Predictably Irrational

Summary Written by Prashanth Gopalan

The Big Idea

Irrational Relativity

"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."- Predictably Irrational, page 21

In 1993, American securities regulators forced publicly trading companies to reveal pay and salary details for all of their top executives for the first time in history. Ostensibly, this was in a bid to build public awareness around the outrageous executive compensation schemes that were in place at the time.

Newspapers regularly ran stories comparing CEO pay schemes implemented in different companies, and financial pundits spent hours on television and reams of print decrying the loss of America’s moral compass in the financial world. Which makes what happened next all the more curious.

CEO compensation schemes skyrocketed. By 2008, CEOs were earning more than 369 times the salary of the average worker, up from 131 times in 1993, and 76 times in 1976.

Why? Because now, all CEOs knew what other CEOs were earning and, since no-one likes to be left out, each demanded pay schemes that matched the salaries of their counterparts. Dollar for dollar, companies started keeping up with the Joneses, and executive compensation schemes steadily pushed themselves towards even more outrageous boundaries.

But regular people behave irrationally too.

Have you noticed how many people purchase a bigger, faster, shinier car, or a bigger, better and swankier house than before – even if they can’t afford to keep up with the payments?

The allure of relativity is so strong that it clouds judgment. It’s no surprise that every religion and philosophy out there urges people to avoid coveting their neighbours’ possessions; it’s not because they fear for peoples’ neighbours, but rather it’s because they fear for what we could do to ourselves when we try to head for the greener grass of the neighbours’ lawn.

Insight #1

Irrationality Comes with a Price

"Initial prices [for products] 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)."- Predictably Irrational, pages 29-30

How much would you pay for a necklace made of black pearls?

It’s the 1970s: Soul Train is on the air, Nixon is in China and sideburns are all the rage. You’ve never seen a black pearl necklace before in your life but all of a sudden, there it is, a lovely necklace made of Tahitian black pearls, sitting delicately on the slender neck of a Fifth Avenue jewellery store mannequin.

How much would you pay for that necklace? $100? $200? You’ve never seen it before and you certainly don’t know how much it’s worth.

Here’s where it gets interesting. Suppose I had a price tag of $250 stuck to the necklace. Would the simple display of this number alongside the necklace influence your valuation of black pearls? What if someone had made a mistake and stuck a price tag of $2.50 instead, do you think this would cause you to value black pearls differently?

It turns out that once we make a certain product the standard for all products in that category, it’s much easier for us to assign value to each product in that category. So if Starbucks comes to define our daily coffee experience (with its accompanying $7 price tags), Tim Hortons, Second Cup and Seattle’s Best are all judged according to that one standard Venti, affecting how we view and value each brand in turn. The key is to get that initial “standard of value” correct.

Ask yourself this question: Is what I’m consuming really worth the time, effort and money that I spend in procuring it? Would I better off using that money to do something else – like purchasing and reading a book?

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Insight #2

The True Cost of Nothing

"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…and so, given this choice, we go for what is FREE!."- Predictably Irrational, Page 54-55

If you’ve ever bought a book through, you might notice that you’re eligible for FREE! shipping for orders that go over a certain amount.

Buy one book for $16.97 and pay $3 in shipping costs. Buy two books that total more than $30 and get FREE! shipping. Sounds great right? FREE! shipping, why would you pass up on that? Turns out that a lot of Amazon’s book shoppers think alike, and for a long time Amazon enjoyed hefty global online book sales, except for in one place: France.

Why France? Turns out that the French division of Amazon decided to charge the princely sum of one euro ($1.35 USD) on orders over 30 Euros, causing sales to dampen. Shipping wasn’t FREE! so French customers behaved “rationally” (ie. buying only the book they came for, rather than 3 or 4 more). When Amazon France adopted the FREE! shipping option, French customers responded irrationally and online national book sales skyrocketed to match Amazon’s international levels.

FREE! doesn’t just make us behave erratically, it makes us behave downright irrationally – but predictably irrationally. The human brain gets so excited by the idea of getting something for nothing that we often end up making poor decisions that can easily be avoided. How long did you wait in line for that free scoop of Baskin Robbins ice cream? How long did you spend waiting in line to enter your local museum when they decided to allow free admission for a limited time window?

So the next time you go to a mall intending to buy a pair of high quality sweat absorbing athletic socks with 30% discount, but end up leaving with some cheap plain cotton socks that won’t last you a month, simply because they happened to be stored in a bin marked FREE!, you’ll know what happened.

If you can’t figure it out, go pick up this book. You just might end up cutting down on quite a few cups of coffee.

Read the book

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Dan Ariely

Using simple experiments Dan Ariely studies how people actually act in the marketplace, as opposed to how they should or would perform if they were completely rational. His interests span a wide range of daily behaviours and his experiments are consistently interesting, amusing, and informative, demonstrating profound ideas that fly in the face of common wisdom.

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