Category Archives: Behavioral Economics

Pride in the dismal science

Tim Harford responds to question as to whether the study of economics attracts, or creates, sociopaths. Because apparently it is one or the other.

I would also posit that students’ responses to hypothetical situations while in an academic environment are not necessarily an accurate reflection of real world behaviour, but in any case Harford is a few steps ahead of me:

“If there is a single foundational principle in economics it is that when you give people the chance to trade with each other, both of them tend to become better off. Maybe that’s naive but it’s all about “abundance” and is the precise opposite of a zero-sum mentality.

. . .

Economists may appear ethically impoverished on the question of co-operating in the prisoner’s dilemma but they seem to have a far more favourable attitude to immigration from poorer countries. To an economist, foreigners are people too.”

And don’t miss the last paragraph, in which he explains the “dismal” epithet.

 

Vodka Discrimination?

From Marginal Revolution:

What’s surprisingly affordable in hotel rooms across the globe is, however, vodka. It’s much cheaper than peanuts and, in some cases, even water.

That is the case for instance in Zurich, Helsinki, and Oslo.  (Where is the profitable cross-subsidy?  Or is this price discrimination?  Is vodka less likely to be claimed for reimbursement from third-party payment?)  In Toronto hotel minibars, a can of nuts costs on average $18.23, at least among the hotels sampled.

 

 

Why you shouldn’t bet on Walmart anymore

Walmart has recently decided to get rid of its signature greeters, at least for the late night shift. After all, we are living in lean times and if Walmart can find a way to save money then those savings will pass on to the consumer, right? Also, greeters are a luxury which isn’t necessarily synonymous with Walmart either way, right?

Wrong.

Walmart’s move to get rid of its greeters, aside from going against Sam Walton’s view of a friendly store, is actually a very bad business move.

Shoplifting is costing stores close to 10 Billion in the US. While Walmart doesn’t release specific figures, it is estimated to be losing close to $3 Billion per year. Every year over 30% of retail business fail because of shoplifting.

An obvious solution to this is security, both with cameras and security personnel. This can reduce shoplifting, but can also make normal shoppers (the vast majority of the clients) feel uneasy.

Enter the greeters, a concept pioneered by Walmart in the 1980′s, and now followed by many other stores, including the Gap, Old Navy, Best Buy, Bed Bath & Beyond and Kmart. Even Bank of America has started having “hosts” greet customers as they enter.

Greeters, in this sense, fulfill two roles. First off, they make these establishments seem more friendly and “human”, in an age of ever more automation. Secondly, however, they deter customers from stealing. Again, numbers are hard to come by, but studies have shown that once a person feels his presence in a store has been noticed and acknowledged, he will be far less likely to steal.

In other words, good people feel welcome, bad people are deterred. So it will be interesting to see how Walmart fairs with fewer greeters, especially since they are being phased out of their midnight-7am shift when, presumably, more problems may occur.

We are all Behavioral (part two)

After our last article on this subject, alert reader Liam pointed out that it might be harder to find an example when buyers are NOT behavioral and behave completely rationally during their purchases. This is quite true, so we thought we’d keep this entry short and show a good example of a company who has understood how people act and think. This company is, appropriately, the Economist.

Dan Ariely pointed out that the Economist had an odd pricing structure on its website. Its options were:

- Subscribe to a full year of online access to The Economist  for $59.

- Subscribe to a full year of the print edition of The Economist in print for $125.

- Subscribe to a full year of both the online print editions of The Economist for $125.

Now, if you were to come across this you might think they hadn’t put much thought into it at all, right. More importantly, however, if a magazine you enjoyed had this pricing structure, which option would you choose? Well, since online access costs $59 and the print edition costs $125, the smart money would decide to purchase both, where the entire cost of online access is done away with, right?

Now let’s assume the Economist earns more with the print edition (print always had higher margins than online content, which is why so many magazine and newspaper companies are in trouble now), so they would try to encourage more print subscriptions. Once the fixed costs of writing the article are taken into account, the variable costs of each new subscriber are minimal at best, so the more subscribers paying the most is the most beneficial option to the Economist (or any publication).

