Friday afternoon in the life of an eighteen-year-old Israeli, everything changed irreversibly in a matter of a few seconds. An explosion of a large magnesium flare, the kind used to illuminate battlefields at night, left 70 percent of my body covered with third-degree burns.

The next three years found me wrapped in bandages in a hospital and then emerging into public only occasionally, dressed in a tight synthetic suit and mask that made me look like a crooked version of Spider-Man. Without the ability to participate in the same daily activities as my friends and family, I felt partially separated from society and as a consequence started to observe the very activities that were once my daily routine as if I were an outsider. As if I had come from a different culture (or planet), I started reflecting on the goals of different behaviors, mine and those of others. For example, I started wondering why I loved one girl but not another, why my daily routine was designed to be comfortable for the physicians but not for me, why I loved going rock climbing but not studying history, why I cared so much about what other people thought of me, and mostly what it is about life that motivates people and causes us to behave as we do.

During the years in the hospital following my accident, I had extensive experience with different types of pain and a great deal of time between treatments and operations to reflect on it. Initially, my daily agony was largely played out in the “bath,” a procedure in which I was soaked in disinfectant solution, the bandages were removed, and the dead particles of skin were scraped off. When the skin is intact, disinfectants create a low-level sting, and in general the bandages come off easily. But when there is little or no skin—as in my case because of my extensive burns—the disinfectant stings unbearably, the bandages stick to the flesh, and removing them (often tearing them) hurts like nothing else I can describe.

Early on in the burn department I started talking to the nurses who administered my daily bath, in order to understand their approach to my treatment. The nurses would routinely grab hold of a bandage and rip it off as fast as possible, creating a relatively short burst of pain; they would repeat this process for an hour or so until they had removed every one of the bandages. Once this process was over I was covered with ointment and with new bandages, in order to repeat the process again the next day.

The nurses, I quickly learned, had theorized that a vigorous tug at the bandages, which caused a sharp spike of pain, was preferable (to the patient) to a slow pulling of the wrappings, which might not lead to such a severe spike of pain but would extend the treatment, and therefore be more painful overall. The nurses had also concluded that there was no difference between two possible methods: starting at the most painful part of the body and working their way to the least painful part; or starting at the least painful part and advancing to the most excruciating areas.

As someone who had actually experienced the pain of the bandage removal process, I did not share their beliefs (which had never been scientifically tested). Moreover, their theories gave no consideration to the amount of fear that the patient felt anticipating the treatment; to the difficulties of dealing with fluctuations of pain over time; to the unpredictability of not knowing when the pain will start and ease off; or to the benefits of being comforted with the possibility that the pain would be reduced over time. But, given my helpless position, I had little influence over the way I was treated.

As soon as I was able to leave the hospital for a prolonged period (I would still return for occasional operations and treatments for another five years), I began studying at Tel Aviv University. During my first semester, I took a class that profoundly changed my outlook on research and largely determined my future. This was a class on the physiology of the brain, taught by professor Hanan Frenk. In addition to the fascinating material Professor Frenk presented about the workings of the brain, what struck me most about this class was his attitude to questions and alternative theories. Many times, when I raised my hand in class or stopped by his office to suggest a different interpretation of some results he had presented, he replied that my theory was indeed a possibility (somewhat unlikely, but a possibility nevertheless)—and would then challenge me to propose an empirical test to distinguish it from the conventional theory.

Coming up with such tests was not easy, but the idea that science is an empirical endeavor in which all the participants, including a new student like myself, could come up with alternative theories, as long as they found empirical ways to test these theories, opened up a new world to me. On one of my visits to Professor Frenk’s office, I proposed a theory explaining how a certain stage of epilepsy developed, and included an idea for how one might test it in rats.

Professor Frenk liked the idea, and for the next three months I operated on about 50 rats, implanting catheters in their spinal cords and giving them different substances to create and reduce their epileptic seizures. One of the practical problems with this approach was that the movements of my hands were very limited, because of my injury, and as a consequence it was very difficult for me to operate on the rats. Luckily for me, my best friend, Ron Weisberg (an avid vegetarian and animal lover), agreed to come with me to the lab for several weekends and help me with the procedures—a true test of friendship if ever there was one.

In the end, it turned out that my theory was wrong, but this did not diminish my enthusiasm. I was able to learn something about my theory, after all, and even though the theory was wrong, it was good to know this with high certainty. I always had many questions about how things work and how people behave, and my new understanding—that science provides the tools and opportunities to examine anything I found interesting—lured me into the study of how people behave.

With these new tools, I focused much of my initial efforts on understanding how we experience pain. For obvious reasons I was most concerned with such situations as the bath treatment, in which pain must be delivered to a patient over a long period of time. Was it possible to reduce the overall agony of such pain? Over the next few years I was able to carry out a set of laboratory experiments on myself, my friends, and volunteers—using physical pain induced by heat, cold water, pressure, loud sounds, and even the psychological pain of losing money in the stock market—to probe for the answers.

By the time I had finished, I realized that the nurses in the burn unit were kind and generous individuals (well, there was one exception) with a lot of experience in soaking and removing bandages, but they still didn’t have the right theory about what would minimize their patients’ pain. How could they be so wrong, I wondered, considering their vast experience? Since I knew these nurses personally, I knew that their behavior was not due to maliciousness, stupidity, or neglect. Rather, they were most likely the victims of inherent biases in their perceptions of their patients’ pain—biases that apparently were not altered even by their vast experience.

For these reasons, I was particularly excited when I returned to the burn department one morning and presented my results, in the hope of influencing the bandage removal procedures for other patients. It turns out, I told the nurses and physicians, that people feel less pain if treatments (such as removing bandages in a bath) are carried out with lower intensity and longer duration than if the same goal is achieved through high intensity and a shorter duration. In other words, I would have suffered less if they had pulled the bandages off slowly rather than with their quick-pull method.

The nurses were genuinely surprised by my conclusions, but I was equally surprised by what Etty, my favorite nurse, had to say. She admitted that their understanding had been lacking and that they should change their methods. But she also pointed out that a discussion of the pain inflicted in the bath treatment should also take into account the psychological pain that the nurses experienced when their patients screamed in agony. Pulling the bandages quickly might be more understandable, she explained, if it were indeed the nurses’ way of shortening their own torment (and their faces often did reveal that they were suffering). In the end, though, we all agreed that the procedures should be changed, and indeed, some of the nurses followed my recommendations.

My recommendations never changed the bandage removal process on a greater scale (as far as I know), but the episode left a special impression on me. If the nurses, with all their experience, misunderstood what constituted reality for the patients they cared so much about, perhaps other people similarly misunderstand the consequences of their behaviors and, for that reason, repeatedly make the wrong decisions. I decided to expand my scope of research, from pain to the examination of cases in which individuals make repeated mistakes—without being able to learn much from their experiences.

THIS JOURNEY INTO the many ways in which we are all irrational, then, is what this book is about. The discipline that allows me to play with this subject matter is called behavioral economics, or judgment and decision making (JDM).

Behavioral economics is a relatively new field, one that draws on aspects of both psychology and economics. It has led me to study everything from our reluctance to save for retirement to our inability to think clearly during sexual arousal. It’s not just the behavior that I have tried to understand, though, but also the decision-making processes behind such behavior—yours, mine, and everybody else’s. Before I go on, let me try to explain, briefly, what behavioral economics is all about and how it is different from standard economics. Let me start out with a bit of Shakespeare:

What a piece of work is a man! how noble in reason! how infinite in faculty! in form and moving how express and admirable! in action how like an angel! in apprehension how like a god! The beauty of the world, the paragon of animals. —from Act II, scene 2, of Hamlet

The predominant view of human nature, largely shared by economists, policy makers, nonprofessionals, and everyday Joes, is the one reflected in this quotation. Of course, this view is largely correct. Our minds and bodies are capable of amazing acts. We can see a ball thrown from a distance, instantly calculate its trajectory and impact, and then move our body and hands in order to catch it. We can learn new languages with ease, particularly as young children. We can master chess. We can recognize thousands of faces without confusing them. We can produce music, literature, technology, and art—and the list goes on and on.

Shakespeare is not alone in his appreciation for the human mind. In fact, we all think of ourselves along the lines of Shakespeare’s depiction (although we do realize that our neighbors, spouses, and bosses do not always live up to this standard). Within the domain of science, these assumptions about our ability for perfect reasoning have found their way into economics. In economics, this very basic idea, called rationality, provides the foundation for economic theories, predictions, and recommendations.

From this perspective, and to the extent that we all believe in human rationality, we are all economists. I don’t mean that each of us can intuitively develop complex game-theoretical models or understand the generalized axiom of revealed preference (GARP); rather, I mean that we hold the basic beliefs about human nature on which economics is built. In this book, when I mention the rational economic model, I refer to the basic assumption that most economists and many of us hold about human nature—the simple and compelling idea that we are capable of making the right decisions for ourselves.

Although a feeling of awe at the capability of humans is clearly justified, there is a large difference between a deep sense of admiration and the assumption that our reasoning abilities are perfect. In fact, this book is about human irrationality—about our distance from perfection. I believe that recognizing where we depart from the ideal is an important part of the quest to truly understand ourselves, and one that promises many practical benefits. Understanding irrationality is important for our everyday actions and decisions, and for understanding how we design our environment and the choices it presents to us.

My further observation is that we are not only irrational, but predictably irrational—that our irrationality happens the same way, again and again. Whether we are acting as consumers, businesspeople, or policy makers, understanding how we are predictably irrational provides a starting point for improving our decision making and changing the way we live for the better.

This leads me to the real “rub” (as Shakespeare might have called it) between conventional economics and behavioral economics. In conventional economics, the assumption that we are all rational implies that, in everyday life, we compute the value of all the options we face and then follow the best possible path of action. What if we make a mistake and do something irrational? Here, too, traditional economics has an answer: “market forces” will sweep down on us and swiftly set us back on the path of righteousness and rationality. On the basis of these assumptions, in fact, generations of economists since Adam Smith have been able to develop far-reaching conclusions about everything from taxation and health-care policies to the pricing of goods and services.

But, as you will see in this book, we are really far less rational than standard economic theory assumes. Moreover, these irrational behaviors of ours are neither random nor senseless. They are systematic, and since we repeat them again and again, predictable. So, wouldn’t it make sense to modify standard economics, to move it away from naive psychology (which often fails the tests of reason, introspection, and—most important—empirical scrutiny)? This is exactly what the emerging field of behavioral economics, and this book as a small part of that enterprise, is trying to accomplish.

AS YOU WILL see in the pages ahead, each of the chapters in this book is based on a few experiments I carried out over the years with some terrific colleagues (at the end of the book, I have included short biographies of my amazing collaborators). Why experiments? Life is complex, with multiple forces simultaneously exerting their influences on us, and this complexity makes it difficult to figure out exactly how each of these forces shapes our behavior. For social scientists, experiments are like microscopes or strobe lights. They help us slow human behavior to a frame-by-frame narration of events, isolate individual forces, and examine those forces carefully and in more detail. They let us test directly and unambiguously what makes us tick.

There is one other point I want to emphasize about experiments. If the lessons learned in any experiment were limited to the exact environment of the experiment, their value would be limited. Instead, I would like you to think about experiments as an illustration of a general principle, providing insight into how we think and how we make decisions—not only in the context of a particular experiment but, by extrapolation, in many contexts of life.

In each chapter, then, I have taken a step in extrapolating the findings from the experiments to other contexts, attempting to describe some of their possible implications for life, business, and public policy. The implications I have drawn are, of course, just a partial list.

To get real value from this, and from social science in general, it is important that you, the reader, spend some time thinking about how the principles of human behavior identified in the experiments apply to your life. My suggestion to you is to pause at the end of each chapter and consider whether the principles revealed in the experiments might make your life better or worse, and more importantly what you could do differently, given your new understanding of human nature. This is where the real adventure lies.

And now for the journey.

CHAPTER 1

The Truth about Relativity

Why Everything Is Relative—Even

When It Shouldn’t Be

One day while browsing the World Wide Web (obviously for work—not just wasting time), I stumbled on the following ad, on the Web site of a magazine, the Economist.

I read these offers one at a time. The first offer—the Internet subscription for $59—seemed reasonable. The second option—the $125 print subscription—seemed a bit expensive, but still reasonable.

