Tag Archives: Rationality

How Rational Are We Really?

Has it ever bothered you how outrageously high Starbucks and Apple’s prices are compared to their competitors?

Has it bothered you even more that both these companies are arguably more successful than their competitors in spite of their pricing practices?

Well it bothers me, so I set out to get to the bottom of it.

The laws of supply and demand do not explicitly show that there is a price where consumers are “overpaying”, but this is because the definition of the price in this model is how much the consumers are willing to pay. In order to determine if an individual is overpaying, there needs to be context such as how similar products are priced, the circumstances around the purchasing decision etc.

In my opinion, the 3 major reasons people overpay for products are the Anchoring Model, buyer’s preferences and incentives, and the inelasticity of goods.

The Anchoring Model:

The Anchoring Model works off the principle that our minds rely too heavily on the first pieces of information it sees . By manipulating the initial piece of information that consumers receive, price-makers can affect the consumer’s perception of subsequent information. For example, consider two phones that are identical. One is marketed at a price of $800 where as the other is marketed as $800 but is 50% from its initial price of $1600. Even if you wouldn’t normally purchase a phone at $800, you would still feel inclined to purchase the one at 50% off since there is a sense of value created through the “discount”. Using this strategy, companies can convince consumers to pay more than they were initially willing to pay.

As Dan Ariely outlines in this video , Starbucks is able to convert Dunkin Donuts customers into its own through the anchoring process. After walking into Starbucks once, the consumer convinces themselves to walk in each time they pass by Starbucks until they eventually are considered a regular Starbucks customer. Through minor details such as not serving donuts, Starbucks was able to undermine the previous notion of “coffee” established by Dunkin Donuts and implement their own set of standards including prices.

In this case, the decision making is quite irrational. Although the consumer rationalizes to themselves through the discount, this decision is made using misleading information. Personally, in order to circumvent these tactics, I monitor the price of products I’m interested in regularly so I know what I should expect, however, this isn’t always possible and it’s understandable how people may fall into this trap. 

Buyer’s Preferences and Incentives

Another reason people may pay more than they should for a good is a combination of buyer’s preferences and the use of incentives. The sneaker market is a good example of this. Over time, the price of sneakers has increased substantially

Eric Myers, a Northeastern MBA graduate and director at engineering firm INTEGRIS Group said the following.

“Rising sneaker prices can be attributed to a variety of factors: rising costs of labor in China, increased costs for raw material, inflation, and general price increases, yet it appears that the price increases have significantly outpaced these factors over the past decade,”

This is likely due to the nature of marketing and cultural shifts in our society. They have positioned sneakers as what’s “cool” right now and as such the demand curve has shifted right due to a favorable change in buyers preferences, resulting in a higher equilibrium price. Furthermore, through social incentives, individuals will buy expensive shoes in order to fit in with the crowd. As a teenager,  I understand the sentiment of this type of decision making, but that does not make it logical. In this case, the cause of the behavior is irrational, but the results of these decisions follow normal economic models so it can be understood to an extent.

Elasticity

In certain cases, the lack of elasticity of the a good results in people paying more than they need to. For example, coffee is an inelastic good for many since it only takes a small portion of ones income and it is somewhat of a necessity. Due to this, coffee-makers know that they can raise their prices slightly and people will continue to buy coffee. Technically, consumers would be overpaying relative to the previous price, but since a consumer surplus (a difference between the price paid and the price a consumer is willing to pay), they will continue to buy coffee. In this case, the behavior is rational since it doesn’t make sense to stop drinking coffee due to marginal increases in price. 

Overall, in most cases where consumers are overpaying for their products, it is due to irrational decisions making that is primarily based on feelings . However, there are cases, such as the case with elasticity, where overpaying isn’t necessarily irrational.

Advertisements

Let’s talk about prices, and rationality.

We’re soooo irrational, it’s crazy.

Every since I was a little girl, I’ve seen everyone around me – friend, strangers, and family members fall for this. Hell, I’ve even seen myself fall for it even though I know better. From clothing to food, we humans Keep. On. falling. For. The. Same. Trick. OVER AND OVER AGAIN! Yep, we’re extremely irrational – emotions could affect us, a little bit of irrelevant information could affect us from buying things.

Us irrational buyers effect the demand portion of the supply and demand graph, causing a shift in the graph. According to our wants, the companies selling the goods and services bend to our will and produce as much as we, the buyers desire.

Image result for supply and demand
In a way, we’re the ones in control of the companies!!

