Misbehaving: The Making of Behavioral Economics (10 page)

There are several things to notice about this example, which was fine-tuned to deal with the objections I anticipated hearing from economists. Crucially, the consumption act is identical in the two situations. The respondent gets to drink one bottle of his favorite brand of beer on the beach. He never enters or even sees the establishment from which the beer has been purchased, and thus does not consume any ambience, positive or negative. Also, by ruling out any negotiation with the seller, the respondents have no reason to disguise their true preferences. In economists’ lingo, the situation is
incentive compatible
.

With those provisos out of the way, we can proceed to the punch line. People are willing to pay more for the beer if it was purchased from the resort than from the convenience store. The median
†
answers, adjusted for inflation, were $7.25 and $4.10.

These results show that people are willing to pay different prices for the same beer, consumed at the same spot on the beach, depending on where it was bought. Why do the respondents care where the beer was bought? One reason is expectations. People expect prices to be higher at a fancy hotel, in part because the costs are quite obviously higher. Paying seven dollars for a beer at a resort is annoying but expected; paying that at a bodega is an outrage! This is the essence of transaction utility.

Econs do not experience transaction utility. For them, the purchase location is another supposedly irrelevant factor, or SIF. It is not that Econs are immune to bargains. If someone was selling beers on the beach for ten cents, then even an Econ would be happy, but that happiness would be fully captured by the acquisition utility. Those who enjoy transaction utility are getting pleasure (or pain) from the terms of the deal per se.

Since transaction utility can be either positive or negative—that is, there can be both great deals and awful gouges—it can both prevent purchases that are welfare-enhancing and induce purchases that are a waste of money. The beer on the beach example illustrates a case where someone can be dissuaded from making a worthwhile purchase. Suppose Dennis says he would only pay $4 for the beer from the bodega, but $7 from the hotel. His friend Tom could make Dennis happier if bought the beer at the store for $5 but told Dennis he had bought it from the hotel. Dennis would get to drink his beer thinking the deal was fine. It is only his distaste for overpaying that stops him from agreeing to this transaction without Tom’s subterfuge.

For those who are at least living comfortably, negative transaction utility can prevent our consuming special experiences that will provide a lifetime of happy memories, and the amount by which the item was overpriced will long be forgotten. Good deals, on the other hand, can lure all of us into making purchases of objects of little value. Everyone has items in their closets that are rarely worn but were “must buys” simply because the deal was too good, and of course somewhere in the garage or attic is our version of Maya’s quilt.

Because consumers think this way, sellers have an incentive to manipulate the perceived reference price and create the illusion of a “deal.” One example that has been used for decades is announcing a largely fictional “suggested retail price,” which actually just serves as a misleading suggested
reference
price. In America, some products always seem to be on sale, such as rugs and mattresses, and at some retailers, men’s suits. Goods that are marketed this way share two characteristics: they are bought infrequently and quality is difficult to assess. The infrequent purchases help because consumers often do not notice that there is always a sale going on. Most of us are pleasantly surprised that when we wander in to buy a new mattress, there happens to be a sale this week. And when the quality of a product, like a mattress, is hard to assess, the suggested retail price can do double duty. It can simultaneously suggest that quality is high (thus increasing perceived acquisition utility) and imply that there is transaction utility to be had because the product is “on sale.”

Shoppers can get hooked on the thrill derived from transaction utility. If a retailer known for frequent discounting tries to wean their customers away from expecting great deals, it can struggle. Several retailers have tried over the years to entice customers with something called “everyday low pricing,” but these experiments usually fail.
‡
Getting a great deal is more fun than saving a small and largely invisible amount on each item.

Macy’s and JC Penney are just two U.S. retailers to have notably tried—and failed—to wean their customers off their addiction to frequent sales. In an image makeover undertaken in 2006–07, Macy’s leadership specifically targeted coupons as a price reduction device, and wanted to reduce their usage. Macy’s saw coupons as a threat, linking the brand too closely to less prestigious retailers such as JC Penney or Kohl’s. After taking over several other department store chains across the country and rebranding them all as Macy’s, they cut the use of coupons by 30% in the spring of 2007, compared to the prior spring. This did not go over well with customers. Sales plummeted, and Macy’s quickly promised to return to its previous glut of coupons by the holiday season of that same year.