But then I read the third option: a print and Internet subscription for $125. I read it twice before my eye ran back to the previous options. Who would want to buy the print option alone, I wondered, when both the Internet and the print subscriptions were offered for the same price? Now, the print-only option may have been a typographical error, but I suspect that the clever people at the Economist’s London offices (and they are clever—and quite mischievous in a British sort of way) were actually manipulating me. I am pretty certain that they wanted me to skip the Internet-only option (which they assumed would be my choice, since I was reading the advertisement on the Web) and jump to the more expensive option: Internet and print.

But how could they manipulate me? I suspect it’s because the Economist’s marketing wizards (and I could just picture them in their school ties and blazers) knew something important about human behavior: humans rarely choose things in absolute terms. We don’t have an internal value meter that tells us how much things are worth. Rather, we focus on the relative advantage of one thing over another, and estimate value accordingly. (For instance, we don’t know how much a six-cylinder car is worth, but we can assume it’s more expensive than the four-cylinder model.)

In the case of the Economist, I may not have known whether the Internet-only subscription at $59 was a better deal than the print-only option at $125. But I certainly knew that the print-and-Internet option for $125 was better than the print-only option at $125. In fact, you could reasonably deduce that in the combination package, the Internet subscription is FREE! “It’s a bloody steal—go for it, governor!” I could almost hear them shout from the riverbanks of the Thames. And I have to admit, if I had been inclined to subscribe I probably would have taken the package deal myself. (Later, when I tested the offer on a large number of participants, the vast majority preferred the Internet-and-print deal.)

So what was going on here? Let me start with a fundamental observation: most people don’t know what they want unless they see it in context. We don’t know what kind of racing bike we want—until we see a champ in the Tour de France ratcheting the gears on a particular model. We don’t know what kind of speaker system we like—until we hear a set of speakers that sounds better than the previous one. We don’t even know what we want to do with our lives—until we find a relative or a friend who is doing just what we think we should be doing. Everything is relative, and that’s the point. Like an airplane pilot landing in the dark, we want runway lights on either side of us, guiding us to the place where we can touch down our wheels.

In the case of the Economist, the decision between the Internet-only and print-only options would take a bit of thinking. Thinking is difficult and sometimes unpleasant. So the Economist’s marketers offered us a no-brainer: relative to the print-only option, the print-and-Internet option looks clearly superior.

The geniuses at the Economist aren’t the only ones who understand the importance of relativity. Take Sam, the television salesman. He plays the same general type of trick on us when he decides which televisions to put together on display:

36-inch Panasonic for $690

42-inch Toshiba for $850

50-inch Philips for $1,480

Which one would you choose? In this case, Sam knows that customers find it difficult to compute the value of different options. (Who really knows if the Panasonic at $690 is a better deal than the Philips at $1,480?) But Sam also knows that given three choices, most people will take the middle choice (as in landing your plane between the runway lights). So guess which television Sam prices as the middle option? That’s right—the one he wants to sell!

Of course, Sam is not alone in his cleverness. The New York Times ran a story recently about Gregg Rapp, a restaurant consultant, who gets paid to work out the pricing for menus. He knows, for instance, how lamb sold this year as opposed to last year; whether lamb did better paired with squash or with risotto; and whether orders decreased when the price of the main course was hiked from $39 to $41.

One thing Rapp has learned is that high-priced entrées on the menu boost revenue for the restaurant—even if no one buys them. Why? Because even though people generally won’t buy the most expensive dish on the menu, they will order the second most expensive dish. Thus, by creating an expensive dish, a restaurateur can lure customers into ordering the second most expensive choice (which can be cleverly engineered to deliver a higher profit margin).¹

SO LET’S RUN through the Economist’s sleight of hand in slow motion.

As you recall, the choices were:

1. Internet-only subscription for $59.

2. Print-only subscription for $125.

3. Print-and-Internet subscription for $125.

When I gave these options to 100 students at MIT’s Sloan School of Management, they opted as follows:

1. Internet-only subscription for $59—16 students

2. Print-only subscription for $125—zero students

3. Print-and-Internet subscription for $125—84 students

So far these Sloan MBAs are smart cookies. They all saw the advantage in the print-and-Internet offer over the print-only offer. But were they influenced by the mere presence of the print-only option (which I will henceforth, and for good reason, call the “decoy”). In other words, suppose that I removed the decoy so that the choices would be the ones seen in the figure below:

Would the students respond as before (16 for the Internet only and 84 for the combination)?

Certainly they would react the same way, wouldn’t they? After all, the option I took out was one that no one selected, so it should make no difference. Right?

Au contraire! This time, 68 of the students chose the Internet-only option for $59, up from 16 before. And only 32 chose the combination subscription for $125, down from 84 before.*

What could have possibly changed their minds? Nothing rational, I assure you. It was the mere presence of the decoy that sent 84 of them to the print-and-Internet option (and 16 to the Internet-only option). And the absence of the decoy had them choosing differently, with 32 for print-and-Internet and 68 for Internet-only.

This is not only irrational but predictably irrational as well. Why? I’m glad you asked.

LET ME OFFER you this visual demonstration of relativity.

As you can see, the middle circle can’t seem to stay the same size. When placed among the larger circles, it gets smaller. When placed among the smaller circles, it grows bigger. The middle circle is the same size in both positions, of course, but it appears to change depending on what we place next to it.

This might be a mere curiosity, but for the fact that it mirrors the way the mind is wired: we are always looking at the things around us in relation to others. We can’t help it. This holds true not only for physical things—toasters, bicycles, puppies, restaurant entrées, and spouses—but for experiences such as vacations and educational options, and for ephemeral things as well: emotions, attitudes, and points of view.

We always compare jobs with jobs, vacations with vacations, lovers with lovers, and wines with wines. All this relativity reminds me of a line from the film Crocodile Dundee, when a street hoodlum pulls a switchblade against our hero, Paul Hogan. “You call that a knife?” says Hogan incredulously, withdrawing a bowie blade from the back of his boot. “Now this,” he says with a sly grin, “is a knife.”

RELATIVITY IS (RELATIVELY) easy to understand. But there’s one aspect of relativity that consistently trips us up. It’s this: we not only tend to compare things with one another but also tend to focus on comparing things that are easily comparable—and avoid comparing things that cannot be compared easily.

That may be a confusing thought, so let me give you an example. Suppose you’re shopping for a house in a new town. Your real estate agent guides you to three houses, all of which interest you. One of them is a contemporary, and two are colonials. All three cost about the same; they are all equally desirable; and the only difference is that one of the colonials (the “decoy”) needs a new roof and the owner has knocked a few thousand dollars off the price to cover the additional expense.

So which one will you choose?

The chances are good that you will not choose the contemporary and you will not choose the colonial that needs the new roof, but you will choose the other colonial. Why? Here’s the rationale (which is actually quite irrational). We like to make decisions based on comparisons. In the case of the three houses, we don’t know much about the contemporary (we don’t have another house to compare it with), so that house goes on the sidelines. But we do know that one of the colonials is better than the other one. That is, the colonial with the good roof is better than the one with the bad roof. Therefore, we will reason that it is better overall and go for the colonial with the good roof, spurning the contemporary and the colonial that needs a new roof.

To better understand how relativity works, consider the following illustration:

In the left side of this illustration we see two options, each of which is better on a different attribute. Option (A) is better on attribute 1—let’s say quality. Option (B) is better on attribute 2—let’s say beauty. Obviously these are two very different options and the choice between them is not simple. Now consider what happens if we add another option, called (–A) (see the right side of the illustration). This option is clearly worse than option (A), but it is also very similar to it, making the comparison between them easy, and suggesting that (A) is not only better than (–A) but also better than (B).

In essence, introducing (–A), the decoy, creates a simple relative comparison with (A), and hence makes (A) look better, not just relative to (–A), but overall as well. As a consequence, the inclusion of (–A) in the set, even if no one ever selects it, makes people more likely to make (A) their final choice.

Does this selection process sound familiar? Remember the pitch put together by the Economist? The marketers there knew that we didn’t know whether we wanted an Internet subscription or a print subscription. But they figured that, of the three options, the print-and-Internet combination would be the offer we would take.

Here’s another example of the decoy effect. Suppose you are planning a honeymoon in Europe. You’ve already decided to go to one of the major romantic cities and have narrowed your choices to Rome and Paris, your two favorites. The travel agent presents you with the vacation packages for each city, which includes airfare, hotel accommodations, sightseeing tours, and a free breakfast every morning. Which would you select?

For most people, the decision between a week in Rome and a week in Paris is not effortless. Rome has the Coliseum; Paris, the Louvre. Both have a romantic ambience, fabulous food, and fashionable shopping. It’s not an easy call. But suppose you were offered a third option: Rome without the free breakfast, called -Rome or the decoy.

If you were to consider these three options (Paris, Rome, -Rome), you would immediately recognize that whereas Rome with the free breakfast is about as appealing as Paris with the free breakfast, the inferior option, which is Rome without the free breakfast, is a step down. The comparison between the clearly inferior option (-Rome) makes Rome with the free breakfast seem even better. In fact, -Rome makes Rome with the free breakfast look so good that you judge it to be even better than the difficult-to-compare option, Paris with the free breakfast.

ONCE YOU SEE the decoy effect in action, you realize that it is the secret agent in more decisions than we could imagine. It even helps us decide whom to date—and, ultimately, whom to marry. Let me describe an experiment that explored just this subject.

As students hurried around MIT one cold weekday, I asked some of them whether they would allow me to take their pictures for a study. In some cases, I got disapproving looks. A few students walked away. But most of them were happy to participate, and before long, the card in my digital camera was filled with images of smiling students. I returned to my office and printed 60 of them—30 of women and 30 of men.

The following week I made an unusual request of 25 of my undergraduates. I asked them to pair the 30 photographs of men and the 30 of women by physical attractiveness (matching the men with other men, and the women with other women). That is, I had them pair the Brad Pitts and the George Clooneys of MIT, as well as the Woody Allens and the Danny DeVitos (sorry, Woody and Danny). Out of these 30 pairs, I selected the six pairs—three female pairs and three male pairs—that my students seemed to agree were most alike.

Now, like Dr. Frankenstein himself, I set about giving these faces my special treatment. Using Photoshop, I mutated the pictures just a bit, creating a slightly but noticeably less attractive version of each of them. I found that just the slightest movement of the nose threw off the symmetry. Using another tool, I enlarged one eye, eliminated some of the hair, and added traces of acne.

No flashes of lightning illuminated my laboratory; nor was there a baying of the hounds on the moor. But this was still a good day for science. By the time I was through, I had the MIT equivalent of George Clooney in his prime (A) and the MIT equivalent of Brad Pitt in his prime (B), and also a George Clooney with a slightly drooping eye and thicker nose (–A, the decoy) and a less symmetrical version of Brad Pitt (-B, another decoy). I followed the same procedure for the less attractive pairs. I had the MIT equivalent of Woody Allen with his usual lopsided grin (A) and Woody Allen with an unnervingly misplaced eye (–A), as well as Danny DeVito (B) and a slightly disfigured version of Danny DeVito (–B).

For each of the 12 photographs, in fact, I now had a regular version as well as an inferior (–) decoy version. (See the illustration for an example of the two conditions used in the study.)

It was now time for the main part of the experiment. I took all the sets of pictures and made my way over to the student union. Approaching one student after another, I asked each to participate. When the students agreed, I handed them a sheet with three pictures (as in the illustration here). Some of them had the regular picture (A), the decoy of that picture (–A), and the other regular picture (B). Others had the regular picture (B), the decoy of that picture (–B), and the other regular picture (A).

For example, a set might include a regular Clooney (A), a decoy Clooney (–A), and a regular Pitt (B); or a regular Pitt (B), a decoy Pitt (–B), and a regular Clooney (A). After selecting a sheet with either male or female pictures, according to their preferences, I asked the students to circle the people they would pick to go on a date with, if they had a choice. All this took quite a while, and when I was done, I had distributed 600 sheets.

What was my motive in all this? Simply to determine if the existence of the distorted picture (–A or –B) would push my participants to choose the similar but undistorted picture. In other words, would a slightly less attractive George Clooney (–A) push the participants to choose the perfect George Clooney over the perfect Brad Pitt?

There were no pictures of Brad Pitt or George Clooney in my experiment, of course. Pictures (A) and (B) showed ordinary students. But do you remember how the existence of a colonial-style house needing a new roof might push you to choose a perfect colonial over a contemporary house—simply because the decoy colonial would give you something against which to compare the regular colonial? And in the Economist’s ad, didn’t the print-only option for $125 push people to take the print-and-Internet option for $125? Similarly, would the existence of a less perfect person (–A or –B) push people to choose the perfect one (A or B), simply because the decoy option served as a point of comparison?

