Priceless: The Myth of Fair Value (and How to Take Advantage of It) (2 page)

Luby holds a physics degree from the University of Chicago. In his job as price consultant, he more often thinks like a magician. Like a skillful conjurer, he is asked to manage what buyers notice and remember. Skippy peanut butter’s customers often have small children and purchase it so regularly that they remember the last price they paid. For such products, consultants recommend creative ways of “invisibly” shrinking packages. In summer 2008 Kellogg’s phased in thinner boxes of Cocoa Krispies, Froot Loops, Corn Pops, Apple Jacks, and Honey Smacks cereals. No one noticed. Shoppers just see the box’s width and height on the shelf; by the time they reach for the box, the decision has been made and they’re thinking of something else.

Dial and Zest recently changed the sculptural contours of their bars, shaving half an ounce off the weight. The boxes stayed about the same. Quilted Northern made its Ultra Plush toilet paper half an inch narrower. The makers of Puffs tissues shrank the length of their product from 8.6 to 8.4 inches. As the Puffs box remained the same (9.5 inches wide), there is presently over an inch of air hidden inside. You can’t see it because the opening is in the middle. In any case, a shopper wouldn’t notice the shrinkage unless she archived old Puffs tissues and measured them.

This ruse can go on only so long. Cereal boxes would collapse to cardboard envelopes; jars would become plastic voids. Eventually there arrives a point at which the manufacturer must make a bold move everyone will notice. It introduces a new, economy-size package. In size, shape, or other design features, the new package (and its price) is difficult
to compare to the old. The consumer is flummoxed, unable to tell whether the new package is a good deal or not. So she tosses it into the cart. The cycle of shrinking packages repeats, ad infinitum.

If you find this a silly charade, you’re not alone. Just about everyone does,
when they think about it
. Many grumble they’d rather pay an inflation-adjusted price for the quantities they’ve known. Others swear they look at the market’s comparison labels, giving price per ounce, and wouldn’t be fooled. One of the things that price consultants have learned is that what consumers say and what they do are not the same thing. For the most part, memories of prices are short, and memories of boxes and packages shorter.

It wasn’t so long ago that companies priced their products with no strategy beyond the demand curves of Economics 101. In the past generation, firms such as Boston Consulting, Roland Berger, Revionics, and Atenga have prospered by advising businesses on the surprisingly complex psychology of price. No firm has spearheaded the professionalization of pricing more than Simon-Kucher & Partners (SKP). German business professor Hermann Simon and two of his doctoral students founded the firm in Bonn in 1985. SKP is now nearing five hundred employees stationed all over the globe, with U.S. offices in Cambridge, New York, and San Francisco. With sixty Ph.D.s on staff, quite a few in physics, SKP has a reputation as the rocket scientists of pricing. The firm exudes a
Star Trek
cosmopolitanism. Employees from India, Korea, Germany, Switzerland, and Spain mingle in the Cambridge office, and it’s the practice to rotate promising consultants among nations. Each year SKP assembles its far-flung employees for a party at a castle on the Rhine.

The influence of SKP on the prices we pay for just about everything is as little recognized as it is staggering. Rules that apply to other types of consultancies don’t apply to pricing. An ad agency would not have Coca-Cola
and
Pepsi as clients—but SKP does. In many industries, SKP advises half a dozen of the leading firms. Its current roster of clients includes Procter & Gamble, Nestlé, Microsoft, Intel, Texas Instruments, T-Mobile, Vodaphone, Nokia, Sony Ericsson, Honeywell, Thyssen-Krupp, Warner Music, Bertelsmann, Merck, Bayer, Johnson & Johnson,
UBS, Barclays, HSBC, Goldman Sachs, Dow Jones, Hilton, British Airways, Lufthansa, Emirates Airlines, BMW, Mercedes, Volkswagen, Toyota, General Motors, Volvo, Caterpillar, Adidas, and the Toronto Blue Jays. The same psychological tricks apply whether you’re setting a price for text messages or toilet paper or airline tickets. To SKP’s consultants, prices are the most pervasive of hidden persuaders.