JC Penney similarly eschewed coupons for a brief period in 2012 in pursuit of an everyday low price strategy. Noting that less than 1% of revenues came from full-price transactions, CEO Ron Johnson in a surprisingly candid press release announced an end to what he dubbed “fake prices”—the mythical suggested retail price—and the start of a simpler pricing scheme. In addition to abolishing traditional sales via coupons, the new scheme did away with prices ending in .99, rounding them up to the nearest dollar. JC Penney claimed the end price consumers paid was effectively the same, after all these changes.

It might well be true that consumers were not paying any more under the new regime, but they were missing out on lots of transaction utility. They even lost that tiny pleasure of paying just “under” a given dollar amount, e.g., $9.99 rather than $10. The experiment was a flop. JC Penney’s sales and stock price plummeted as the changes took effect in 2012. A year later, Johnson was ousted and coupons returned to JC Penney customers. But as of 2014, sales had not yet recovered. Maybe consumers did not like being told that the suggested retail prices, the source of so much transaction utility pleasure, were fake.

Sharp readers (and shoppers) might wonder about large-format discount retailers such as Walmart and Costco. These retailers successfully operate under an everyday low pricing strategy, sometimes without explicit reference to an original higher price. But they have not eliminated transaction utility; just the opposite. They have convinced their customers that the entire shopping experience is an orgy of bargain hunting, and go out of their way to reinforce that image. Along with providing genuinely low prices, Walmart also offers a variation on the old ploy of guaranteeing that they have the lowest prices available by allowing shoppers to scan their receipts into a “savings catcher” app that promises to give a refund to anyone if there is a lower price available. Unless Macy’s and JC Penney wanted to give up all pretensions of offering an upscale shopping experience, they could not compete with these true low-cost providers in providing transaction utility to their customers.

For consumers, there is nothing wrong with being on the lookout for a bargain. Saving money on one purchase makes another purchase possible. But we don’t want to get caught buying something we won’t use just because the deal is too good to pass up. For businesses, it is important to realize that everyone is interested in a good deal. Whether it is via sales or genuine low prices, the lure of a deal will attract customers. The parking lot at Costco, a warehouse-style retailer with a reputation for low prices, always has a large number of luxury automobiles. Even affluent consumers get a kick from transaction utility.

________________

*
   Perhaps surprisingly, the one group of people that come closest to thinking this way about opportunity costs is the poor. In their recent book
Scarcity
, Sendhil Mullainathan and Eldar Shafir (2013) report that, on this dimension, the poor come closer to behaving like Econs than those who are better off, simply because opportunity costs are highly salient for them. If a $100 windfall could pay the overdue utility bill or replace the kids’ shoes that are now too small, opportunity costs are front and center. However, this incessant fretting about opportunity costs takes a toll. Having to constantly worry about where the money is going to come from to pay the rent makes it hard to keep up with everything, and may contribute to some of the bad decisions made by the poor, such as taking out and rolling over payday loans.

†
   The median is the statistical term for middle. If all the prices are ranked from high to low, the median answer is the one with as many answers higher as lower.

‡
   A recent study finds that when U.S. supermarkets were confronted with the challenge of a Walmart entering their home market, all suffered, but those who used a promotional pricing strategy (e.g., frequent sales) experienced significantly greater revenues and long-term viability than an everyday low price strategy (Ellickson, Misra, and Nair, 2012).

8

Sunk Costs

Vince paid $1,000 to an indoor tennis club that entitled him to play once a week for the indoor season. After two months he developed tennis elbow, which made playing painful. He continued to play in pain for three more months because he did not want to waste the membership fee. He only stopped playing when the pain became unbearable.

W
hen an amount of money has been spent and the money cannot be retrieved, the money is said to be sunk, meaning gone. Expressions such as “don’t cry over spilt milk” and “let bygones be bygones” are another way of putting economists’ advice to ignore sunk costs. But this is hard advice to follow, as the example from the List about driving to a basketball game in a blizzard, and the story of Vince and his tennis elbow, illustrate.