Note: For this illustration, I used computerized faces, not those of the MIT students. And of course, the letters did not appear on the original sheets.

It did. Whenever I handed out a sheet that had a regular picture, its inferior version, and another regular picture, the participants said they would prefer to date the “regular” person—the one who was similar, but clearly superior, to the distorted version—over the other, undistorted person on the sheet. This was not just a close call—it happened 75 percent of the time.

To explain the decoy effect further, let me tell you something about bread-making machines. When Williams-Sonoma first introduced a home “bread bakery” machine (for $275), most consumers were not interested. What was a home bread-making machine, anyway? Was it good or bad? Did one really need home-baked bread? Why not just buy a fancy coffeemaker sitting nearby instead? Flustered by poor sales, the manufacturer of the bread machine brought in a marketing research firm, which suggested a fix: introduce an additional model of the bread maker, one that was not only larger but priced about 50 percent higher than the initial machine.

Now sales began to rise (along with many loaves of bread), though it was not the large bread maker that was being sold. Why? Simply because consumers now had two models of bread makers to choose from. Since one was clearly larger and much more expensive than the other, people didn’t have to make their decision in a vacuum. They could say: “Well, I don’t know much about bread makers, but I do know that if I were to buy one, I’d rather have the smaller one for less money.” And that’s when bread makers began to fly off the shelves.²

OK for bread makers. But let’s take a look at the decoy effect in a completely different situation. What if you are single, and hope to appeal to as many attractive potential dating partners as possible at an upcoming singles event? My advice would be to bring a friend who has your basic physical characteristics (similar coloring, body type, facial features), but is slightly less attractive (–you).

Why? Because the folks you want to attract will have a hard time evaluating you with no comparables around. However, if you are compared with a “–you,” the decoy friend will do a lot to make you look better, not just in comparison with the decoy but also in general, and in comparison with all the other people around. It may sound irrational (and I can’t guarantee this), but the chances are good that you will get some extra attention. Of course, don’t just stop at looks. If great conversation will win the day, be sure to pick a friend for the singles event who can’t match your smooth delivery and rapier wit. By comparison, you’ll sound great.

Now that you know this secret, be careful: when a similar but better-looking friend of the same sex asks you to accompany him or her for a night out, you might wonder whether you have been invited along for your company or merely as a decoy.

RELATIVITY HELPS US make decisions in life. But it can also make us downright miserable. Why? Because jealousy and envy spring from comparing our lot in life with that of others.

It was for good reason, after all, that the Ten Commandments admonished, “Neither shall you desire your neighbor’s house nor field, or male or female slave, or donkey or anything that belongs to your neighbor.” This might just be the toughest commandment to follow, considering that by our very nature we are wired to compare.

Modern life makes this weakness even more pronounced. A few years ago, for instance, I met with one of the top executives of one of the big investment companies. Over the course of our conversation he mentioned that one of his employees had recently come to him to complain about his salary.

“How long have you been with the firm?” the executive asked the young man.

“Three years. I came straight from college,” was the answer.

“And when you joined us, how much did you expect to be making in three years?”

“I was hoping to be making about a hundred thousand.”

The executive eyed him curiously.

“And now you are making almost three hundred thousand, so how can you possibly complain?” he asked.

“Well,” the young man stammered, “it’s just that a couple of the guys at the desks next to me, they’re not any better than I am, and they are making three hundred ten.”

The executive shook his head.

An ironic aspect of this story is that in 1993, federal securities regulators forced companies, for the first time, to reveal details about the pay and perks of their top executives. The idea was that once pay was in the open, boards would be reluctant to give executives outrageous salaries and benefits. This, it was hoped, would stop the rise in executive compensation, which neither regulation, legislation, nor shareholder pressure had been able to stop. And indeed, it needed to stop: in 1976 the average CEO was paid 36 times as much as the average worker. By 1993, the average CEO was paid 131 times as much.

But guess what happened. Once salaries became public information, the media regularly ran special stories ranking CEOs by pay. Rather than suppressing the executive perks, the publicity had CEOs in America comparing their pay with that of everyone else. In response, executives’ salaries skyrocketed. The trend was further “helped” by compensation consulting firms (scathingly dubbed “Ratchet, Ratchet, and Bingo” by the investor Warren Buffett) that advised their CEO clients to demand outrageous raises. The result? Now the average CEO makes about 369 times as much as the average worker—about three times the salary before executive compensation went public.

Keeping that in mind, I had a few questions for the executive I met with.

“What would happen,” I ventured, “if the information in your salary database became known throughout the company?”

The executive looked at me with alarm. “We could get over a lot of things here—insider trading, financial scandals, and the like—but if everyone knew everyone else’s salary, it would be a true catastrophe. All but the highest-paid individual would feel underpaid—and I wouldn’t be surprised if they went out and looked for another job.”

Isn’t this odd? It has been shown repeatedly that the link between amount of salary and happiness is not as strong as one would expect it to be (in fact, it is rather weak). Studies even find that countries with the “happiest” people are not among those with the highest personal income. Yet we keep pushing toward a higher salary. Much of that can be blamed on sheer envy. As H. L. Mencken, the twentieth-century journalist, satirist, social critic, cynic, and freethinker noted, a man’s satisfaction with his salary depends on (are you ready for this?) whether he makes more than his wife’s sister’s husband. Why the wife’s sister’s husband? Because (and I have a feeling that Mencken’s wife kept him fully informed of her sister’s husband’s salary) this is a comparison that is salient and readily available.*

All this extravagance in CEOs’ pay has had a damaging effect on society. Instead of causing shame, every new outrage in compensation encourages other CEOs to demand even more. “In the Web World,” according to a headline in the New York Times, the “Rich Now Envy the Superrich.”

In another news story, a physician explained that he had graduated from Harvard with the dream of someday receiving a Nobel Prize for cancer research. This was his goal. This was his dream. But a few years later, he realized that several of his colleagues were making more as medical investment advisers at Wall Street firms than he was making in medicine. He had previously been happy with his income, but hearing of his friends’ yachts and vacation homes, he suddenly felt very poor. So he took another route with his career—the route of Wall Street.³ By the time he arrived at his twentieth class reunion, he was making 10 times what most of his peers were making in medicine. You can almost see him, standing in the middle of the room at the reunion, drink in hand—a large circle of influence with smaller circles gathering around him. He had not won the Nobel Prize, but he had relinquished his dreams for a Wall Street salary, for a chance to stop feeling “poor.” Is it any wonder that family practice physicians, who make an average of $160,000 a year, are in short supply?*

CAN WE DO anything about this problem of relativity?

The good news is that we can sometimes control the “circles” around us, moving toward smaller circles that boost our relative happiness. If we are at our class reunion, and there’s a “big circle” in the middle of the room with a drink in his hand, boasting of his big salary, we can consciously take several steps away and talk with someone else. If we are thinking of buying a new house, we can be selective about the open houses we go to, skipping the houses that are above our means. If we are thinking about buying a new car, we can focus on the models that we can afford, and so on.

We can also change our focus from narrow to broad. Let me explain with an example from a study conducted by two brilliant researchers, Amos Tversky and Daniel Kahneman. Suppose you have two errands to run today. The first is to buy a new pen, and the second is to buy a suit for work. At an office supply store, you find a nice pen for $25. You are set to buy it, when you remember that the same pen is on sale for $18 at another store 15 minutes away. What would you do? Do you decide to take the 15-minute trip to save the $7? Most people faced with this dilemma say that they would take the trip to save the $7.

Now you are on your second task: you’re shopping for your suit. You find a luxurious gray pinstripe suit for $455 and decide to buy it, but then another customer whispers in your ear that the exact same suit is on sale for only $448 at another store, just 15 minutes away. Do you make this second 15-minute trip? In this case, most people say that they would not.

But what is going on here? Is 15 minutes of your time worth $7, or isn’t it? In reality, of course, $7 is $7—no matter how you count it. The only question you should ask yourself in these cases is whether the trip across town, and the 15 extra minutes it would take, is worth the extra $7 you would save. Whether the amount from which this $7 will be saved is $10 or $10,000 should be irrelevant.

This is the problem of relativity—we look at our decisions in a relative way and compare them locally to the available alternative. We compare the relative advantage of the cheap pen with the expensive one, and this contrast makes it obvious to us that we should spend the extra time to save the $7. At the same time, the relative advantage of the cheaper suit is very small, so we spend the extra $7.

This is also why it is so easy for a person to add $200 to a $5,000 catering bill for a soup entrée, when the same person will clip coupons to save 25 cents on a one-dollar can of condensed soup. Similarly, we find it easy to spend $3,000 to upgrade to leather seats when we buy a new $25,000 car, but difficult to spend the same amount on a new leather sofa (even though we know we will spend more time at home on the sofa than in the car). Yet if we just thought about this in a broader perspective, we could better assess what we could do with the $3,000 that we are considering spending on upgrading the car seats. Would we perhaps be better off spending it on books, clothes, or a vacation? Thinking broadly like this is not easy, because making relative judgments is the natural way we think. Can you get a handle on it? I know someone who can.

He is James Hong, cofounder of the Hotornot.com rating and dating site. (James, his business partner Jim Young, Leonard Lee, George Loewenstein, and I recently worked on a research project examining how one’s own “attractiveness” affects one’s view of the “attractiveness” of others.)

For sure, James has made a lot of money, and he sees even more money all around him. One of his good friends, in fact, is a founder of PayPal and is worth tens of millions. But Hong knows how to make the circles of comparison in his life smaller, not larger. In his case, he started by selling his Porsche Boxster and buying a Toyota Prius in its place.⁴

“I don’t want to live the life of a Boxster,” he told the New York Times, “because when you get a Boxster you wish you had a 911, and you know what people who have 911s wish they had? They wish they had a Ferrari.”

That’s a lesson we can all learn: the more we have, the more we want. And the only cure is to break the cycle of relativity.

Reflections on Dating and Relativity

In Chapter 1, on relativity, I offered some dating advice. I proposed that if you want to go bar-hopping, you should consider taking along someone who looks similar to you but who is slightly less attractive than you are. Because of the relative nature of evaluations, others would perceive you not only as cuter than your decoy, but also as better-looking than other people in the bar. By the same logic, I also pointed out that the flip side of this coin is that if someone invites you to be his or her wingman (or wingwoman), you can easily figure out what your friend really thinks of you. As it turns out, I forgot to include one important warning that came courtesy of the daughter of a colleague of mine from MIT.

“Susan” was an undergraduate at Cornell who wrote to me, saying she was delighted with my trick and that it had worked wonderfully for her. Once she found the ideal decoy, her social life improved. But a few weeks later she wrote again, telling me that she’d been at a party where she’d had a few drinks. For some odd reason, she decided to tell her friend why she invited her to accompany her everywhere. The friend was understandably upset, and the story did not end well.

The moral of this story? Never, ever tell your friend why you’re asking him or her to come with you. Your friend might have suspicions, but for the love of God, don’t eliminate all doubt.

Reflections on Traveling and Relativity

When Predictably Irrational came out, I went on a book tour that lasted six straight weeks. I traveled from airport to airport, city to city, radio station to radio station, talking to reporters and readers for what seemed like days on end, without engaging in any type of personal discussion. Every conversation was short, “all business,” and focused on my research. There was no time to enjoy a cup of coffee or a beer with any of the wonderful people I encountered.

Toward the end of the tour I found myself in Barcelona. There I met Jon, an American tourist who, like me, did not speak any Spanish. We felt an immediate camaraderie. I imagine this kind of bonding happens often with travelers from the same country who are far from home and find themselves sharing observations about how they differ from the locals around them. Jon and I ended up having a wonderful dinner and a deeply personal discussion. He told me things that he seemed not to have shared before, and I did the same. There was an unusual closeness between us, as if we were long-lost brothers. After staying up very late talking, we both needed to sleep. We would not have a chance to meet again before parting ways the following morning, so we exchanged e-mail addresses. This was a mistake.

About six months later, Jon and I met again for lunch in New York. This time, it was hard for me to figure out why I’d felt such a connection with him, and no doubt he felt the same. We had a perfectly amicable and interesting lunch, but it lacked the intensity of our first meeting, and I was left wondering why.

