Children learn to count automatically by five and ten almost as soon as they learn to count. (Counting by four or seven or eight seems far more difficult. Even most adults find it challenging.) Roman numerals clump by five and ten. We prefer multiples of five—twenty-five, fifty, and seventy-five—to other multiples. This seems to be a universal quality, for according to Dehaene, “All the languages of the world have selected a set of round numbers.” Hence, setting prices to this predilection is only natural—what Robert Schindler, a professor of marketing at Rutgers School of Business, calls the “pull of the salient.”
Schindler was the keynote speaker at the Fordham University pricing conference. Slightly built and tonsorially challenged, Schindler has the bland, distracted look of a backroom accountant. But he is a rock star in this circle, and his presentation, provocatively titled “What Prices Reveal About the Mind,” brought down the house. Price promotions, Schindler began, are designed to evoke excitement by mimicking play and bringing out the customer’s inner child. For example, “nine for the price of ten” loyalty cards at Starbucks and other retail emporia seduce customers to buy more just to “score” free product. Buying more overpriced coffee than you need or want makes no rational sense, of course, but that’s the point. “We buy with our emotions, but that only describes the behavior; it doesn’t explain it,” Schindler told me. “We don’t know the first thing about our emotions; in fact, we’re in darkest Africa when it comes to understanding our emotions. What we do know—and what’s amazing—is how effective price has become at raising emotions and recruiting our mental energy. We pay attention to prices in a way we attend to nothing else. Price points have magical properties.”
Schindler bases this view on theory, and also on experience. Price is not only his job, it is his obsession. He is fascinated by people who classify themselves as “deal prone”; that is, who actively seek out and enjoy good deals. We may all believe we fit this category, but for psychologists like Schindler it is a matter of degree. He recalls speaking with a middle-aged woman who insisted that he take a look at the bargains she had accumulated in her living room. “She showed me this frayed and sagging sofa from 1986 or 1987,” Schindler said. “She bought it on sale and was still getting pleasure from it because buying it, owning it, validated her. Being a smart shopper, getting a good deal was central to her self-esteem. This may not have been logical and may not have made sense to someone else, but it was very real for her.”
Pricing doesn’t defy reason, but sometimes it does skirt around it. For example, beginning in 1880 or so the magical number nine started creeping into prices. Before then most numbers were round, but the nine seemed to get customers’ attention. Since then, nine has become the most common number found on a price tag and is especially popular when pitching low-price appeal. “This is a worldwide phenomenon,” Schindler said—except in Japan where the more auspicious number is eight. Nines are especially potent, of course, when they make the left-most digit on a price tag drop down a notch—$30.00 to $29.99, say, or $200.00 to $199.99. Even though we all “know” this trick, that $9.99 is essentially $10.00, not $9.00, the penny reduction lures by conveying the “cheaper” message subliminally. And, sorry to say, we are fooled every time. “There is a processing system within the brain that is not so smart,” Schindler explained, “a primitive mentality intuited by Freud and now being detected by scientists.”
Nearly a century ago, long before the development of scanning technologies, Freud postulated a two-stage processing system in the brain: the primary process and the secondary process. The primary process is impulsive and childlike, the devil on your shoulder. The secondary is more cautious, the “angel” on your other shoulder. As Freud’s daughter, psychoanalyst Anna Freud, later elaborated, “When the primary process prevails, there is no synthesis of ideas, affects are liable to displacement, opposites are not mutually exclusive and may even coincide, and condensation occurs as a matter of course.” The primary process is the primitive, unconscious element of the mind; it doesn’t fret about the past or speculate about the future. Like a small child, the primary process can’t see beyond the “now.” The more staid secondary process can con ceptualize both the past and the future, and ittests reality by applying rules of logic and evidence. It is the patient, sensible, grown-up part of the brain. The primary process leads you to grab the last piece of cake on the plate, the secondary process forces you to weigh that action, to consider how much you’ve already eaten and how many other people are vying for the slice. The primary system appears early in life and peaks at about age seven, when the secondary process kicks in. Freud contended that these two states coexisted, that the primary process remains active throughout life in the unconscious and even the conscious mind, sneaking out especially during times of stress or conflict. Recent experiments indicate that the primary process can be evoked even by minor distractions.