The two real options are:
- Online: $59
- Print: $125

But by offering their options the way they do, a majority of users purchase the latter, paying more than double for the same content.

We are all behavioral (part one)

Economists have now discovered (or at least most of them have) that people are not efficiency robots, but they are what economists call “behavioral”, and what non-economists call “human”. What does this mean? Well, it turns out that people have biases, people can be lazy, people sometimes work against themselves and often make detrimental choices.

Before all the “humans” out there choose to laugh at economists, however, it should be pointed out that many people fail to see the behavioral in all of us. We often think we’re being perfectly rational in our decision making, when in reality we’re just being plain old human.

Exhibit A: The Bread Maker
When Williams-Sonoma first released the bread maker in the US, very few customers were interested. No one had felt a particular need to make their own bread before, and merely adding another kitchen appliance seemed like a needless bother, especially at a price tag of $275. Marketing endeavors were made in order to show the fun of bread making, as well as the freshness of bread, but people still preferred to buy their fresh bread, bake it in the oven, or to be happy with their store bought bread. Williams Sonoma was about to ditch the personal bread making idea altogether, but decided to hire a consulting firm as a last ditch attempt to improve sales. The firm suggested they create a second, more expensive model. This model, at $429, was designed to be much too expensive and big for household purposes, but should be placed next to the original model. Suddenly, the choice consumers faced wasn’t whether or not to buy an expensive bread maker, but which bread maker to buy. Since they were “rational” consumers, they of course chose the bargain at $275 rather than the bigger $429 model. This is called Price-Anchoring in economics-speak.

Exhibit B: Cheerios
When one shops at a store like Safeway, they have a choice between the Cheerios brand and the store brand (in this case, Safeway). The Cheerios brand will often cost twice as much as the store brand, yet many people prefer to buy it regardless. Why is this? Well, most will answer it is quality. Would you rather buy cereal from a company that specializes in quality cereal or from one that just makes it on the side on the cheap to make extra sales? But wait a minute, does this mean that Safeway has a factory making its own Cheerios brands and, if so, does it also make its own milk, coffee, frozen chicken and everything else that is a store brand? If so, where are all its factories and why is it spreading itself so thin? Is this really a viable business model?
The answer, of course, is no. Safeway doesn’t produce any of its own food, they merely distribute. So what are you buying when you buy the Safeway brand? Usually you’re buying Cheerios, or another expensive brand. The reasoning is that the cheapest and most expensive brands will not cannibalize each other, since they cater to different markets. This means it is profitable for Cheerios to sell a portion of its product on the cheap to Safeway and sell the rest at a high mark-up to consumers. Safeway, in the meantime, repackages the Cheerios and can sell them at a lower mark-up. Both firms end up making money, since they can use one product to cater to two very different consumer groups. The consumers, on the other hand, are being quite behavioral in their decision making when they buy cheerios.
Interestingly, even after knowing (and acknowledging) this fact many consumers will opt for the Cheerios brand. This is due to “signaling”, which is another topic for another post.

In what other ways do consumers behave irrationally?

Bet on who you know

What if I asked you who was the better sprinter, Usain Bolt or LaShawn Merritt, chances are the vast majority of you would give me the same answer: Usain Bolt. And yet, the vast majority of you could probably not name one specific race that Usain won, nor what his specialty is, let alone how many medals he won compared to Merritt. So why are you so sure? It’s because you have heard (presumably) of Usain Bolt, yet you’ve never heard (presumably) of LaShawn Merritt. This is what is known in Behavioral Economics as the “Recognition Heuristic”. In other words, the most recognized person will tend to the (fastest, strongest, best, etc.).

By the way, if you followed stats, you would see that LaShawn Merritt has won 9 gold medals, compared to Usain Bolt’s 13.