In retrospect, I think it was because I’d fallen victim to the effects of relativity. When Jon and I first met, everyone around us was Spanish, and as cultural outsiders we were each other’s best alternative for companionship. But once we returned home to our beloved American families and friends, the basis for comparison switched back to “normal” mode. Given this situation, it was hard to understand why Jon or I would want to spend another evening in each other’s company rather than with those we love.

My advice? Understand that relativity is everywhere, and that we view everything through its lens—rose-colored or otherwise. When you meet someone in a different country or city and it seems that you have a magical connection, realize that the enchantment might be limited to the surrounding circumstances. This realization might prevent you from subsequent disenchantment.

CHAPTER 2

The Fallacy of Supply and Demand

Why the Price of Pearls—and Everything Else—

Is Up in the Air

At the onset of World War II, an Italian diamond dealer, James Assael, fled Europe for Cuba. There, he found a new livelihood: the American army needed waterproof watches, and Assael, through his contacts in Switzerland, was able to fill the demand.

When the war ended, Assael’s deal with the U.S. government dried up, and he was left with thousands of Swiss watches. The Japanese needed watches, of course. But they didn’t have any money. They did have pearls, though—many thousands of them. Before long, Assael had taught his son how to barter Swiss watches for Japanese pearls. The business blossomed, and shortly thereafter, the son, Salvador Assael, became known as the “pearl king.”

The pearl king had moored his yacht at Saint-Tropez one day in 1973, when a dashing young Frenchman, Jean-Claude Brouillet, came aboard from an adjacent yacht. Brouillet had just sold his air-freight business and with the proceeds had purchased an atoll in French Polynesia—a blue-lagooned paradise for himself and his young Tahitian wife. Brouillet explained that its turquoise waters abounded with black-lipped oysters, Pinctada margaritifera. And from the black lips of those oysters came something of note: black pearls.

At the time there was no market for Tahitian black pearls, and little demand. But Brouillet persuaded Assael to go into business with him. Together they would harvest black pearls and sell them to the world. At first, Assael’s marketing efforts failed. The pearls were gunmetal gray, about the size of musket balls, and he returned to Polynesia without having made a single sale. Assael could have dropped the black pearls altogether or sold them at a low price to a discount store. He could have tried to push them to consumers by bundling them together with a few white pearls. But instead Assael waited a year, until the operation had produced some better specimens, and then brought them to an old friend, Harry Winston, the legendary gemstone dealer. Winston agreed to put them in the window of his store on Fifth Avenue, with an outrageously high price tag attached. Assael, meanwhile, commissioned a full-page advertisement that ran in the glossiest of magazines. There, a string of Tahitian black pearls glowed, set among a spray of diamonds, rubies, and emeralds.

The pearls, which had shortly before been the private business of a cluster of black-lipped oysters, hanging on a rope in the Polynesian sea, were soon parading through Manhattan on the arched necks of the city’s most prosperous divas. Assael had taken something of dubious worth and made it fabulously fine. Or, as Mark Twain once noted about Tom Sawyer, “Tom had discovered a great law of human action, namely, that in order to make a man covet a thing, it is only necessary to make the thing difficult to attain.”

HOW DID THE pearl king do it? How did he persuade the cream of society to become passionate about Tahitian black pearls—and pay him royally for them? In order to answer this question, I need to explain something about baby geese.

A few decades ago, the naturalist Konrad Lorenz discovered that goslings, upon breaking out of their eggs, become attached to the first moving object they encounter (which is generally their mother). Lorenz knew this because in one experiment he became the first thing they saw, and they followed him loyally from then on through adolescence. With that, Lorenz demonstrated not only that goslings make initial decisions based on what’s available in their environment, but that they stick with a decision once it has been made. Lorenz called this natural phenomenon imprinting.

Is the human brain, then, wired like that of a gosling? Do our first impressions and decisions become imprinted? And if so, how does this imprinting play out in our lives? When we encounter a new product, for instance, do we accept the first price that comes before our eyes? And more importantly, does that price (which in academic lingo we call an anchor) have a long-term effect on our willingness to pay for the product from then on?

It seems that what’s good for the goose is good for humans as well. And this includes anchoring. From the beginning, for instance, Assael “anchored” his pearls to the finest gems in the world—and the prices followed forever after. Similarly, once we buy a new product at a particular price, we become anchored to that price. But how exactly does this work? Why do we accept anchors?

Consider this: if I asked you for the last two digits of your social security number (mine are 79), then asked you whether you would pay this number in dollars (for me this would be $79) for a particular bottle of Côtes du Rhône 1998, would the mere suggestion of that number influence how much you would be willing to spend on wine? Sounds preposterous, doesn’t it? Well, wait until you see what happened to a group of MBA students at MIT a few years ago.

“NOW HERE WE have a nice Côtes du Rhône Jaboulet Parallel,” said Drazen Prelec, a professor at MIT’s Sloan School of Management, as he lifted a bottle admiringly. “It’s a 1998.”

At the time, sitting before him were the 55 students from his marketing research class. On this day, Drazen, George Loewenstein (a professor at Carnegie Mellon University), and I would have an unusual request for this group of future marketing pros. We would ask them to jot down the last two digits of their social security numbers and tell us whether they would pay this amount for a number of products, including the bottle of wine. Then, we would ask them to actually bid on these items in an auction.

What were we trying to prove? The existence of what we called arbitrary coherence. The basic idea of arbitrary coherence is this: although initial prices (such as the price of Assael’s pearls) are “arbitrary,” once those prices are established in our minds they will shape not only present prices but also future prices (this makes them “coherent”). So, would thinking about one’s social security number be enough to create an anchor? And would that initial anchor have a long-term influence? That’s what we wanted to see.

“For those of you who don’t know much about wines,” Drazen continued, “this bottle received eighty-six points from Wine Spectator. It has the flavor of red berry, mocha, and black chocolate; it’s a medium-bodied, medium-intensity, nicely balanced red, and it makes for delightful drinking.”

Drazen held up another bottle. This was a Hermitage Jaboulet La Chapelle, 1996, with a 92-point rating from the Wine Advocate magazine. “The finest La Chapelle since 1990,” Drazen intoned, while the students looked up curiously. “Only 8,100 cases made . . .”

In turn, Drazen held up four other items: a cordless trackball (TrackMan Marble FX by Logitech); a cordless keyboard and mouse (iTouch by Logitech); a design book (The Perfect Package: How to Add Value through Graphic Design); and a one-pound box of Belgian chocolates by Neuhaus.

Drazen passed out forms that listed all the items. “Now I want you to write the last two digits of your social security number at the top of the page,” he instructed. “And then write them again next to each of the items in the form of a price. In other words, if the last two digits are twenty-three, write twenty-three dollars.”

“Now when you’re finished with that,” he added, “I want you to indicate on your sheets—with a simple yes or no—whether you would pay that amount for each of the products.”

When the students had finished answering yes or no to each item, Drazen asked them to write down the maximum amount they were willing to pay for each of the products (their bids). Once they had written down their bids, the students passed the sheets up to me and I entered their responses into my laptop and announced the winners. One by one the student who had made the highest bid for each of the products would step up to the front of the class, pay for the product,* and take it with them.

The students enjoyed this class exercise, but when I asked them if they felt that writing down the last two digits of their social security numbers had influenced their final bids, they quickly dismissed my suggestion. No way!

When I got back to my office, I analyzed the data. Did the digits from the social security numbers serve as anchors? Remarkably, they did: the students with the highest-ending social security digits (from 80 to 99) bid highest, while those with the lowest-ending numbers (1 to 20) bid lowest. The top 20 percent, for instance, bid an average of $56 for the cordless keyboard; the bottom 20 percent bid an average of $16. In the end, we could see that students with social security numbers ending in the upper 20 percent placed bids that were 216 to 346 percent higher than those of the students with social security numbers ending in the lowest 20 percent (see table on the facing page).

Now if the last two digits of your social security number are a high number I know what you must be thinking: “I’ve been paying too much for everything my entire life!” This is not the case, however. Social security numbers were the anchor in this experiment only because we requested them. We could have just as well asked for the current temperature or the manufacturer’s suggested retail price (MSRP). Any question, in fact, would have created the anchor. Does that seem rational? Of course not. But that’s the way we are—goslings, after all.*

The data had one more interesting aspect. Although the willingness to pay for these items was arbitrary, there was also a logical, coherent aspect to it. When we looked at the bids for the two pairs of related items (the two wines and the two computer components), their relative prices seemed incredibly logical. Everyone was willing to pay more for the keyboard than for the trackball—and also pay more for the 1996 Hermitage than for the 1998 Côtes du Rhône. The significance of this is that once the participants were willing to pay a certain price for one product, their willingness to pay for other items in the same product category was judged relative to that first price (the anchor).

This, then, is what we call arbitrary coherence. Initial prices are largely “arbitrary” and can be influenced by responses to random questions; but once those prices are established in our minds, they shape not only what we are willing to pay for an item, but also how much we are willing to pay for related products (this makes them coherent).

Now I need to add one important clarification to the story I’ve just told. In life we are bombarded by prices. We see the manufacturer’s suggested retail price (MSRP) for cars, lawn mowers, and coffeemakers. We get the real estate agent’s spiel on local housing prices. But price tags by themselves are not necessarily anchors. They become anchors when we contemplate buying a product or service at that particular price. That’s when the imprint is set. From then on, we are willing to accept a range of prices—but as with the pull of a bungee cord, we always refer back to the original anchor. Thus the first anchor influences not only the immediate buying decision but many others that follow.

We might see a 57-inch LCD high-definition television on sale for $3,000, for instance. The price tag is not the anchor. But if we decide to buy it (or seriously contemplate buying it) at that price, then the decision becomes our anchor henceforth in terms of LCD television sets. That’s our peg in the ground, and from then on—whether we shop for another set or merely have a conversation at a backyard cookout—all other high-definition televisions are judged relative to that price.

Anchoring influences all kinds of purchases. Uri Simonsohn (a professor at the University of Pennsylvania) and George Loewenstein, for example, found that people who move to a new city generally remain anchored to the prices they paid for housing in their former city. In their study they found that people who move from inexpensive markets (say, Lubbock, Texas) to moderately priced cities (say, Pittsburgh) don’t increase their spending to fit the new market.* Rather, these people spend an amount similar to what they were used to in the previous market, even if this means having to squeeze themselves and their families into smaller or less comfortable homes. Likewise, transplants from more expensive cities sink the same dollars into their new housing situation as they did in the past. People who move from Los Angeles to Pittsburgh, in other words, don’t generally downsize their spending much once they hit Pennsylvania: they spend an amount similar to what they used to spend in Los Angeles.

It seems that we get used to the particularities of our housing markets and don’t readily change. The only way out of this box, in fact, is to rent a home in the new location for a year or so. That way, we adjust to the new environment—and, after a while, we are able to make a purchase that aligns with the local market.

SO WE ANCHOR ourselves to initial prices. But do we hop from one anchor price to another (flip-flopping, if you will), continually changing our willingness to pay? Or does the first anchor we encounter become our anchor for a long time and for many decisions? To answer this question, we decided to conduct another experiment—one in which we attempted to lure our participants from old anchors to new ones.

For this experiment we enlisted some undergraduate students, some graduate students, and some investment bankers who had come to the campus to recruit new employees for their firms. Once the experiment started we presented our participants with three different sounds, and following each, asked them if they would be willing to get paid a particular amount of money (which served as the price anchor) for hearing those sounds again. One sound was a 30-second high-pitched 3,000-hertz sound, somewhat like someone screaming in a high-pitched voice. Another was a 30-second full-spectrum noise (also called white noise), which is similar to the noise a television set makes when there is no reception. The third was a 30-second oscillation between high-pitched and low-pitched sounds. (I am not sure if the bankers understood exactly what they were about to experience, but maybe even our annoying sounds were less annoying than talking about investment banking.)

We used sounds because there is no existing market for annoying sounds (so the participants couldn’t use a market price as a way to think about the value of these sounds). We also used annoying sounds, specifically, because no one likes such sounds (if we had used classical music, some would have liked it better than others). As for the sounds themselves, I selected them after creating hundreds of sounds, choosing these three because they were, in my opinion, equally annoying.

We placed our participants in front of computer screens at the lab, and had them clamp headphones over their ears.