To make things clear, let’s stipulate that if a friend invited Vince to play tennis (for free) at another club, Vince would say no because of his painful elbow. In economics lingo that means the utility of playing tennis is negative. But having paid $1,000 he continues to play, seemingly making himself worse off every time he does so. Why would he do such a thing? That is the question I wanted to answer.

Over the years I collected dozens of examples of people paying attention to sunk costs. One involved a friend, Joyce, who was fighting with her six-year-old daughter Cindy about what she should wear to school. Cindy had decided that she no longer wanted to wear dresses, only pants or shorts. Joyce insisted that Cindy had to wear three dresses that had been purchased in preparation for the beginning of first grade. Shouts of “I bought those dresses, and you are going to wear them!” began many days, with Cindy replying that she would not go to school if she had to wear a dress. I am guessing that Joyce probably asked, unhelpfully, whether Cindy thought that money grows on trees.

I was brought in as a mediator, and explained the economic logic to Joyce. The money paid for the dresses was gone, and wearing the dresses would not get it back. As long as sticking to pants and shorts would not require any new clothing purchases, then insisting that Cindy wear the dresses would not help their financial situation. Joyce was thrilled to hear this news. She hated fighting with her daughter, but genuinely felt guilty about “wasting” the purchase of those three dresses. Having an economist tell her that ignoring sunk costs is perfectly rational, even required, was all she needed. Maya Bar-Hillel started calling me the world’s only clinical economist. (After her quilt purchase she became my first client.)

I may or may not have deserved that title, but I was hardly the only economist to recognize that Humans have trouble with this concept. In fact, the mistake is so common it has an official name—the
sunk cost fallacy
—and the fallacy is often mentioned in basic economics textbooks. But many people, even if they understand the concept in principle, can find it difficult to follow the advice to ignore sunk costs in practice.

Driving to the game in the blizzard, or playing tennis in pain, are mistakes no Econ would make. They rightly treat sunk costs as irrelevant. But for Humans, sunk costs linger and become another SIF, and not only for things like dinners and concerts. Many people believe that the United States continued its futile war in Vietnam because we had invested too much to quit. Barry Staw, a professor of organizational behavior, wrote a paper on what he called “escalation of commitment” and called the paper “Knee-Deep in the Big Muddy,” after an antiwar song by the folk singer Pete Seeger.
*
Every thousand lives lost and every billion dollars spent made it more difficult to declare defeat and move on, in Staw’s view. Some supposedly irrelevant factors can matter quite a lot.

Why do sunk costs matter? And why might people think that continuing a course of action—going to the game or concert, or continuing a futile war—is worth it? As we saw in the previous chapter, when you make a purchase at a price that does not produce any transaction utility (or disutility), you do not feel the purchase price as a loss. You have paid some money, and when you consume the product you will get the pleasure of the acquisition utility and the account will clear; your earlier cost is canceled out by your later gain. But what happens when you buy the ticket and then skip the event?

Paying $100 for a ticket to a concert that you do not attend feels a lot like losing $100. To continue the financial accounting analogy, when you buy the ticket and then fail to use it you have to “recognize the loss” in the mental books you are keeping. Going to the event allows you to settle this account without taking a loss.

Similarly, the more you use something that you have paid for, the better you can feel about the transaction. Here is a thought experiment. You buy a pair of shoes, perhaps because they were on sale and, while still expensive, you could not pass up all that transaction utility. You proudly wear them to work one day and by noon your feet hurt. After letting your feet heal, you try the shoes again, just for an evening this time, but they still hurt. Two questions: Assuming that the shoes never get comfortable, how many more times will you try to wear these shoes before you give up? And, after you have stopped wearing them, how long will they sit in the back of your closet before you toss them or donate them to charity? If you are like most people, the answers depend on how much you paid for the shoes. The more you paid, the more pain you will bear before you stop wearing them, and the longer they will take up room in your closet.