So anyway, why do we care? Well, an interesting phenomenon can start to appear. For example, let’s say you actually follow running more than the average reader, and you are familiar with LaShawn Merritt. You know he tends to run slightly longer races (400m) compared to Usain, and you remember he won 9 gold medals. You might think that Usain is the “David Beckham” of sprinting, while LaShawn is actually the better sprinter. In other words, if you do following running, there is much more chance you’d actually pick LaShawn Merritt over Usain Bolt than if you don’t. And you would be wrong.

So does this mean it is better to be ignorant? Not at all (stay in school!). But this does mean that you might often get better answers about American sports by asking, say, Europeans, and vice versa. This is called collective recognition heuristic.

Once again though, why do we care? Well, let’s say you are wondering who will win the next presidential election. We’ve already waxed lyrical about prediction markets and their accuracy. What if we could find similar accuracy merely by asking a bunch of non-americans who they think will win, or at least, which candidate is most recognized?

This isn’t an exact science, and will not be until more studies are performed in this field, but it could be an interesting source for pollsters and bettors.

Using Economics for Real Life

Forbes recently had an excellent article on Alvin Roth entitled “Un-Freakonomics“. Alvin Roth has created almost a cult following by doing the opposite of what Dubner and Levitt achieved with Freakonomics. Rather than use ‘the dismal science’ to find out whether Sumo wrestlers are cheating or not, he uses economics to do things like save lives.

This is a rarity in itself since most theorists do not also work in the field, but Roth isn’t scared of rolling up his sleeves and applying his theories. One example was with the New York city high school match. Roth himself was a high school dropout from Queens, and knew that the New York system of matching students with schools was a complete mess. In fact, what happened was you would rank your top 5 high schools and mail them in, and these lists would then be mailed to each high school. So each school knew if they were your number 1 choice or not. He took a variation of an algorithm which matches men and women who might want to marry, and applied it to students and high schools. This same system was then used for Boston primary schools.

Another accomplishment was designing a system for kidney donors. Many times a loved one will want to donate a kidney but not have a matching blood type. His system allows them to exchange with another relative of another patient who is in the same predicament. Even Dan Ariely, of Predictably Irrational, states “I’m his biggest fan.”

We would also like to take this opportunity to remind everyone that our new book “Bringing Sexy Back to Economics“, uses economics to analyze serious matters such as gun laws, providing water to drought stricken areas and finding ways of feeding the world. The more Economics can do to change the world, the more sexy it will be.

The Upside of Irrationality

For those of you who enjoyed Freakonomics, Super Freakonomics, The Economic Naturalist, Nudge, Bringing Sexy Back to Economics, and various other books, and therefore thought you’d seen more or less all there was to see about quirky Economics, I am sorry to disappoint you, but Dan Ariely’s “The Upside of Irrationality” turns out to have some very interesting material.

This book covers many different topics, from bankers’ bonuses to online dating to cooking to revenge to charity donations. Lately, when reading behavioral economics books, I’ve found much of the information to be duplicate. In other words, an author will mention or build upon someone else’s studies, but add very little that is new. This would give the feel that he or she is merely ‘riding the behavioral economics wave’. This is not one of those books.

Without giving too many spoilers, one of the more interesting sections regards emotions, and how they affect the way in which we make decisions. For example, a terrier left aboard a tanker that had to be abandoned in the Pacific was featured on news channels, leading to $48,000 being spent on its rescue. One might wonder if the money might not have been better spent on humans who desperately needed it. Likewise, the cost of cleaning and rehabilitating each otter after the Exxon-Valdez disaster was $80,000.

Another interesting section had to do with bankers bonuses in finance. Although it does seem like Ariely does not fully understand the motivation behind these bonuses. He quotes Barney Frank in saying “At the level of pay that those of you who run banks get, why the hell do you need bonuses to do the right thing?” Most bankers are in the business solely for the money. They don’t trouble themselves with the “right thing” and they sacrifice much in their lifestyle in order to get the highest paying jobs in the world. That, at the end of the day, is their motivation. The interesting part, however, doesn’t change, in that higher bonuses seem to lead to sub-par results. Ariely attributes this to the pressure, nervousness and distraction that exorbitant bonuses bring, thereby leading people to ‘choke’ and not perform as well. He might want to discuss this with Malcolm Gladwell, and his theories on ‘choking vs. panic’ under stress.