As the room quieted down, the first group saw this message appear in front of them: “In a few moments we are going to play a new unpleasant tone over your headset. We are interested in how annoying you find it. Immediately after you hear the tone, we will ask you whether, hypothetically, you would be willing to repeat the same experience in exchange for a payment of 10 cents.” The second group got the same message, only with an offer of 90 cents rather than 10 cents.

Would the anchor prices make a difference? To find out, we turned on the sound—in this case the irritating 30-second, 3,000-hertz squeal. Some of our participants grimaced. Others rolled their eyes.

When the screeching ended, each participant was presented with the anchoring question, phrased as a hypothetical choice: Would the participant be willing, hypothetically, to repeat the experience for a cash payment (which was 10 cents for the first group and 90 cents for the second group)? After answering this anchoring question, the participants were asked to indicate on the computer screen the lowest price they would demand to listen to the sound again. This decision was real, by the way, as it would determine whether they would hear the sound again—and get paid for doing so.*

Soon after the participants entered their prices, they learned the outcome. Participants whose price was sufficiently low “won” the sound, had the (unpleasant) opportunity to hear it again, and got paid for doing so. The participants whose price was too high did not listen to the sound and were not paid for this part of the experiment.

What was the point of all this? We wanted to find out whether the first prices that we suggested (10 cents and 90 cents) had served as an anchor. And indeed they had. Those who first faced the hypothetical decision about whether to listen to the sound for 10 cents needed much less money to be willing to listen to this sound again (33 cents on average) relative to those who first faced the hypothetical decision about whether to listen to the sound for 90 cents—this second group demanded more than twice the compensation (73 cents on average) for the same annoying experience. Do you see the difference that the suggested price had?

BUT THIS WAS only the start of our exploration. We also wanted to know how influential the anchor would be in future decisions. Suppose we gave the participants an opportunity to drop this anchor and run for another? Would they do it? To put it in terms of goslings, would they swim across the pond after their original imprint and then, midway, swing their allegiance to a new mother goose? In terms of goslings, I think you know that they would stick with the original mom. But what about humans? The next two phases of the experiment would enable us to answer these questions.

In the second phase of the experiment, we took participants from the previous 10-cents and 90-cents groups and treated them to 30 seconds of a white, wooshing noise. “Hypothetically, would you listen to this sound again for 50 cents?” we asked them at the end. The respondents pressed a button on their computers to indicate yes or no.

“OK, how much would you need to be paid for this?” we asked. Our participants typed in their lowest price; the computer did its thing; and, depending on their bids, some participants listened to the sound again and got paid and some did not. When we compared the prices, the 10-cents group offered much lower bids than the 90-cents group. This means that although both groups had been equally exposed to the suggested 50 cents, as their focal anchoring response (to “Hypothetically, would you listen to this sound again for 50 cents?”), the first anchor in this annoying sound category (which was 10 cents for some and 90 cents for others) predominated.

Why? Perhaps the participants in the 10-cents group said something like the following to themselves: “Well, I listened previously to that annoying sound for a low amount. This sound is not much different. So if I said a low amount for the previous one, I guess I could bear this sound for about the same price.” Those who were in the 90-cents group used the same type of logic, but because their starting point was different, so was their ending point. These individuals told themselves, “Well, I listened previously to that annoying sound for a high amount. This sound is not much different. So since I said a high amount for the previous one, I guess I could bear this sound for about the same price.” Indeed, the effect of the first anchor held—indicating that anchors have an enduring effect for present prices as well as for future prices.

There was one more step to this experiment. This time we had our participants listen to the oscillating sound that rose and fell in pitch for 30 seconds. We asked our 10-cents group, “Hypothetically, would you listen to this sound again for 90 cents?” Then we asked our 90-cents group, “Would you listen to this sound again for 10 cents?” Having flipped our anchors, we would now see which one, the local anchor or the first anchor, exerted the greatest influence.

Once again, the participants typed in yes or no. Then we asked them for real bids: “How much would it take for you to listen to this again?” At this point, they had a history with three anchors: the first one they encountered in the experiment (either 10 cents or 90 cents), the second one (50 cents), and the most recent one (either 90 cents or 10 cents). Which one of these would have the largest influence on the price they demanded to listen to the sound?

Again, it was as if our participants’ minds told them, “If I listened to the first sound for x cents, and listened to the second sound for x cents as well, then I can surely do this one for x cents, too!” And that’s what they did. Those who had first encountered the 10-cent anchor accepted low prices, even after 90 cents was suggested as the anchor. On the other hand, those who had first encountered the 90-cent anchor kept on demanding much higher prices, regardless of the anchors that followed.

What did we show? That our first decisions resonate over a long sequence of decisions. First impressions are important, whether they involve remembering that our first DVD player cost much more than such players cost today (and realizing that, in comparison, the current prices are a steal) or remembering that gas was once a dollar a gallon, which makes every trip to the gas station a painful experience. In all these cases the random, and not so random, anchors that we encountered along the way and were swayed by remain with us long after the initial decision itself.

NOW THAT WE know we behave like goslings, it is important to understand the process by which our first decisions translate into long-term habits. To illustrate this process, consider this example. You’re walking past a restaurant, and you see two people standing in line, waiting to get in. “This must be a good restaurant,” you think to yourself. “People are standing in line.” So you stand behind these people. Another person walks by. He sees three people standing in line and thinks, “This must be a fantastic restaurant,” and joins the line. Others join. We call this type of behavior herding. It happens when we assume that something is good (or bad) on the basis of other people’s previous behavior, and our own actions follow suit.

But there’s also another kind of herding, one that we call self-herding. This happens when we believe something is good (or bad) on the basis of our own previous behavior. Essentially, once we become the first person in line at the restaurant, we begin to line up behind ourself in subsequent experiences. Does that make sense? Let me explain.

Recall your first introduction to Starbucks, perhaps several years ago. (I assume that nearly everyone has had this experience, since Starbucks sits on every corner in America.) You are sleepy and in desperate need of a liquid energy boost as you embark on an errand one afternoon. You glance through the windows at Starbucks and walk in. The prices of the coffee are a shock—you’ve been blissfully drinking the brew at Dunkin’ Donuts for years. But since you have walked in and are now curious about what coffee at this price might taste like, you surprise yourself: you buy a small coffee, enjoy its taste and its effect on you, and walk out.

The following week you walk by Starbucks again. Should you go in? The ideal decision-making process should take into account the quality of the coffee (Starbucks versus Dunkin’ Donuts); the prices at the two places; and, of course, the cost (or value) of walking a few more blocks to get to Dunkin’ Donuts. This is a complex computation—so instead, you resort to the simple approach: “I went to Starbucks before, and I enjoyed myself and the coffee, so this must be a good decision for me.” So you walk in and get another small cup of coffee.

In doing so, you just became the second person in line, standing behind yourself. A few days later, you again walk by Starbucks and this time, you vividly remember your past decisions and act on them again—voilà! You become the third person in line, standing behind yourself. As the weeks pass, you enter again and again and every time, you feel more strongly that you are acting on the basis of your preferences. Buying coffee at Starbucks has become a habit with you.

BUT THE STORY doesn’t end there. Now that you have gotten used to paying more for coffee, and have bumped yourself up onto a new curve of consumption, other changes also become simpler. Perhaps you will now move up from the small cup for $2.20 to the medium size for $3.50 or to the Venti for $4.15. Even though you don’t know how you got into this price bracket in the first place, moving to a larger coffee at a relatively greater price seems pretty logical. So is a lateral move to other offerings at Starbucks: Caffè Americano, Caffè Misto, Macchiato, and Frappuccino, for instance.

If you stopped to think about this, it would not be clear whether you should be spending all this money on coffee at Starbucks instead of getting cheaper coffee at Dunkin’ Donuts or even free coffee at the office. But you don’t think about these trade-offs anymore. You’ve already made this decision many times in the past, so you now assume that this is the way you want to spend your money. You’ve herded yourself—lining up behind your initial experience at Starbucks—and now you’re part of the crowd.

HOWEVER, THERE IS something odd in this story. If anchoring is based on our initial decisions, how did Starbucks manage to become an initial decision in the first place? In other words, if we were previously anchored to the prices at Dunkin’ Donuts, how did we move our anchor to Starbucks? This is where it gets really interesting.

When Howard Shultz created Starbucks, he was as intuitive a businessman as Salvador Assael. He worked diligently to separate Starbucks from other coffee shops, not through price but through ambience. Accordingly, he designed Starbucks from the very beginning to feel like a continental coffeehouse.

The early shops were fragrant with the smell of roasted beans (and better-quality roasted beans than those at Dunkin’ Donuts). They sold fancy French coffee presses. The showcases presented alluring snacks—almond croissants, biscotti, raspberry custard pastries, and others. Whereas Dunkin’ Donuts had small, medium, and large coffees, Starbucks offered Short, Tall, Grande, and Venti, as well as drinks with high-pedigree names like Caffè Americano, Caffè Misto, Macchiato, and Frappuccino. Starbucks did everything in its power, in other words, to make the experience feel different—so different that we would not use the prices at Dunkin’ Donuts as an anchor, but instead would be open to the new anchor that Starbucks was preparing for us. And that, to a great extent, is how Starbucks succeeded.

GEORGE, DRAZEN, AND I were so excited with the experiments on coherent arbitrariness that we decided to push the idea one step farther. This time, we had a different twist to explore.

Do you remember the famous episode in The Adventures of Tom Sawyer, the one in which Tom turned the whitewashing of Aunt Polly’s fence into an exercise in manipulating his friends? As I’m sure you recall, Tom applied the paint with gusto, pretending to enjoy the job. “Do you call this work?” Tom told his friends. “Does a boy get a chance to whitewash a fence every day?” Armed with this new “information,” his friends discovered the joys of whitewashing a fence. Before long, Tom’s friends were not only paying him for the privilege, but deriving real pleasure from the task—a win-win outcome if there ever was one.

From our perspective, Tom transformed a negative experience to a positive one—he transformed a situation in which compensation was required to one in which people (Tom’s friends) would pay to get in on the fun. Could we do the same? We thought we’d give it a try.

One day, to the surprise of my students, I opened the day’s lecture on managerial psychology with a poetry selection, a few lines of “Whoever you are holding me now in hand” from Walt Whitman’s Leaves of Grass:

Whoever you are holding me now in hand,

Without one thing all will be useless,

I give you fair warning before you attempt me further,

I am not what you supposed, but far different.

Who is he that would become my follower?

Who would sign himself a candidate for my affections?

The way is suspicious, the result uncertain, perhaps destructive,

You would have to give up all else, I alone would expect to be your sole and exclusive standard,

Your novitiate would even then be long and exhausting,

The whole past theory of your life and all conformity to the lives around you would have to be abandon’d,

Therefore release me now before troubling yourself any further, let go your hand from my shoulders,

Put me down and depart on your way.

After closing the book, I told the students that I would be conducting three readings from Walt Whitman’s Leaves of Grass that Friday evening: one short, one medium, and one long. Owing to limited space, I told them, I had decided to hold an auction to determine who could attend. I passed out sheets of paper so that they could bid for a space; but before they did so, I had a question to ask them.

I asked half the students to write down whether, hypothetically, they would be willing to pay me $10 for a 10-minute poetry recitation. I asked the other half to write down whether, hypothetically, they would be willing to listen to me recite poetry for ten minutes if I paid them $10.

This, of course, served as the anchor. Now I asked the students to bid for a spot at my poetry reading. Do you think the initial anchor influenced the ensuing bids?

Before I tell you, consider two things. First, my skills at reading poetry are not of the first order. So asking someone to pay me for 10 minutes of it could be considered a stretch. Second, even though I asked half of the students if they would pay me for the privilege of attending the recitation, they didn’t have to bid that way. They could have turned the tables completely and demanded that I pay them.

And now to the results (drumroll, please). Those who answered the hypothetical question about paying me were indeed willing to pay me for the privilege. They offered, on average, to pay me about a dollar for the short poetry reading, about two dollars for the medium poetry reading, and a bit more than three dollars for the long poetry reading. (Maybe I could make a living outside academe after all.)

But, what about those who were anchored to the thought of being paid (rather than paying me)? As you might expect, they demanded payment: on average, they wanted $1.30 to listen to the short poetry reading, $2.70 to listen to the medium poetry reading, and $4.80 to endure the long poetry reading.

