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Like Pavlov's dog with a bargain

My wife was watching the news and had apparently seen a report about the new phone. She said, "You're not getting the new iPhone." I said, "Yes, I am." She said, "Then we're getting a divorce." She was kidding (I think).

"You're not going to spend another $400 or $500 on an iPhone when you have a perfect one right in your pocket," she added. I said, "You are so right. I'm going to spend $199." She stared at me for several seconds, and then she asked me a question that made my heart flutter: "So am I going to get your old iPhone?"

What happened in between the divorce threat and my wife's sudden acquiescence to the new iPhone was the result, I think, of a simple yet remarkable trick in behavioral economics that was played upon me, my wife, and millions of other people by Apple's Steve Jobs and his backers at AT&T Wireless. It is a trick that turns up in how we buy stocks, how we think about the price of houses, how we choose entrees on a menu and why we shudder at the new price of gas.

So, why am I not getting a divorce?

The answer seems to be that we have no easy way to judge the value of the things we buy. So what our brains do is look for easy comparisons to give us answers. In the case of the iPhone, the initial price of the device when it was released last year was $599.

"It establishes a reference price of $600, and now when it comes down — that's very, very exciting," said Dan Ariely, a Duke University behavioral economist and the author of Predictably Irrational, a book about how we make decisions.

Not only are we getting a perceived deal on the product, but we are also getting a deal on the deal.

"You get the iPhone, and you get the deal," said Richard Thaler, a University of Chicago economist who came up with the notion of transaction utility, which he has described as "the difference between the amount paid and the 'reference price' for the good, that is, the regular price that the consumer expects to pay for this product."

These kinds of pricing tricks get played on us all the time. Companies split their stocks every day. According to the questions-and-answers section of the Securities and Exchange Commission's Web site: "Companies often split their stock when they believe the price of their stock exceeds the amount smaller individual investors would be willing to pay for the stock. By reducing the price of the stock, companies try to make their stock more affordable to these investors."

If the stock of XYZ Inc. is priced at $70, then splits 2-for-1, it's then $35. It looks like a better value. Sale on XYZ stock! The only problem is that XYZ Inc. is still worth the same amount of money — there are just more shares outstanding.

The next time you sit down for a nice meal at your favorite dining spot, take a close look at the prices of entrees. Usually there are one or two really expensive items, a bunch of mid-level ones and a few inexpensive ones. The reason those really expensive items are there is that they are the reference point. You will consider them, then perhaps consider them too expensive, but instead of trading all the way down for the cheapest options, you likely will settle at the middle, thinking you got a deal relative to the pricey entree.

"Those $30 entrees will sell a lot more," said Gregg Rapp, a menu engineer in Palm Springs, Calif. By having what he calls a positioning item on the menu — the reference point — "average check prices at the restaurant will grow," he said.

The pricing game can have the opposite effect, too, causing us to want to buy less of something. Perfect example: gas. For as long as I could remember, gas never topped $2 a gallon, meaning that was my reference point. But the other day the price staring at me was $4.09. That's when I seriously thought of buying a hybrid or taking public transportation. It was like how I responded to the iPhone going from $399 to $199, only in reverse.

The only upside to the new gas equation is that if prices stay this high long enough, a gallon of gas for $3 — if we ever see it again — will feel like a deal.

Like Pavlov's dog with a bargain 06/28/08 [Last modified: Monday, November 1, 2010 1:33pm]
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