Priceless: The Myth of Fair Value (and How to Take Advantage of It) (7 page)

Hunt called this effect “anchoring” (using the word in still a different sense). He distinguished two varieties.
Contrast
anchoring occurs when you compare two stimuli. The glare of a streetlight makes the evening star look faint, and woe to the comedian who follows someone 40 percent funnier.
Assimilation
anchoring occurs when you have to invent an answer, given one or more possible responses. This occurs when people name a crime half as bad as another, or when jurors deliberate on a damage award after hearing an attorney’s demand. The two types of anchoring have opposite effects. In contrast anchoring, subjective perceptions are displaced
away
from the anchor. In assimilation, responses are drawn
toward
the anchor.

Helson spent a lot of effort trying to understand what qualifies an experience as an anchor, capable of influencing a judgment. His answers were “recency, frequency, intensity, area, duration, and higher-order
attributes such as meaningfulness, familiarity and ego-involvement.” That isn’t such a mouthful as it sounds. Start with
recency
. A 5-ounce weight feels heavy a couple of seconds after you lift a 3-ounce weight. Wait an hour between weights, and the contrast effect vanishes. You forget how heavy the previous weight felt.

Frequency matters too. Lifting a series of 3-ounce weights causes an adaptation to that particular degree of heaviness. Should you then lift a 5-ounce weight, it feels heavy. The effect of the multiple 3-ounce anchors is stronger than the effect of just one anchor.

Helson’s most interesting findings were about “higher-order attributes” such as meaningfulness. He pulled a trick on some of his subjects. In the midst of an experiment, he requested that the subject move a tray of weights out of the way. The tray (plus the weights it held) was a “weight” heavier than any of those used in the experiment. But the heavy tray did
not
make the next object lifted seem light in comparison. The subjects were focused on the little metal weights, not the tray, and they tuned it out. This demonstrated that anchoring is not a muscular reaction but a mental one.

There is a magnitude scale of overwhelming importance in everyone’s life. It’s called
price
.

Perhaps around 3000 BC, the Mesopotamians realized that the shekel, their unit of weight, could also denote that weight of barley—or the value of whatever might be bartered for that amount of barley. This was the beginning of money and of prices.

To an economist, a “reserve price” is the maximum amount a buyer is willing to pay, or the minimum a seller is willing to accept. Transactions are expected to take place at a price somewhere between these extremes. Economics investigates how market forces affect prices paid.

There is a quite different way of looking at things. Reserve prices can be thought of as a magnitude scale. For a buyer, prices are a numerical measure of desire to possess something. For a seller, prices measure desire to keep what one already has (including such all-important possessions as time, energy, and self-respect).

In the common sense of everyday affairs, prices are one-dimensional, like marks on a ruler. For every commodity, there’s a single point on the scale. These points neatly order all the world’s stuff by price. The psychological reality of prices is not that simple.

Those in S. S. Stevens’s Harvard lab got some free lessons in the psychology of money. “Smitty was a close man with a dollar, and he spent his laboratory budget as if it were his personal checking account,” said colleague George Miller. Stevens was notorious for denying raises. When confronted, he had the perfect psychophysical explanation.
You
don’t want a raise
, Stevens would say.
One day you’ll leave Harvard. If you get used to a high salary here, you’ll be completely priced out of the market elsewhere.
To Stevens, a good salary was a low salary surrounded by a ring of abject poverty.

Stevens posed this riddle to his classes: “Suppose I were to tell you that I have a special fund for the purpose, and that I am going to give you ten dollars. That would make you happy, would it not? Now think this over carefully: how much would I have to give you to make you twice as happy?”

Philosophers are free to object that a phrase like “twice as happy” is meaningless. But Stevens’s students didn’t seem to have a problem answering the question in the spirit intended. Their replies would have shocked economists more than philosophers. The average answer was about $40.

Think of it this way. Getting $10 you didn’t expect is a nice little surprise. For the next day or two, at odd moments, you’ll think about the extra cash in your wallet and feel good. A week from now, the money will be spent and forgotten.

Now: Can you honestly say that getting $20 would be
twice
as good? Everything I just said about $10 applies to $20.

By this line of reasoning, it ought to take more than $20 to make someone twice as happy; and it did. In classrooms, the average answer has ranged from $35 to $50.

Diminishing returns for money was hardly news. No economist would have been surprised in the least had Stevens found that it took $4 million to double the pleasure of getting $1 million. Those are life-changing sums. A million dollars buys much of what money can buy (in Stevens’s time, anyway). No one expects one’s second million to be as meaningful as the first.

This is known as a
wealth effect
. It can’t explain Stevens’s little experiment. His subjects were Harvard students, many from wealthy families and most looking forward to a lifetime of financial security. From a lifetime perspective, a few tens of dollars should have been meaningless. The only thing that should have mattered was what the money could buy. Whatever the conversion rate of money to happiness, $20 buys twice as much as $10 does. The “correct” answer should be $20.

Why didn’t Stevens’s students see things that way? Apparently, they
weren’t just thinking of what the money could buy. Money itself was a “stimulus” producing a sensation—and it worked much like the other stimuli Stevens studied.

Stevens lived long enough to see a number of careful studies measuring the subjective impact of money. In 1959 the Japanese psychophysicist Tarow Indow showed pictures and descriptions of wristwatches to a group of 127 college students. He had them rate the desirability of each watch, then name a fair price for it in yen. The students believed that in order to get a watch twice as desirable, it was necessary to pay about 8.7 times as much.