Much like Tom Sawyer, then, I was able to take an ambiguous experience (and if you could hear me recite poetry, you would understand just how ambiguous this experience is) and arbitrarily make it into a pleasurable or painful experience. Neither group of students knew whether my poetry reading was of the quality that is worth paying for or of the quality that is worth listening to only if one is being financially compensated for the experience (they did not know if it is pleasurable or painful). But once the first impression had been formed (that they would pay me or that I would pay them), the die was cast and the anchor set. Moreover, once the first decision had been made, other decisions followed in what seemed to be a logical and coherent manner. The students did not know whether listening to me recite poetry was a good or bad experience, but whatever their first decision was, they used it as input for their subsequent decisions and provided a coherent pattern of responses across the three poetry readings.

Of course, Mark Twain came to the same conclusions: “If Tom had been a great and wise philosopher, like the writer of this book, he would now have comprehended that work consists of whatever a body is obliged to do, and that play consists of whatever a body is not obliged to do.” Mark Twain further observed: “There are wealthy gentlemen in England who drive four-horse passenger-coaches twenty or thirty miles on a daily line in the summer because the privilege costs them considerable money; but if they were offered wages for the service, that would turn it into work, and then they would resign.”*

WHERE DO THESE thoughts lead us? For one, they illustrate the many choices we make, from the trivial to the profound, in which anchoring plays a role. We decide whether or not to purchase Big Macs, smoke, run red lights, take vacations in Patagonia, listen to Tchaikovsky, slave away at doctoral dissertations, marry, have children, live in the suburbs, vote Republican, and so on. According to economic theory, we base these decisions on our fundamental values—our likes and dislikes.

But what are the main lessons from these experiments about our lives in general? Could it be that the lives we have so carefully crafted are largely just a product of arbitrary coherence? Could it be that we made arbitrary decisions at some point in the past (like the goslings that adopted Lorenz as their parent) and have built our lives on them ever since, assuming that the original decisions were wise? Is that how we chose our careers, our spouses, the clothes we wear, and the way we style our hair? Were they smart decisions in the first place? Or were they partially random first imprints that have run wild?

Descartes said, Cogito ergo sum—“I think, therefore I am.” But suppose we are nothing more than the sum of our first, naive, random behaviors. What then?

These questions may be tough nuts to crack, but in terms of our personal lives, we can actively improve on our irrational behaviors. We can start by becoming aware of our vulnerabilities. Suppose you’re planning to buy a cutting-edge cell phone (the one with the three-megapixel, 8× zoom digital camera), or even a daily $4 cup of gourmet coffee. You might begin by questioning that habit. How did it begin? Second, ask yourself what amount of pleasure you will be getting out of it. Is the pleasure as much as you thought you would get? Could you cut back a little and better spend the remaining money on something else? With everything you do, in fact, you should train yourself to question your repeated behaviors. In the case of the cell phone, could you take a step back from the cutting edge, reduce your outlay, and use some of the money for something else? And as for the coffee—rather than asking which blend of coffee you will have today, ask yourself whether you should even be having that habitual cup of expensive coffee at all.*

We should also pay particular attention to the first decision we make in what is going to be a long stream of decisions (about clothing, food, etc.). When we face such a decision, it might seem to us that this is just one decision, without large consequences; but in fact the power of the first decision can have such a long-lasting effect that it will percolate into our future decisions for years to come. Given this effect, the first decision is crucial, and we should give it an appropriate amount of attention.

Socrates said that the unexamined life is not worth living. Perhaps it’s time to inventory the imprints and anchors in our own life. Even if they once were completely reasonable, are they still reasonable? Once the old choices are reconsidered, we can open ourselves to new decisions—and the new opportunities of a new day. That seems to make sense.

ALL THIS TALK about anchors and goslings has larger implications than consumer preferences, however. Traditional economics assumes that prices of products in the market are determined by a balance between two forces: production at each price (supply) and the desires of those with purchasing power at each price (demand). The price at which these two forces meet determines the prices in the marketplace.

This is an elegant idea, but it depends centrally on the assumption that the two forces are independent and that together they produce the market price. The results of all the experiments presented in this chapter (and the basic idea of arbitrary coherence itself) challenge these assumptions. First, according to the standard economic framework, consumers’ willingness to pay is one of the two inputs that determine market prices (this is the demand). But as our experiments demonstrate, what consumers are willing to pay can easily be manipulated, and this means that consumers don’t in fact have a good handle on their own preferences and the prices they are willing to pay for different goods and experiences.

Second, whereas the standard economic framework assumes that the forces of supply and demand are independent, the type of anchoring manipulations we have shown here suggest that they are, in fact, dependent. In the real world, anchoring comes from manufacturer’s suggested retail prices (MSRPs), advertised prices, promotions, product introductions, etc.—all of which are supply-side variables. It seems then that instead of consumers’ willingness to pay influencing market prices, the causality is somewhat reversed and it is market prices themselves that influence consumers’ willingness to pay. What this means is that demand is not, in fact, a completely separate force from supply.

AND THIS IS not the end of the story. In the framework of arbitrary coherence, the relationships we see in the marketplace between demand and supply (for example, buying more yogurt when it is discounted) are based not on preferences but on memory. Here is an illustration of this idea. Consider your current consumption of milk and wine. Now imagine that two new taxes will be introduced tomorrow. One will cut the price of wine by 50 percent, and the other will increase the price of milk by 100 percent. What do you think will happen? These price changes will surely affect consumption, and many people will walk around slightly happier and with less calcium. But now imagine this. What if the new taxes are accompanied by induced amnesia for the previous prices of wine and milk? What if the prices change in the same way, but you do not remember what you paid for these two products in the past?

I suspect that the price changes would make a huge impact on demand if people remembered the previous prices and noticed the price increases; but I also suspect that without a memory for past prices, these price changes would have a trivial effect, if any, on demand. If people had no memory of past prices, the consumption of milk and wine would remain essentially the same, as if the prices had not changed. In other words, the sensitivity we show to price changes might in fact be largely a result of our memory for the prices we have paid in the past and our desire for coherence with our past decisions—not at all a reflection of our true preferences or our level of demand.

The same basic principle would also apply if the government one day decided to impose a tax that doubled the price of gasoline. Under conventional economic theory, this should cut demand. But would it? Certainly, people would initially compare the new prices with their anchor, would be flabbergasted by the new prices, and so might pull back on their gasoline consumption and maybe even get a hybrid car. But over the long run, and once consumers readjusted to the new price and the new anchors (just as we adjust to the price of Nike sneakers, bottled water, and everything else), our gasoline consumption, at the new price, might in fact get close to the pretax level. Moreover, much as in the example of Starbucks, this process of readjustment could be accelerated if the price change were to also be accompanied by other changes, such as a new grade of gas, or a new type of fuel (such as corn-based ethanol fuel).

I am not suggesting that doubling the price of gasoline would have no effect on consumers’ demand. But I do believe that in the long term, it would have a much smaller influence on demand than would be assumed from just observing the short-term market reactions to price increases.

ANOTHER IMPLICATION OF arbitrary coherence has to do with the claimed benefits of the free market and free trade. The basic idea of the free market is that if I have something that you value more than I do—let’s say a sofa—trading this item will benefit both of us. This means that the mutual benefit of trading rests on the assumption that all the players in the market know the value of what they have and the value of the things they are considering getting from the trade.

But if our choices are often affected by random initial anchors, as we observed in our experiments, the choices and trades we make are not necessarily going to be an accurate reflection of the real pleasure or utility we derive from those products. In other words, in many cases we make decisions in the marketplace that may not reflect how much pleasure we can get from different items. Now, if we can’t accurately compute these pleasure values, but frequently follow arbitrary anchors instead, then it is not clear that the opportunity to trade is necessarily going to make us better off. For example, because of some unfortunate initial anchors we might mistakenly trade something that truly gives us a lot of pleasure (but regrettably had a low initial anchor) for something that gives us less pleasure (but owing to some random circumstances had a high initial anchor). If anchors and memories of these anchors—but not preferences—determine our behavior, why would trading be hailed as the key to maximizing personal happiness (utility)?

SO, WHERE DOES this leave us? If we can’t rely on the market forces of supply and demand to set optimal market prices, and we can’t count on free-market mechanisms to help us maximize our utility, then we may need to look elsewhere. This is especially the case with society’s essentials, such as health care, medicine, water, electricity, education, and other critical resources. If you accept the premise that market forces and free markets will not always regulate the market for the best, then you may find yourself among those who believe that the government (we hope a reasonable and thoughtful government) must play a larger role in regulating some market activities, even if this limits free enterprise. Yes, a free market based on supply, demand, and no friction would be the ideal if we were truly rational. Yet when we are not rational but irrational, policies should take this important factor into account.

Reflections on the Existence of Well-Defined Preferences

One of the lessons from Chapter 2 was that we generally believe we have precise and well-articulated preferences, but in reality, we only think that we know what we want. Here’s an example of an experience where I went into a situation with one set of ideas about what I wanted and emerged with a very different understanding.

When I turned 30, I decided it was time to trade in my motorcycle for a car, but I could not decide which car was right for me. The Web was just taking off, and to my delight, I found a site that provided advice on purchasing cars. The Web site, which is now defunct, asked a series of questions ranging from my preferred safety rating to my desired braking distance, my ideal turning radius, the number of passengers I’d like to be able to bring along, and, of course, my price range.

I spent fifteen minutes answering these questions. At the top of each page, I watched the progress bar inch closer to my result. It was exciting—I was really interested in seeing what kind of recommendation the site would come up with. The final screen displayed all the answers I had provided in the last fifteen minutes; all I had to do was click on “Submit” to receive my tailored recommendation. The second I did, I learned that my perfect car was (drum roll, please) a Ford Taurus.

What?

Now, I might not know much about cars (in truth, I know very little about them), but I knew that I did not want a Ford Taurus (and I don’t mean any disrespect to what I am sure is generally a fine automobile). The problem was that, having just surrendered my motorcycle, I couldn’t see myself driving such a sedate sedan. I was now facing a dilemma: I had tried a deliberative and thoughtful process for my car selection, and I didn’t like the answer I got. So, I did what I think anyone in my position would do. I hit the back button a few times, backtracked to earlier stages of the interview process, and changed many of my original answers to what I convinced myself were more accurate and appropriate responses. I lowered my interest in safety and the number of passengers I wanted to take with me, and changed many of my answers to fit what I deemed a more appropriate motorcycle replacement. From time to time, I checked to see how the different responses translated into different recommendations.

I kept this up until the car-advising Web site suggested a Mazda Miata. The moment the program was kind enough to recommend a small convertible, I felt grateful for the fantastic software and decided to follow its advice. A few weeks later, I became the proud owner of a Miata, which served me loyally for many years.

WHAT HAPPENED HERE? On one hand, I knew that buying a car was no trivial matter, and I wanted to approach such a large decision by carefully weighing the cost and benefits in a cold, calculated, and sensible way. At the same time, I knew I was making an important and symbolic move into adulthood, and I understood that kids and the inevitable minivan (which I drive these days) were awaiting me. Nevertheless, my brain and my heart were engaged in a practical tug-of-war. Deep down, what I really wanted was a car that felt closer to a motorcycle—something that was fun to drive.

Taking the systematic and calculated approach to solving this problem did not yield the “correct” answer, so I went back and fudged around with my responses, letting the computerized method rationalize my choice for me. This way, I ended up with a decision that made me happy, and at the same time, it was a decision that I could easily explain to myself. With a neat and programmed computerized process, it was now obvious why the small convertible was, in fact, the right choice for me.

This elaborate computerized justification process might seem artificial and extreme, but I suspect that the same basic elements end up playing out in many of our important decisions. This experience taught me that sometimes we want our decisions to have a rational veneer when, in fact, they stem from a gut feeling—what we crave deep down. I suspect that in our attempts to make sure that we end up with decisions that seem well-reasoned and thoughtful, we commonly undergo a lot of unnecessary mental gymnastics and justifications, particularly when the choices are large and significant. Sometimes these rationalizations are complex and time-consuming, and sometimes we have the benefit of a software program to help us with more efficient rationalization. Perhaps this was the real function of the Web site I used—it was not necessarily designed to help me make a better decision, but to help me justify my choice and feel confident about it.

In the end, following our gut feelings and rationalizing them after the fact is not always bad. It can sometimes lead us to pick a satisfactory outcome or, at the very least, prevent us from ending up with a car we really don’t want.

