Saturday, December 17, 2011

Predictably Irrational: Chapter 3

Dan Ariely is a behavioural economist who refutes the idea that we are fundamentally rational. Through empirical data, experiments and anecdotes, he illustrates that our irrationality can actually be predicted. He then presents ways in which we can make more rational decisions, both as investors and as people.

Another factor that makes us behave completely irrationally is when something is "free". Ariely describes a number of experiments which show people behaving somewhat rationally when things are a dollar or a penny, but this quasi-rationality totally breaks down when something is free.

For example, people shopping in a store would much rather have a free $10 gift certificate than pay $7 for a $20 certificate, even though the profit for the latter is $13 vs $10. This allure of "free" can play havoc with our minds.

Companies take advantage of this all the time, making products/services available for "free" as long as we buy something else. One company that used this well is Amazon, which made free shipping available for purchases of a certain size, and saw those types of sales increase dramatically. In Amazon France, where shipping was reduced to 20 cents or so, the results were not so dramatic. When Amazon France dropped shipping to zero, it too saw sales spike, as consumers behaved rather irrationally.

The fact that something is free also makes us overpay in other ways. Often, we go for the free item when we would get better value from the non-free one. (For example, car dealerships offer "free gas" to buyers rather than apply a cash discount, which could influence your choice of cars whereas it shouldn't!) We also waste our time, both doing things we wouldn't otherwise do (e.g. spending the day at a museum in which we have little interest) and standing in lines we would otherwise avoid.

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