Anchoring Effect
What is this effect?
Anchoring effect describes the common human tendency to rely too much on the first piece of information offered (the “anchor”) to the buyer when making decisions.

This is why places like Pacific Mall in Toronto can still stay open, despite all the haggling. No seller would ever put the selling price of a product lower than their production cost, just because you as a buyer convinced them that you should have the item for a lower price. Eventually, every buyer gets tricked into believing that they got an excellent bargain from their purchase. Information asymmetry is the first reason buyers never get a good deal. This only occurs when one party knows more about a product than the other party does. In the case above, it’s when the seller knows more about a product than the buyer.

We DO NOT pay a rational price for goods.

Given the level of asymmetry or ‘unevenness’ in the knowledge of the transaction between the buyer and seller, this is where anchoring effect comes in.

Related image
“But lowkey I’m still making $$$$”

Dave Ariely, the James B. Duke Professor of Psychology and Behavioral Economics at Duke University conducted lots of research, one being him reading a poem to his students and telling them he would do poetry readings of varying lengths (short, medium and long). He asked half his students if they would hypothetically agree to listen to him if they were paid $10 and the other half if they would pay him $10 for the honor of listening to him. They were then left to bid for each section. Those who had been offered money, offered on average $1.30 for a short poetry reading, $2.70 for a medium and $4.80 for the long reading. Interestingly those who had been asked if they would pay Ariely offered a dollar for the short, about two dollars for the medium and just over three dollars for the long reading. The initial offer not only anchored how much they would pay but also whether they would pay or be paid. This is called arbitrary coherence, as the initial price is randomly chosen (arbitrary) and in turn affects future prices (coherence).


Way Overpriced!

Image result for overpriced meme

Materialistic? Non-materialistic? Which one are you?
I’m definitely more on the materialistic side.

The more the person values luxury goods, the more materialistic they are, since they’re higher on the materialistic scale measuring material values.

Economic psychologists documented in their recent studies that materialistic and non-materialistic people view the world differently from each other. They also studied something called the “labeling effect”, a term used by psychologists and marketers which describe the effect people evaluate products based on external cues, such as a product label, a server’s recommendation and/or the price – rather than the quality of the product.

These researchers conducted a study where a group of people were shown 2 bottles of wine, one cheaper than the other, but in fact they were the exact same wine in 2 different bottles. When asked to grade both wines, materialistic people graded the cheaper wine significantly lower than the expensive one.

But this is a basic human tendency called confirmation bias, where we interpret the world in a way that fits with our preexisting views. This means that we need something to compare an object to, for a price. In the case above, the confirmation bias is seen as  materialistic people giving a low score for the cheaper wine.

So yes, products can be indeed overpriced.

Prices & Rationality?

iphone“Prices are getting out of hand”

Picture this, you’re on your way home from school and you feel the sweltering heat as you recall this morning hearing forecasts of 38ºC and today being the hottest day of the year. Every time you try to swallow your saliva it’s as if there’s a wall preventing it from going down. The inside of your throat feels like a new scratching post for your kitty, Mr. Whiskers. As you wince in pain, you finally enter your local grocery store. Once inside, you search intently for a bottle of water. You look up and see ‘Isle 3: beverages, water, sports drinks’. You scan the shelves and you see a no-name water bottle priced at $1.00/bottle and right beside that is ‘Fiji Water’ priced at $3.00/bottle.

At this point, three things are probably going through your mind.

  1. I need this water NOW.
  2. How can prices be so irrational that things can be drastically different in costs when they serve the same purpose? They’re both just water. and
  3. If I was at home, I could just get this for free, how are they getting away with selling this?

You purchase the dollar bottled water, quench your thirst and decide to stay in the grocery store for 2 reasons.

  1. To take shelter from the scorching heat. and
  2. To further investigate this pricing matter.

Thus you begin to wonder, are the prices for goods rational or can they actually be overpriced such as the ‘Fiji Water’ you saw earlier? There has to be more to this than is what just meets the surface if they’ve been doing this for decades.

This idea of pricing and what consumers will actually pay for certain goods revolves around behavioural economics. The idea of rationality and irrationality. As Dan Arley puts it:

“behavioral economics does not assume that people are rational. Instead, behavioral economists start by figuring out how people actually behave, often in a controlled lab environment in which we can understand behavior better, and use this as a starting point for building our understanding of human nature. As a consequence of this different starting point, behavioral economists usually come to different conclusions about the logic and efficacy of almost anything,”

It’s interesting how there are many different conclusions depending on how you view things and where you start in regards to rationality and irrationality.