When setting discounts, marketers aim to activate the primary process in the brain, the emotional, impulsive side. In technical terms, their goal is to “spike the affective response to block the cognitive assessment.” In layperson’s terms, their goal is to distract customers from thinking hard about a purchase or, for that matter, thinking hard about anything at all. None of us—no matter how rational—is totally immune to this strategy. “The nine price ending thing is small, but it is real, and it serves as an illustration of a larger point,” Schindler told me. “Illusions guide our buying behavior.”
FOR SOME TIME
illusions also guided economists who predicted buying behavior. Chief among these illusions was that we humans always act in our own best interest. This fantasy, although losing currency in recent years, had prevailed in one form or another in American political and economic thought for over a century.
It was not always that way. Like psychology, economics was once a branch of “moral science,” concerned with the mind but also the heart. Adam Smith, the crusty Scottish philosopher generally credited as the founder of modern economics, began his
Moral Sentiments
: “How selfish soever man may be supposed, there are evidently some principles in his nature which interest him in the fortune of others and render their happiness necessary to him, though he derives nothing from it except the pleasure of seeing it. . . . The greatest ruffian, the most hardened violator of the laws of society, is not altogether without it.”
Smith and his followers were moral philosophers who regarded emotions as key to human decision making. But twentieth-century economists increasingly positioned themselves not as philosophers but as “hard scientists” who focused on the quantifiable and the absolute. They wanted nothing to do with psychology, which they considered a “soft science” and therefore subjective. In order to depict economic decisions mathematically, this “neoclassical school” discarded ephemeral variables such as guilt, fairness, justice, and regret, and made the hard-nosed assumption that human behavior was always built on a certain self-serving logic. They created as their model an economically “perfect” being called
Homo economicus
, a purely hypothetical creature who knows what he wants and strives to get it unperturbed by emotion and driven almost entirely by calculating self-interest. Homo economicus was considered a stand-in for Homo sapiens, who economists by definition were pressed to assume in their modeling to be purely rational, self-interested beings striving methodically to get as much for themselves as possible. This reasoning led to the theory of “utility maximization,” the idea that when normal humans do something—no matter how weird or stupid it seems—it is rational because they wouldn’t have done it if it did not maximize their personal gain.
This theory has significant predictive power: Humans do strive much of the time to maximize personal gain. But it also has its limits. Saying consumers act in a certain way because they believe it will benefit them restates the circumstance rather than explaining it, a tautology that simply does not hold up under scrutiny or in real life. It doesn’t explain why people wait in line for half an hour at the gas station to save 4 cents a gallon on gasoline or why they drive 5 miles out of their way to use a 50-cent coupon to buy a carton of eggs. It doesn’t explain why people decline to pay more than $200 for a ticket to a football game and yet refuse to sell that same ticket for $300. (If they won’t pay more than $200 for the ticket, then $300 should in theory be
worth
more to them than the ticket.) In fact, utility maximization doesn’t explain many ways in which real people relate to money.
In their seminal “Prospect Theory: An Analysis of Decision Under Risk,” published in the journal
Econometrica
in 1979, Israel-born psychologists Daniel Kahneman and Amos Tversky challenged the homo economicus orthodoxy. They argued that human decision making is less a matter of weighing evidence and calculating probabilities than it is of reconciling new information with old familiar patterns branded into the brain from as early as birth. These patterns of mind, or what psychologists call “heuristics,” allow us to make judgments quickly. Much like Freud’s primary system, they require very little if any conscious thought, and that is as it should be. Our brains were forged in the crucible of evolution, when a slow reaction time could be fatal. Confronted with a scowling enemy or a growling beast, those who hesitated were almost certainly lost. But in the modern world these cognitive shortcuts sometimes lead us astray. When it comes to money, focusing too hard on scowls and growls can cause us to act in a way that seems irrational and can ultimately harm rather than help us.
As illustration of this, Kahneman and Tversky evoked the universal phenomenon of loss aversion, the tendency of most people to strongly prefer avoiding losses rather than acquiring gains. At first blush this sounds counterintuitive. Doesn’t everyone want to win? The answer, of course, is yes, but not as much as we don’t want to lose. If you don’t play, you can’t win, but you also can’t lose. And that’s the reason so many of us decline to play when we should. Not playing results in lost opportunities, but scientists have shown that humans are not wired to spontaneously factor in missed opportunities, particularly when those opportunities are projected far into the future. We are wired, however, to worry a good deal about losing. And when it comes to feelings of loss, it is not necessarily the actual loss but the perception of loss that keeps us from acting in what would seem to be a rational manner.