Though a price is just a number, it can evoke a complex set of emotions—something now visible in brain scans. Depending on the context, the same price may be perceived as a bargain or a rip-off; or it may not matter at all. A few of the tricks are timeless, like shrinking packages and prices ending in the magic number 9. But price consultancy is more than the latest chapter in flat-world hucksterism. It draws on some of the most important and innovative recent work in psychology. In the mundane act of naming a price, we translate the desires of our hearts into the public language of numbers. That turns out to be a surprisingly tricky process.

Imagine you are asked to heft a suitcase and guess its weight. How accurate would your guess be? Not very, most would admit. The arm muscles and brain and eye just aren’t wired to gauge pounds or kilograms. That’s why supermarkets have scales and carnival weight-guessers draw slack-jawed crowds.

Now imagine that the suitcase is lost luggage being auctioned. The lock is picked, and the suitcase is shown to contain some resort clothes, a high-end camera, and other lightly used merchandise. Your task now is to guess the winning bid—the market value of the suitcase and its contents. How accurate do you think this guess would be? Would it be any better than your guess about weight?

Auctions can be unpredictable. Okay, I’ll make it easy for you. Pretend you’re a bidder in the auction. All you have to do is decide your top bid. You’re not guessing what
other
people will do; you’re just expressing how much the suitcase is worth to you, in dollars and cents. How exact would that valuation be? It’s not the easiest thing to attach a price to something with no clear market value. You may end up wondering whether your top price is any more sharply defined than the other two guesses.

One of the running themes of price psychology is that judgments of monetary value have much in common with sensory judgments like weight—or brightness, loudness, warmth, coldness, or intensity of odors. The study of sensory perceptions is known as
psychophysics
. Back in the 1800s, psychophysicists determined that people are acutely sensitive to
differences and not so sensitive to absolute values. Given two identical-looking suitcases, one weighing 32 pounds and one 36 pounds, it’s a cinch to tell which is the heavier by lifting. But without a scale, it’s hard to be certain whether either suitcase would meet an airline’s 44-pound limit.

People display a similar cluelessness about prices. This all-important fact goes largely unrecognized. That’s because we live our lives in a media cloud of advertised prices and market values. Because we remember what things are “supposed to” cost, we can adopt the pretense of having an unerring sense of value. Consumers are like a sight-impaired person who can navigate familiar surroundings because he has memorized where the furniture is. This is compensation, not keenness of vision.

Every now and then we get a hint of how myopic the price sense is. Anyone who’s held a yard sale knows how difficult it can be to put meaningful prices on household castoffs. “This old Tribe Called Quest CD should be worth twice as much as that Alanis Morissette—I’m sure of that. I’m not so sure whether Tribe should be selling for $10 or 10 cents.”

In a 2003 paper, economists Dan Ariely, George Loewenstein, and Drazen Prelec termed this curious mix of conviction and uncertainty coherent arbitrariness. Relative valuations are stable and coherent, while actual dollar amounts can be wildly arbitrary. Yard sales reveal a truth we might not care to admit in a business deal: prices are made-up numbers that don’t always carry much conviction.

This book tells the story of a simple finding with far-reaching consequences. The numbers that make our world go around are not so solid, immutable, and logically grounded as they appear. In the new psychology of price, values are slippery and contingent, as fluid as the reflections in a fun-house mirror.

This challenges the credo that “everyone has a price,” something ingrained in business sense and common sense alike. Terry Southern’s 1959 novel,
The Magic Christian
, riffs on that bit of folk wisdom. Billionaire antihero Guy Grand is a prankster who devotes his life to proving that every man and woman has a price. In a typical caper, Grand buys an office building in Chicago just to tear it down and replace it with
a boiling vat of manure, blood, and urine from the stockyards. Simmering in the hellish muck is $1 million in hundred-dollar bills. A sign on the vat announces
FREE
$
HERE
. Grand’s doctrine is that there is nothing so degrading that someone won’t do it for a sufficiently large pile of cash.
The Magic Christian
permits the reader no scope for feeling superior. We may not all be money-grubbing materialists, but it is difficult for anyone in our society not to believe in the weirdly transcendent power of money.

The “everyone has a price” theory holds that valuations are stable and can be revealed by a little wheeling and dealing. When offered a bargain (Faustian or otherwise), I compare it with an internal price and decide whether to accept it. It is not too much of an exaggeration to say that all of traditional economic theory is founded on this simple Guy Grand premise: everyone’s got a price, and those prices determine actions.