CHAPTER 3

The Cost of Zero Cost

Why We Often Pay Too Much When

We Pay Nothing

Have you ever grabbed for a coupon offering a FREE! package of coffee beans—even though you don’t drink coffee and don’t even have a machine with which to brew it? What about all those FREE! extra helpings you piled on your plate at a buffet, even though your stomach had already started to ache from all the food you had consumed? And what about the worthless FREE! stuff you’ve accumulated—the promotional T-shirt from the radio station, the teddy bear that came with the box of Valentine chocolates, the magnetic calendar your insurance agent sends you each year?

It’s no secret that getting something free feels very good. Zero is not just another price, it turns out. Zero is an emotional hot button—a source of irrational excitement. Would you buy something if it were discounted from 50 cents to 20 cents? Maybe. Would you buy it if it were discounted from 50 cents to two cents? Maybe. Would you grab it if it were discounted from 50 cents to zero? You bet!

What is it about zero cost that we find so irresistible? Why does FREE! make us so happy? After all, FREE! can lead us into trouble: things that we would never consider purchasing become incredibly appealing as soon as they are FREE! For instance, have you ever gathered up free pencils, key chains, and notepads at a conference, even though you’d have to carry them home and would only throw most of them away? Have you ever stood in line for a very long time (too long), just to get a free cone of Ben and Jerry’s ice cream? Or have you bought two of a product that you wouldn’t have chosen in the first place, just to get the third one for free?

ZERO HAS HAD a long history. The Babylonians invented the concept of zero; the ancient Greeks debated it in lofty terms (how could something be nothing?); the ancient Indian scholar Pingala paired zero with the numeral 1 to get double digits; and both the Mayans and the Romans made zero part of their numeral systems. But zero really found its place about AD 498, when the Indian astronomer Aryabhata sat up in bed one morning and exclaimed, “Sthanam sthanam dasa gunam”—which translates, roughly, as “Place to place in 10 times in value.” With that, the idea of decimal-based place-value notation was born. Now zero was on a roll: It spread to the Arab world, where it flourished; crossed the Iberian Peninsula to Europe (thanks to the Spanish Moors); got some tweaking from the Italians; and eventually sailed the Atlantic to the New World, where zero ultimately found plenty of employment (together with the digit 1) in a place called Silicon Valley.

So much for a brief recounting of the history of zero. But the concept of zero applied to money is less clearly understood. In fact, I don’t think it even has a history. Nonetheless, FREE! has huge implications, extending not only to discount prices and promotions, but also to how FREE! can be used to help us make decisions that would benefit ourselves and society.

If FREE! were a virus or a subatomic particle, I might use an electron microscope to probe the object under the lens, stain it with different compounds to reveal its nature, or somehow slice it apart to reveal its inner composition. In behavioral economics we use a different instrument, however, one that allows us to slow down human behavior and examine it frame by frame, as it unfolds. As you have undoubtedly guessed by now, this procedure is called an experiment.

IN ONE EXPERIMENT, Kristina Shampanier (a PhD student at MIT), Nina Mazar (a professor at the University of Toronto), and I went into the chocolate business. Well, sort of. We set up a table at a large public building and offered two kinds of chocolates—Lindt truffles and Hershey’s Kisses. There was a large sign above our table that read, “One chocolate per customer.” Once the potential customers stepped closer, they could see the two types of chocolate and their prices.*

For those of you who are not chocolate connoisseurs, Lindt is produced by a Swiss firm that has been blending fine cocoas for 160 years. Lindt’s chocolate truffles are particularly prized—exquisitely creamy and just about irresistible. They cost about 30 cents each when we buy them in bulk. Hershey’s Kisses, on the other hand, are good little chocolates, but let’s face it, they are rather ordinary: Hershey cranks out 80 million Kisses a day. In Hershey, Pennsylvania, even the streetlamps are made in the shape of the ubiquitous Hershey’s Kiss.

So what happened when the “customers” flocked to our table? When we set the price of a Lindt truffle at 15 cents and a Kiss at one cent, we were not surprised to find that our customers acted with a good deal of rationality: they compared the price and quality of the Kiss with the price and quality of the truffle, and then made their choice. About 73 percent of them chose the truffle and 27 percent chose a Kiss.

Now we decided to see how FREE! might change the situation. So we offered the Lindt truffle for 14 cents and the Kisses free. Would there be a difference? Should there be? After all, we had merely lowered the price of both kinds of chocolate by one cent.

But what a difference FREE! made. The humble Hershey’s Kiss became a big favorite. Some 69 percent of our customers (up from 27 percent before) chose the FREE! Kiss, giving up the opportunity to get the Lindt truffle for a very good price. Meanwhile, the Lindt truffle took a tumble; customers choosing it decreased from 73 to 31 percent.

What was going on here? First of all, let me say that there are many times when getting FREE! items can make perfect sense. If you find a bin of free athletic socks at a department store, for instance, there’s no downside to grabbing all the socks you can. The critical issue arises when FREE! becomes a struggle between a free item and another item—a struggle in which the presence of FREE! leads us to make a bad decision. For instance, imagine going to a sports store to buy a pair of white socks, the kind with a nicely padded heel and a gold toe. Fifteen minutes later you’re leaving the store, not with the socks you came in for, but with a cheaper pair that you don’t like at all (without a padded heel and gold toe) but that came in a package with a FREE! second pair. This is a case in which you gave up a better deal and settled for something that was not what you wanted, just because you were lured by the FREE!

To replicate this experience in our chocolate experiment, we told our customers that they could choose only a single sweet—the Kiss or the truffle. It was an either-or decision, like choosing one kind of athletic sock over another. That’s what made the customers’ reaction to the FREE! Kiss so dramatic: Both chocolates were discounted by the same amount of money. The relative price difference between the two was unchanged—and so was the expected pleasure from both.

According to standard economic theory (simple cost-benefit analysis), then, the price reduction should not lead to any change in the behavior of our customers. Before, about 27 percent chose the Kiss and 73 percent chose the truffle. And since nothing had changed in relative terms, the response to the price reduction should have been exactly the same. A passing economist, twirling his cane and espousing conventional economic theory, in fact, would have said that since everything in the situation was the same, our customers should have chosen the truffles by the same margin of preference.*

And yet here we were, with people pressing up to the table to grab our Hershey’s Kisses, not because they had made a reasoned cost-benefit analysis before elbowing their way in, but simply because the Kisses were FREE! How strange (but predictable) we humans are!

THIS CONCLUSION, INCIDENTALLY, remained the same in other experiments as well. In one case we priced the Hershey’s Kiss at two cents, one cent, and zero cents, while pricing the truffle correspondingly at 27 cents, 26 cents, and 25 cents. We did this to see if discounting the Kiss from two cents to one cent and the truffle from 27 cents to 26 cents would make a difference in the proportion of buyers for each. It didn’t. But, once again, when we lowered the price of the Kiss to free, the reaction was dramatic. The shoppers overwhelmingly demanded the Kisses.

We decided that perhaps the experiment had been tainted, since shoppers may not feel like searching for change in a purse or backpack, or they may not have any money on them. Such an effect would artificially make the free offer seem more attractive. To address this possibility, we ran other experiments at one of MIT’s cafeterias. In this setup, the chocolates were displayed next to the cashier as one of the cafeteria’s regular promotions and the students who were interested in the chocolates simply added them to the lunch purchase, and paid for them while going through the cashier’s line. What happened? The students still went overwhelmingly for the FREE! option.

WHAT IS IT about FREE! that’s so enticing? Why do we have an irrational urge to jump for a FREE! item, even when it’s not what we really want?

I believe the answer is this. Most transactions have an upside and a downside, but when something is FREE! we forget the downside. FREE! gives us such an emotional charge that we perceive what is being offered as immensely more valuable than it really is. Why? I think it’s because humans are intrinsically afraid of loss. The real allure of FREE! is tied to this fear. There’s no visible possibility of loss when we choose a FREE! item (it’s free). But suppose we choose the item that’s not free. Uh-oh, now there’s a risk of having made a poor decision—the possibility of a loss. And so, given the choice, we go for what is free.

For this reason, in the land of pricing, zero is not just another price. Sure, 10 cents can make a huge difference in demand (suppose you were selling millions of barrels of oil), but nothing beats the emotional surge of FREE! This, the zero price effect, is in a category all its own.

To be sure, “buying something for nothing” is a bit of an oxymoron. But let me give you an example of how we often fall into the trap of buying something we may not want, simply because of that sticky substance, FREE!

In 2007, I saw a newspaper ad from a major electronics maker, offering me seven FREE! DVD titles if I purchased the maker’s new high-definition DVD player. First of all, did I need a high-definition player at that time? Probably not. But even if I had, wouldn’t it have been wiser to wait for prices to descend? They always do—and today’s $600 high-definition DVD player will very quickly be tomorrow’s $200 machine. Second, the DVD maker had a clear agenda behind its offer. This company’s high-definition DVD system was in cutthroat competition with Blu-Ray, a system backed by many other manufacturers. At the time, Blu-Ray was ahead and has since gone on to dominate the market. So how much is FREE! when the machine being offered will find its way into obsolescence (like Betamax VCRs)? Those are two rational thoughts that might prevent us from falling under the spell of FREE! But, gee, those FREE! DVDs certainly look good!

GETTING SOMETHING FREE! is certainly a draw when we talk about prices. But what would happen if the offer was not a free price, but a free exchange? Are we as susceptible to free products as we are to getting products for free? A few years ago, with Halloween drawing near, I had an idea for an experiment to probe that question. This time I wouldn’t even have to leave my home to get my answers.

Early in the evening, Joey, a nine-year-old kid dressed as Spider-Man and carrying a large yellow bag, climbed the stairs of our front porch. His mother accompanied him, to ensure that no one gave her kid an apple with a razor blade inside. (By the way, there never was a case of razor blades being distributed in apples on Halloween; it is just an urban myth.) She stayed on the sidewalk, however, to give Joey the feeling that he was trick-or-treating by himself.

After the traditional query, “Trick or treat?” I asked Joey to hold open his right hand. I placed three Hershey’s Kisses in his palm and asked him to hold them there for a moment. “You can also get one of these two Snickers bars,” I said, showing him a small one and a large one. “In fact, if you give me one of those Hershey’s Kisses I will give you this smaller Snickers bar. And if you give me two of your Hershey’s Kisses, I will give you this larger Snickers bar.”

Now a kid may dress up like a giant spider, but that doesn’t mean he’s stupid. The small Snickers bar weighed one ounce, and the large Snickers bar weighed two ounces. All Joey had to do was give me one additional Hershey’s Kiss (about 0.16 ounce) and he would get an extra ounce of Snickers. This deal might have stumped a rocket scientist, but for a nine-year-old boy, the computation was easy: he’d get more than six times the return on investment (in the net weight of chocolate) if he went for the larger Snickers bar. In a flash Joey put two of his Kisses into my hand, took the two-ounce Snickers bar, and dropped it into his bag.

Joey wasn’t alone in making this snap decision. All but one of the kids to whom I presented this offer traded in two Kisses for the bigger candy bars.

Zoe was the next kid to walk down the street. She was dressed as a princess, in a long white dress, with a magic wand in one hand and an orange Halloween pumpkin bucket in the other. Her younger sister was resting comfortably in their father’s arms, looking cute and cuddly in her bunny outfit. As they approached, Zoe called out, in a high, cute voice, “Trick or treat!” In the past I admit that I have sometimes devilishly replied, “Trick!” Most kids stand there, baffled, having never thought through their question to see that it allowed an alternative answer.

In this case I gave Zoe her treat—three Hershey’s Kisses. But I did have a trick up my sleeve. I offered little Zoe a deal: a choice between getting a large Snickers bar in exchange for one of her Hershey’s Kisses, or getting the small Snickers bar for FREE! without giving up any Hershey’s Kisses.

Now, a bit of rational calculation (which in Joey’s case was amply demonstrated) would show that the best deal is to forgo the free small Snickers bar, pay the cost of one additional Hershey’s Kiss, and go for the large Snickers bar. On an ounce-for-ounce comparison, it was far better to give up one additional Hershey’s Kiss and get the larger Snickers bar (two ounces) instead of a smaller Snickers bar (one ounce). This logic was perfectly clear to Joe and the kids who encountered the condition in which both Snickers bars had a cost. But what would Zoe do? Would her clever kid’s mind make that rational choice—or would the fact that the small Snickers bar was FREE! blind her to the rationally correct answer?

As you might have guessed by now, Zoe, and the other kids to whom I offered the same deal, was completely blinded by FREE! About 70 percent of them gave up the better deal, and took the worse deal just because it was FREE!