Loss aversion is what spurs a scorned lover to cling to a bad relationship, an unhappy worker to cling to a bad job, and unhappy stockholders to cling to a plummeting stock rather than sell the loser and invest the proceeds in something more promising. In the latter case, the only logical reason to hold a stock is that you believe it is likely to grow in value. But because of our reluctance to admit mistakes and to cleave to what we already own, many of us prefer to avoid facing that central issue. This allows us to persist in the illusion that buying the stock in the first place was the right decision rather than an unfortunate and costly error. Following the thread of this distorted “logic” we convince ourselves that holding on to the stock is reasonable, because if we were right to buy it in the first place, we are right to hold on to it now. This is not the sort of thinking
Homo economicus
would engage in, but it is the sort of thinking real people engage in all the time—including those “brilliant” dot-com paper millionaires who were reduced to paper pauperhood when their star took a tumble.
We humans place an inordinate value on our own experiences and are highly influenced by context or what psychologists call “priming.” Sometimes this is fairly obvious and understandable. For example, we are more likely to worry about getting killed in a car accident if we have recently witnessed a fatal crash. But some priming influences are so indirect as to seem outlandish. Kahneman cited one experiment in which students were asked to estimate the distance on a map between themselves and various cities. The smaller the typeface on the map, the larger the distance estimated by the students. There is a twisted logic to this: The smaller font made the cities appear to be farther away. But it is not a logic that makes sense in the real world. Experiments like this underline the critical role that subjective variables play in cognition, especially when people are pressed to make decisions based on imperfect information. And in economics, information is rarely perfect.
In 2002, Kahneman was awarded a Nobel Prize (tragically, Tversky died prematurely in 1996) for having “integrated insights from psychology into economics, thereby laying the foundation for a new field of research.” Speaking at the annual meeting of the American Association for the Advancement of Science in February 2008, he explained the foundations of his insights. He said that as a rule humans tend to push aside difficult questions in favor of simpler questions that they can answer easily. This is why so many of us have such difficulty with investments. All of us want to regain our losses, naturally, but how to regain a loss is a very difficult question, far more difficult than simply hanging on to a particular stock. So rather than ask ourselves that question, we ask whether our current strategy is a good one. Of course this question does not address the larger and more important question of how best to make money, but how best to make money is a question we are reluctant to face, in particular when we are currently not making any. “If the question is difficult and an answer doesn’t immediately come to mind, we ask ourselves a related question that is easy to answer,” Kahneman said. “Generally speaking, the easy question is the wrong question.”
Tversky and Kahneman may have made less practical sense of such psychological insights had they not teamed up with the promising young economist Richard Thaler. Today a professor of behavioral science and economics in the Graduate School of Business at the University of Chicago, Thaler was, when they met in the late 1970s, a newly minted visiting professor at the National Bureau of Economic Research at Stanford University. Tversky and Kahneman were fellows at the Stanford Institute of Advanced Studies in Behavioral Sciences, and Thaler translated their psychological research into a hardheaded consideration of consumer behavior. His article, “Toward a Positive Theory of Consumer Choice,” published in 1980 in the
Journal of Economic Behavior and Organization,
is a guiding text in what was to become the field of behavioral economics. In it Thaler pointed out that economic theories based on a “rational maximizing model” describe how consumers
should
choose but not how they
do
choose. He argued that in certain well-defined situations many consumers act in a manner that is inconsistent with prevailing economic theory, concluding that “in these situations economic theory will make systematic errors in predicting behavior.” Thaler proposed an alternative descriptive theory built on Kahneman and Tversky’s work, making the case that price was not merely a number but a relationship between buyer and seller in which context is extremely important. In a series of influential papers he described a variety of apparently irrational behaviors that humans engage in when making financial transactions. A common theme in what Thaler called these “anomalies” was the resistance to deal rationally with ambiguity. Humans simply cannot cope with too many unknowns.