Anchoring Effect:

The economic concept of the anchoring effect plays a role in the price decisions consumers make. Anchoring is the idea where people are unable to make decisions in plain terms, instead, they use comparisons. In the grocery store example, the anchor was the free tap water. As a result, you are so used to having water for free that the $1.00 bottle seemed like a rational price to pay for the situation you were in, versus the irrational price of $3.00.

Arley, a behavioural economics conducted research in regards to anchors and found that anchors play an extremely important role in consumer price decisions. If the original anchor is low, there will be lower bids, which is fairly evident when you purchased water. In his experiment, he asked people to use the last 2 digits of their social security numbers to bid for wine. Arley found that,

“People whose last two digits were between 80-99 bid $27.91 dollars on average, while those whose last two digits were between 00-19 bid $8.64.”   

In reality, if you allow people to produce a higher price in mind, then this will make others pay as much as treble the price. People with high social security numbers paid up to 346% more than those with low numbers. As Arley quotes from his book, “Predictably Irrational”; 

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. Any question, in fact, would have created the anchor. Does that seem rational? Of course not”

As you can see from Arley’s example, the price of goods can vary from rational to irrational as easily as people change their perspectives.

Expensive or Expens-NOT:

ten

Now the question is, why do people buy overpriced things when they can buy a cheaper alternative instead? Are these goods priced rationally?

As “Investopedia’s: The Psychology Behind Why People Buy Luxury Goods” states:

“It’s well known that people don’t behave rationally, and considering the enormous consumer debt Americans have, consumers clearly don’t always act in their best financial interests.”

Materialism comes into play when explaining expensive purchases. If a person values luxuries in life, admires people who own expensive things such as cars, homes, clothes or finds happiness through buying expensive items, the more materialistic that person is. This results in the labeling effect. Products are evaluated based on external cues such as labels, recommendations, and prices instead of the product itself.

This study revealed that if you are on the lower end of the materialistic scale you value “expensive” and “cheap” products on a fairly similar scale. Whereas, people on the higher end of the scale valued the “expensive” and “cheap” things more differently in 2 extremes.

As a result, this solidifies the idea of the confirmation bias. This is when you value an expensive item, you expect it to have a higher quality and a cheaper item to be bad.

This explains is how designers such as Louis Vuitton, Supreme, Gucci, Apple and many other companies are able to sell their products at insane prices and continue to have consumers lineup when they release new products. The consumer expects it to be worth the price they buy it at. They acquire these materialistic concepts through these irrational, overpriced purchases but rejustify themselves into rationality through their own happiness and other feelings. 

This aspect is where supply and demand determinants play a role in prices and quantities that are set. In this aspect, the demand determinant that is important in keeping these name brand companies on the market is buyer’s preferences/consumer’s taste. This is the idea of finding happiness or just wanting to purchase expensive things. This causes the demand curve to shift to the right increasing demand. This results in an increase in price and quantity.

demand

As a result, these goods may not be priced rationally and seem overpriced, however, emotions and feelings may explain otherwise and counteract these arguments to justify irrational spendings.

Lastly, there are countless things in today’s market that are overpriced. The markups on the items are insane. You’ve probably heard that “Evian” is simply “naïve” spelled backward. Bottled water companies are able to still sell their products at a 4000% markup where a $2.00 bottle only costs about $0.05 to make.

On the other side of things, the notorious king of overpriced goods are the pharmaceutical companies. The infamous, Martin Shkreli was able to take advantage of the monopoly, super inelastic aids drug by putting a 5000% markup price from $13.50 to $750.00 overnight. 

Shkreli justifies himself by explaining how it takes very little money to make Daraprim as he lists costs, patients relations, and others. He overpriced and abused this life-dependent drug to make profits. This is similar to what many companies are doing today but to a much lesser extreme that many are able to turn a blind eye. These overpriced products include but are not limited to, bottled water, coffee, movie theatre popcorn, greeting cards and much more. All these items are marked up from as low as 40% to as high as 4000%.

In conclusion, are the price of goods rational? In my opinion, the answer to this question is that it varies to certain extents, but in general for goods considering the amount of inflation that is occurring, it is rational. As long as people use the anchoring effect and turn a blind eye to the mark-ups companies are making on their products, then this irrationality can seem rational. As long as these ideas can be explained and backed up with the happiness the products/goods bring anything, in theory, can be a rational price to pay.  However, personally, I do believe that the name brand, ‘hype-beast’ clothing that is trending nowadays are definitely blown out of proportions and ARE overpriced goods as well as anything you can get for free.

supreme

“Oh boy.”