Just in case you think Kristina, Nina, and I make a habit of picking on kids, I’ll mention that we repeated the experiment with bigger kids, in fact students at the MIT student center. The results replicated the pattern we saw on Halloween. Indeed, the draw of zero cost is not limited to monetary transactions. Whether it’s products or money, we just can’t resist the gravitational pull of FREE!

SO DO YOU think you have a handle on FREE!?

OK. Here’s a quiz. Suppose I offered you a choice between a free $10 Amazon gift certificate and a $20 gift certificate for seven dollars. Think quickly. Which would you take?

If you jumped for the FREE! certificate, you would have been like most of the people we tested at one of the malls in Boston. But look again: a $20 gift certificate for seven dollars delivers a $13 profit. That’s clearly better than getting a $10 certificate free (earning $10). Can you see the irrational behavior in action?*

LET ME TELL you a story that describes the real influence of FREE! on our behavior. A few years ago, Amazon.com started offering free shipping of orders over a certain amount. Someone who purchased a single book for $16.95 might pay an additional $3.95 for shipping, for instance. But if the customer bought another book, for a total of $31.90, they would get their shipping FREE!

Some of the purchasers probably didn’t want the second book (and I am talking here from personal experience) but the FREE! shipping was so tempting that to get it, they were willing to pay the cost of the extra book. The people at Amazon were very happy with this offer, but they noticed that in one place—France—there was no increase in sales. Is the French consumer more rational than the rest of us? Unlikely. Rather, it turned out, the French customers were reacting to a different deal.

Here’s what happened. Instead of offering FREE! shipping on orders over a certain amount, the French division priced the shipping for those orders at one franc. Just one franc—about 20 cents. This doesn’t seem very different from FREE! but it was. In fact, when Amazon changed the promotion in France to include free shipping, France joined all the other countries in a dramatic sales increase. In other words, whereas shipping for one franc—a real bargain—was virtually ignored by the French, FREE! shipping caused an enthusiastic response.

America Online (AOL) had a similar experience several years ago when it switched from pay-per-hour service to a monthly payment schedule (in which you could log in as many hours as you wanted for a fixed $19.95 per month). In preparation for the new price structure, AOL geared up for what it estimated would be a small increase in demand. What did it get? An overnight increase from 140,000 to 236,000 customers logging into the system, and a doubling of the average time online. That may seem good—but it wasn’t good. AOL’s customers encountered busy phone lines, and soon AOL was forced to lease services from other online providers (who were only too happy to sell bandwidth to AOL—at the premium of snow shovels in a snowstorm). What Bob Pittman (the president of AOL at the time) didn’t realize was that consumers would respond to the allure of FREE! like starving people at a buffet.

WHEN CHOOSING BETWEEN two products, then, we often overreact to the free one. We might opt for a FREE! checking account (with no benefits attached) rather than one that costs five dollars a month. But if the five-dollar checking account includes free traveler’s checks, online billing, etc., and the FREE! one doesn’t, we may end up spending more for this package of services with the FREE! account than with the five-dollar account. Similarly, we might choose a mortgage with no closing costs, but with interest rates and fees that are off the wall; and we might get a product we don’t really want simply because it comes with a free gift.

My most recent personal encounter with this involved a car. When I was looking for a new car a few years ago, I knew that I really should buy a minivan. In fact, I had read up on Honda minivans and knew all about them. But then an Audi caught my eye, at first through an appealing offer—FREE! oil changes for the next three years. How could I resist?

To be perfectly honest, the Audi was sporty and red, and I was still resisting the idea of being a mature and responsible father to two young kids. It wasn’t as if the free oil change completely swayed me, but its influence on me was, from a rational perspective, unjustifiably large. Just because it was FREE! it served as an additional allure that I could cling to.

So I bought the Audi—and the FREE! oil. (A few months later, while I was driving on a highway, the transmission broke—but that is a different story.) Of course, with a cooler head I might have made a more rational calculation. I drive about 7,000 miles a year; the oil needs to be changed every 10,000 miles; and the cost per change is about $75. Over three years, then, I would save about $150, or about 0.5 percent of the purchase price of the car—not a good reason to base my decision on. It gets worse, though: now I have an Audi that is packed to the ceiling with action figures, a stroller, a bike, and other kids’ paraphernalia. Oh, for a minivan.

THE CONCEPT OF zero also applies to time. Time spent on one activity, after all, is time taken away from another. So if we spend 45 minutes in a line waiting for our turn to get a FREE! taste of ice cream, or if we spend half an hour filling out a long form for a tiny rebate, there is something else that we are not doing with our time.

My favorite personal example is free-entrance day at a museum. Despite the fact that most museums are not very expensive, I find it much more appealing to satisfy my desire for art when the price is zero. Of course I am not alone in this desire. So on these days I usually find that the museum is overcrowded, the line is long, it is hard to see anything, and fighting the crowds around the museum and in the cafeteria is unpleasant. Do I realize that it is a mistake to go to a museum when it is free? You bet I do—but I go nevertheless.

ZERO MAY ALSO affect food purchases. Food manufacturers have to convey all kinds of information on the side of the box. They have to tell us about the calories, fat content, fiber, etc. Is it possible that the same attraction we have to zero price could also apply to zero calories, zero trans fats, zero carbs, etc.? If the same general rules apply, Pepsi will sell more cans if the label says “zero calories” than if it says “one calorie.”

Suppose you are at a bar, enjoying a conversation with some friends. With one brand you get a calorie-free beer, and with another you get a three-calorie beer. Which brand will make you feel that you are drinking a really light beer? Even though the difference between the two beers is negligible, the zero-calorie beer will increase the feeling that you’re doing the right thing, healthwise. You might even feel so good that you go ahead and order a plate of fries.

SO YOU CAN maintain the status quo with a 20-cent fee (as in the case of Amazon’s shipping in France), or you can start a stampede by offering something FREE! Think how powerful that idea is! Zero is not just another discount. Zero is a different place. The difference between two cents and one cent is small. But the difference between one cent and zero is huge!

If you are in business, and understand that, you can do some marvelous things. Want to draw a crowd? Make something FREE! Want to sell more products? Make part of the purchase FREE!

Similarly, we can use FREE! to drive social policy. Want people to drive electric cars? Don’t just lower the registration and inspection fees—eliminate them, so that you have created FREE! In the same way, if health is your concern, focus on early detection as a way to eliminate the progression of severe illnesses. Want people to do the right thing—in terms of getting regular colonoscopies, mammograms, cholesterol checks, diabetes checks, and such? Don’t just decrease the cost (by decreasing the co-pay). Make these critical procedures FREE!

I don’t think most policy strategists realize that FREE! is an ace in their hand, let alone know how to play it. It’s certainly counterintuitive, in these times of budget cutbacks, to make something FREE! But when we stop to think about it, FREE! can have a great deal of power, and it makes a lot of sense.

Reflections on the Price of FREE!

We learned from our experiments that we all get a bit too excited when something is FREE! and that consequently, we can make decisions that are not in our best interest.

For example, imagine that you were choosing between two credit cards: one that offers you a 12 percent APR but has no yearly fee (FREE!), and one that offers you a lower interest rate of 9 percent APR but charges you a $100 annual fee. Which one would you take? Most people would overemphasize the yearly fee and in pursuit of the FREE! offer would end up getting the card that costs them much more in the long run—when they inevitably miss a payment or carry a balance.*

Although identifying and fighting the allure of FREE! is important in order to avoid traps while we are making decisions, there are also some cases in which we can use FREE! to our advantage. Take, for example, the common experience of going to a restaurant with friends. When the server drops off the check at the end of a meal, people often scramble to figure out the norms for payment. Do we each pay for what we ordered? Do we split the bill evenly, even if John had that extra glass of wine and the crème brûlée? FREE! can help us solve this problem, and in the process help us get more joy from dining out with our friends.

The answer, as it turns out, is that one person should pay the entire bill, and that the people involved should take turns paying over time. Here is the logic: When we pay—regardless of the amount of money—we feel some psychological pain, which social scientists call the “pain of paying.” This is the unpleasantness associated with giving up our hard-earned cash, regardless of the circumstances. It turns out that the pain of paying has two interesting features. First, and most obviously, when we pay nothing (for example, when someone else foots the bill) we don’t feel any pain of paying. Second, and less obviously, the pain of paying is relatively insensitive to the amount that we pay. This means that we feel more pain of paying as the bill increases, but every additional dollar on the bill pains us less. (We call this “diminishing sensitivity.” Analogously, if you add one pound to an empty backpack, it feels like a substantial increase in weight. But adding a pound to a backpack that’s already laden with a laptop and some books does not feel like a big difference.) This diminishing sensitivity to the pain of paying means that the first dollar we pay will cause us the highest pain, the second dollar will cause us less, and so on, until we feel just a tiny twinge for, say, the forty-seventh dollar.

So if we are dining with others, we are happiest when we pay nothing (FREE!); we are less happy when we have to pay something; and the additional dollars we fork over cause us a smaller and smaller additional amount of pain as the size of the bill increases. The logical conclusion is that one person should pay the whole bill.

If you’re still unconvinced, consider the following example: Imagine that four people share a meal and the bill comes to $100. Now, if everyone at the table pays $25, every person would feel some pain of paying. In order to make this less abstract, let’s assign “units” as a measure of this pain. We’ll assume that paying $25 translates into 10 units of pain for a total of 40 units of pain for the whole table when it comes time to split the bill. But what if one person pays the entire bill? Since the pain of paying does not increase linearly with the amount of payment, the person who is paying will feel 10 units of pain for the first $25 that he or she pays; maybe 7 units for the next $25; 5 units for the next $25; and 4 units for the last $25. The total of 26 units of pain lowers the amount of pain for the entire table by 14 units. The general point is this: we all love getting our meals for nothing, and as long as we can alternate payers, we can enjoy many FREE! dinners and derive greater overall benefit from our friendships in the process.

“Aha,” you might say, “but what about times when I eat only a green salad while my friend’s husband orders a green salad, a filet mignon dinner, two glasses of the most expensive cabernet sauvignon, and a crème brûlée for dessert? Or when the number of people changes the next time we gather? Or when some people in the group leave town altogether? All of this leaves me holding the bag.”

Certainly, there is no question that all these considerations make the “I’ll buy this time, you buy next time” approach less economically efficient. Nevertheless, given the huge benefits in terms of the pain of paying that this method delivers, I personally would be willing to sacrifice a few bucks here and there to reduce the pain of paying for my friends and myself.

Appendix: Chapter 3

Let me explain how the logic of standard economic theory would apply to our setting. When a person can select one and only one of two chocolates, he needs to consider not the absolute value of each chocolate but its relative value—what he gets and what he gives up. As a first step the rational consumer needs to compute the relative net benefits of the two chocolates (the value of the expected taste minus the cost), and make a decision based on which chocolate has the larger net benefit. How would this look when the cost of the Lindt truffle was 15 cents and the cost of the Hershey’s Kiss was one cent? The rational consumer would estimate the amount of pleasure he expects to get from the truffle and the Kiss (let’s say this is 50 pleasure units and five pleasure units, respectively) and subtract the displeasure he would get from paying 15 cents and one cent (let’s say this is 15 displeasure units and one displeasure unit, respectively). This would give him a total expected pleasure of 35 pleasure units (50 – 15) for the truffle, and a total expected pleasure of four pleasure units (5 - 1) for the Kiss. The truffle leads by 31 points, so it’s an easy choice—the truffle wins hands down.

What about the case when the cost is reduced by the same amount for both products? (Truffles cost 14 cents and the Kiss is free.) The same logic applies. The taste of the chocolates has not changed, so the rational consumer would estimate the pleasure to be 50 and five pleasure units, respectively. What has changed is the displeasure. In this setting the rational consumer would have a lower level of displeasure for both chocolates because the prices have been reduced by one cent (and one displeasure unit). Here is the main point: because both products were discounted by the same amount, their relative difference would be unchanged. The total expected pleasure for the truffle would now be 36 pleasure units (50 - 14), and the total expected pleasure for the Kiss would now be five pleasure units (5 - 0). The truffle leads by the same 31 points, so it should be the same easy choice. The truffle wins hands down.

This is how the pattern of choice should look, if the only forces at play were those of a rational cost-benefit analysis. The fact that the results from our experiments are so different tells us loud and clear that something else is going on, and that the price of zero plays a unique role in our decisions.

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