To give some contemporary figures, Timex watches hover around $40, you can have your pick of Swatches for around $150, a Cartier Tank watch is $3,000, and a Rolex President costs about $30,000. All are good watches that do what a timepiece is supposed to do. The only difference is status. Wearing a Cartier says you’re rich and don’t care who knows it. The Rolex says the same thing, only louder. The Rolex presumably has a higher bling rating than the Cartier, but not anywhere near ten times more. As Indow’s students appreciated, a massive increase in price buys only an incremental increase in cachet.

There were also studies finding power laws for the social status attached to income and the seriousness of a theft of money. To double your social status, you need to earn about 2.6 times as much, according to one study cited by Stevens. The seriousness of thefts rose the slowest with dollar value. A thief would need to steal 60 times as much to double the seriousness of the crime. At first this may sound odd. But most would agree that stealing
anything
is wrong; the amount stolen is a secondary consideration. Hence, according to the power curve of thievery, stealing $6,000 is only about twice as bad as stealing $100.

Overall this research confirmed Stevens’s opinion that perceptions of money were much like those of the senses. Price is a magnitude scale with a meaningful zero (we all know what it means for something to be worthless) and no upper limit. The different characteristic ratios (for gifts, thefts, etc.) are also typical of magnitude scales.

As mad as our culture is about money, we’re actually
less
sensitive to it than to a lot of things. There are many sensations that increase faster
than the stimulus itself. It takes only 1.6 times the weight to double the perception of heaviness (all weightlifters understand this). Only 1.2 times the electric current doubles the sensation of shock (this is why it’s an effective torture). With money, it always takes more than twice the cash to double the thrill. Relatively speaking, there’s not much bang for the buck.

In hindsight, this work on the psychophysics of money was original and hugely important. Price is a unique magnitude scale, of course. We care a lot about absolute values—about the actual prices charged for things. However, caring about absolutes does not confer the power to perceive them accurately. When estimating monetary values, people are easily swayed by the legerdemain of anchoring, by illusions trading on contrasts and the power of suggestion. To an extent that few could have anticipated, this work revealed an invisible hand guiding, and misguiding, the world’s financial decision making.

Practically no one outside of psychophysics paid the slightest attention to it.

Like most of the Jewish mobsters who ran Las Vegas, Benny Goffstein was a family man. When he had a chance to open his own casino, he named it the Four Queens, in honor of his four daughters. Compared to the first casino he’d run, the Riviera, the Four Queens was downtown and downscale, and all the more profitable for it.

One of the Four Queens’ investors was utterly unlike the mob types that Goffstein had encountered at the Riviera. He was Charles B. G. Murphy, a Massachusetts aristocrat of somewhat scandalous tastes. Murphy had been a Yale football player, a friend of J. Sterling Rockefeller, an African explorer, a big game hunter, an attorney, and a gambler. He spent his last years in Las Vegas. Murphy came to Goffstein with a problem. He had set up a charitable foundation to avoid paying taxes. The government was pressuring Murphy to disburse some of the foundation money for good works, lest the tax shelter be disallowed. Murphy was determined to fund scientific research on a topic dear to his heart: gambling.

Murphy called around asking for the name of a scientist who was an expert on gambling. He came up with Ward Edwards, a psychologist at the University of Michigan. Edwards had an unusual request. He and a couple of his former students, who worked for an outfit called the Oregon Research Institute, wanted to do some experiments in a Las Vegas casino. They were big on doing experiments on real people in real settings. Would it be possible to use the Four Queens? Murphy, as major backer, had enough of the street in him to make it clear that this was an offer Goffstein could not refuse.

•   •   •

Ward Edwards (1927–2005) spent his career asking difficult questions. Born in Morristown, New Jersey, he was the son of an economist and grew up hearing the table talk of his father’s colleagues. This instilled in him a rebellious skepticism toward economics. Ward decided on psychology as a career, studying at Swarthmore and Harvard. It was at Harvard that he read the work of John von Neumann and Oskar Morgenstern, and he wasn’t crazy about all he read.

Hungarian-born John von Neumann was one of the great mathematicians of the twentieth century. At the urging of Princeton economist Oskar Morgenstern, von Neumann turned his brilliant mind to the problems of economics. The result was a 1944 book,
Theory of Games and Economic Behavior
. Von Neumann’s running metaphor was that economic conflicts were “games,” something like poker and equally amenable to mathematical analysis.

The poker chips of economic games are dollars and pounds and yen. Or actually, not quite that. Von Neumann, like economists in general, insisted on playing for a subjective currency called
utility
.

That term dates to the eighteenth century. Swiss mathematician Daniel Bernoulli noted that the value of money is relative. A hundred-dollar birthday check can be undreamed-of riches to a five-year-old child and totally meaningless to a forty-five-year-old billionaire. In predicting what people will do with money, it is necessary to adjust for these differing valuations, just as it is sometimes necessary to adjust dollars for inflation.

You can think of utility as a personal “price tag” that everyone places on things and outcomes. I think this yard sale lamp is worth 50 utility-dollars, you think it’s worth zero. The important thing is, people try to amass the most utility, not necessarily the most dollars. Whoever dies with the most utility wins.

Economists took to Bernoulli’s idea for two reasons. One, it acknowledged what was always obvious: that psychology (not just simple avarice) determines economic decisions. Two, utility excused economists from paying much attention to psychology. Economists were mainly interested in forging an exact mathematical science. With a few exceptions, they didn’t want to bother with measuring the psychological aspects of
money. They much preferred to assume it could be done in principle.

Utility is a powerful idea (so goes the prospectus) because its imaginary price tags determine all economic decisions. MIT economist Paul Samuelson developed this notion into his doctrine of “revealed preference.” This appealingly sensible thesis says that the only way to learn about utility is to look at the choices people make. Choices reveal all that we can know of utility, and utility in turn determines the prices that consumers are willing to pay.