My favorite section was the one on online dating. Possibly because I am still single and find online dating to be a useless distraction. He tended to confirm this, equating utilizing these sites to “understanding how a cookie will taste by reading its nutrition label”. He goes on to say “In fact, without exaggerating too much, I think that the market for single people is one of the most egregious market failures in Western Society.”

In conclusion, although you may have to read through yet another explanation of how the ultimatum game works, or what game theory is, Ariely has many interesting findings to offer, which make it well worth your read.

You can purchase Dan Ariely’s “The Upside of Irrationality” here: http://www.amazon.com/exec/obidos/ASIN/0061995037/dumage-20

The Dry-Cleaning Paradox

When driving, chances are that you, the reader, will fill up at a gas station where petrol is cheap. If you need gas at another point along the road, you may fill up at another station. If a third gas station has cheaper gas, you’ll probably then switch to that one.

On the other hand, you probably are much more loyal to your dry cleaner. Perhaps you originally chose it for proximity, or because it was recommended, but if in the meantime you find another dry cleaner closer to home, you’re still likely to stick with your current dry cleaner. In fact, if one day they lose one of your shirts, you are likely to complain, and maybe ask for a future discount or favor, but you are still stay loyal to them (if they lose two or more, however, you’ll probably switch).

Why is this? There is no rational explanation for displaying such loyalty to your dry cleaner while hardly any to your gas station. Is it because you feel dry-cleaning is more important? Well, you usually spend more on gas than on dry-cleaning so it might make more sense to display more loyalty there (in many cities with public transport you will spend more on dry-cleaning, but loyalties tend to remain the same, so that negates this argument).

Maybe it is because you hand something of yours to the dry cleaners, which they need to hand back to you later. Of course, you see them pile the clothes onto a truck that does the rounds of all dry cleaners in the neighborhood and cleans it all in a central location, so this is not very rational. This could make sense if you were handing something you were attached to, yet people show less loyalty for where they drop their car off to get serviced than their shirts.

So why are we so loyal to the place where we drop our clothes off? An interesting question for Behavioral Economists. Our guess is that Laundry falls neatly into a bracket of services expensive enough to warrant a certain level of loyalty (which is why we are more loyal to them than to, say, where we get photocopies made), while cheap enough not to warrant extensive continuous search for the best deals (as opposed to having your car engine replaced, for which you might get several quotes before choosing whom to use).

The natural follow up questions would be how large this bracket is, how much it changes from person to person, and how quickly marketing agencies can take advantage of this knowledge to induce us into spending more money.

The Orszag Experiment

Effective July 30th (not 31st) Peter Orszag has left the Obama administration, and the fact that he has may speak volumes about what the administration was, and is, thinking. Orszag, now former director of the OMB, was a proponent of Behavioral Economics, and he had brought other like-minded people on board with him. Most notable of these was Cass Sunstein (of Nudge fame). He then went on to get involved and leave his mark on the economic stimulus plan and the health care reform law. And yet: now he’s leaving.

Critics, like Glenn Beck and pundits on Fox News, blasted his “voodoo economics”, and in the end Larry Summers started disagreeing over fiscal consolidation. It could have been this, or it could have simply been that Mr. Orszag is planning on getting married soon. Regardless, Behavioral Economists will have less of a voice now that he’s gone (Sunstein, while taken seriously many times, seems to be ridiculed the rest of the time). Orszag is being replaced by Jacob Lew, who held the same position from 1998 to 2001.

Some behavioral economics principles that Orszag introduced to the Obama administration are: Opt-in retirement savings, Easy to understand financial aid forms and simplified “obesity” rating on foods (using stars). We’ll see where we go from here.