There’s now overwhelming evidence that this idea is wrong, at least as a model of how real people act. As far back as the late 1960s, psychologists Sarah Lichtenstein and Paul Slovic demonstrated the deep ambiguity of prices. In their experiments, subjects were unable to set prices consistent with what they wanted or the choices they made. Psychologists have been working out the consequences ever since. In the new view, internal prices are “constructed” as needed from hints in the environment. One demonstration of how that works is the “United Nations” experiment of Amos Tversky and Daniel Kahneman.

Tversky and Kahneman are a legendary team of Israeli American psychologists. Kahneman, now in his mid-seventies, is a very active senior scholar at Princeton’s Woodrow Wilson School. Tversky, the younger man by three years, died of melanoma in 1996, at the age of fifty-nine. In 2002, Kahneman shared the Nobel Prize in Economic Sciences with American economist Vernon Smith. Tversky was cheated of that honor only by his early death.

Kahneman and Tversky’s primary field was a still-young branch of psychology called
behavioral decision theory
. This is the study of how people make decisions. At first encounter, that topic may sound worthy and slightly dull. In fact, it spans the human comedy and tragedy. Life is all about deciding.

The word “behavioral” emphasizes that this is an empirical science, studying how flesh-and-blood people act rather than prescribing how they
ought
to act. Behavioral decision theory is still a small field, much like an extended family. In interviewing some of its most distinguished figures, my talk of “Professor Kahneman” instantly branded me an outsider. To everyone in the field, it’s “Danny” and “Amos,” and this is no false familiarity. Almost everyone knew them. Seated, with his feet up, in the study of his East Village penthouse, “Danny” was almost apologetic when I mentioned his United Nations experiment, part of the body of work that merited his Nobel Prize.

“At the time,” he said, “it was not considered a big sin.” The “sin” was using deception in a psychological experiment, something now frowned upon.

He and Tversky used one piece of aparatus, a carnival-style wheel of fortune marked with numbers up to 100. A group of college students watched as the wheel was spun to select a random number. You can play along—imagine that the wheel is spinning right now and the number is . . . 65. Now answer this two-part question:

(a) Is the percentage of African nations in the United Nations higher or lower than 65 [the number that just came up on the wheel]?

(b) What is the percentage of African nations in the United Nations?

Write your answer here (  )—or pause a moment to think of a
specific number
. Got it?

Like many experiments, and some wheels of fortune, this one was rigged. The wheel was designed to produce one of only two numbers, 10 or 65. This rigging was done only to simplify analysis of the results. In any event, Tversky and Kahneman found that the allegedly random number affected the answers to the second question. The effect was
huge
.

When the wheel stopped on 10, the average estimate of the proportion of African nations in the U.N. was 25 percent. But when the wheel-of-fortune number was 65, the average guess was 45 percent. The latter estimate was almost twice the first. The only difference was that the estimators
had been exposed to a different “random” number
that they knew to be meaningless
.

Okay, you’re saying, people are lousy with geography. The college students didn’t know the right answer and had to guess, to pull a number out of the air. You might imagine that someone at a loss for an answer would parrot a number that happened to have been mentioned recently. That wasn’t what happened. Respondents weren’t simply repeating the actual numbers they’d been cued with (10 or 65). They named their own numbers; but in so doing they were influenced by the magnitude of the number cues.

Tversky and Kahneman used the term “anchoring and adjustment” for this. In their now-classic 1974
Science
article, “Judgment Under Uncertainty: Heuristics and Biases,” they theorized that an initial value (the “anchor”) serves as a mental benchmark or starting point for estimating an unknown quantity. Here, the wheel-of-fortune number was the anchor. The first part of the question had the subjects compare the anchor to the quantity to be estimated. Tversky believed that the subjects then mentally adjusted the anchor upward or downward to arrive at their answers to the second part of the question. This adjustment was usually inadequate. The answer ended up being closer to the anchor than it should be. To someone inspecting only the final outcomes, it’s as if the anchor exerts a magnetic attraction, pulling estimates closer to itself.