Priceless, The Myth of Fair Value (and How to Take Advantage of It)

[chin]

This is the third William Poundstone book I purchased.

The first one was "Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street". It was focused on the development of information theory by Claude Shannon, and the theory's subsequent development and application by John Kelly, Ed Thorpe & others. I was initially interested in the background stories, as my work involves quite a bit of the applications of information theory, and in particular Kelly's Criterion. (See my thread on Ed Thorpe.)

The second Poundstone book I had was "Prisoner's Dilemma", which was published much earlier in 1993. Like "Fortune's Formula", this book focus on the particular scientific studies of game theory - the stories of the founding father John von Neumann, the applications in Cold Wars, etc. I have not read the book, but my daughter did and she found it facinating. (She will be studying game theory in an intense summer program in July, and I hope she will be learning a bit more of the mathematic side of it, in additional to the historical aspects & applications of game theory.)

"Priceless", like the two above, is focusing on a particular area of academic study, with stories of real world applications. This time it is the psychology of pricing, or behavioral economics.

[chin]

I started reading this book about 1 week ago, and only 2/3 through. The book is very interesting and written in a very easy reading style. (If I were not spending too much time playing Mass Effect 2, I would have finished reading the book now.)

One of the central theme or highlight is the application of "anchoring" in the pricing of consumer goods, or in negotiation ranging from court settlement to selling a house. Anchoring refers to the tactic of setting a high initial price to raise the precepted value of the item in negotiation, thus "anchored" the price/value/starting point in the buyer's mind.

Anchoring is something that I see all the time, and very often I thought to myself that "no one is going to fall for that!" But apparently many people, including my own purchasing behavior on reflection, are affected by anchoring.

Before quoting more stories from the book and some personal experience, I would like to especially recommend this book to all my friends here who run their own business or in a position to manage a business. You will always learn something for your business, from the many examples and studies quoted in the book.

(The organization of this book seems not as tight as "Fortune's Formula" - the 1st half stories of the people who pioneered the study of behavioral economics, then a loose collection bite-size chapters of examples of real world applications or studies. But this is really not a complain, and in no way dilute the interestingness of the book.)

[chin]

The book opens with a 1994 news item that McDonald's was to pay US$2.9 million to a customer who spilled her own McCoffee on her laps and caused 3rd degree burn to herself. This outsized damage award instantly became the poster child of what's wrong with the US legal system.

For the purpose of the book, the key question was how was the US$2.9m determined. It turned out that the McCustomer's lawyer, after established why it was McDonald's fault for the 3rd degree burn, placed a clever anchor in the jury's mind on how much damage to award.

He suggested the jurors to penalize McDonald's in the amount of the company's one or two days worth of worldwide coffee sales, and informed the jurors that the daily sales figure was US$1.35 million. It was never justified why "worldwide", why "daily", why "1 or 2 days", or even why "coffee sales". But the anchor was successful, as the jury awarded US$2.7m punitive damage, plus US$160,000 compensatory damage.

[chin]

The book is full of examples of psychology studies of anchoring. One of the little games is called United Nations. It goes something like this:

a. a wheel was spun to select a ramdon number, and stops at, say, 65.

b. then you are asked the 1st question "is the percentage of African nations in the United Nations higher or lower than 65% [the number that just came up on the wheel]?

c. then you are asked the 2nd question "what is ther percentage of African nations in the United Nations?

Stop now and answer the questions.

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As it turned out, the wheel does not stop at a random number. It only stops at 65 or 10. When the 65 came up, people tend to over-estimate the answer to the 2nd question. The seemingly random unrelated number 65 anchors in people's mind when they answer the 2nd question.

I played this little game by myself & with my children, and I am happy to report that we are quite rational, and not much affected by the anchor. If you are logical, you figure that the world is roughly divided into 4 large continents - Africa, Asia Pacific, Europe & the Americas. So 1/4 should be about right for the 2nd question.

The correct answer, for the year the experiment was conducted, was 23%.

[chin]

The above United Nation study shows the effect of anchoring, even with seemingly totally irrelevant numbers, in the human mind when confronted with uncertainties. In the rest of the book, there are many many examples of real world pricing schemes that exploit the weakness in our psychology and decision making under uncertainty.

In 2002, my family went to the US for summer holiday. One of our stops was Las Vegas, and one of our to-dos in Las Vegas was to see the Cirque du Soleil show "O" in the Bellagio. I asked someone I know in the US to purchase the tickets, without giving specific instructions. Out of his habit, he bought the cheapest tickets. I wasn't very happy about it, and thought that I should have told him to get the most expensive tickets. The reason was the we travelled all the way from the other side of the earth at great expenses, why save a few hundred US$ risking not getting the better seats?!

Does it ring a bell? How many times you decided to purchase the expensive (maybt not the most expensive but the 2nd most expensive) tickets when you are unfamiliar with the seatings? I know I have done it many times.

One of the many anchoring stories from the book is the ticket prices at Broadway & Las Vegas! Cheap seats don't sell. When most customers are tourists who have no idea about the value of a seat, they judge the value of the seat by the price. Successful productions would have outragously high price seats, and these seats made the less-outragously-priced-but-still-very-expensive seats reasonable. In fact one of the producer revealed that sometimes "70%-80% of [all the seats] is top price."

And one of my favorite studies is the pricing of luxury goods. Living in Hong Kong, we are constantly exposed to bombardment of luxury goods, products that are very expensive and supposedly shows "who you are!". In a Muse Magazine article, it was said that on average Hong Kong people spend HK$6000 on designer brands every three months.

I have started a thread showing (bragging?) some of the gifts I received, including a Cartier key ring retailed at US$280, a Tiffany money clip retailed at US$150. In the same thread I recounted stories of people buying HK$1500 key chains. Whilst I don't think I would ever pay these high prices for items that have very cheap and equally functional alternatives, I always wonder why some people do, and why people would line up outside the store under a very humid weather to buy plastic bags from LV? (Out of curiosity we bought one, found it much less functional than much cheaper bags, store it away gathering dust for a few years, and recently gave it away to someone who treasures the brand.)

Now back to the book. One of the chapters examined anchoring in the pricing of luxury goods. "You sold one thing to the king, but everyone in court had to have a lesser one" sums up the idea. The "one thing to the king" would be the $280,000 handbag you see in the magazine high society party page, and the "lesser ones" would be the $8000 plastic bag or the $2000 key ring.

I am recounting many of my personal experience here because reading the book made me reflect on my own past. Was I hooked to the anchoring just like the majority? How do I step back to see the big picture and value things rationally? I believe a good book makes you think.

[chin]

When I studied economics in university, we had a very basic assumption that people are rational, and market if efficient. Yet real world anchoring effect clearly shows people do not behave rationally all the time (perhaps the market is not so efficient, and people do not have easy access to full information.) The new study of behavioral economics confronts traditional economic studies.

"Priceless" recounted an exchange between a French economist Allais (who eventually won a Nobel Prize) and Savage from the University of Chicago. The Chicago school of thought assumed decisions about money were (or could be) completely logical. Allais thought it was wrong, and posed the following 3 riddles. "Priceless" adopted a streamlined version, and I will further streamline them.

RIDDLE ONE: which of the following would you rather have
a. a sure $1 million
b. 89% chance getting $1m, 10% getting $2.5m, 1% nothing.
Allais believed most people would choose a for the sure thing. (I believe people with very keen number sense & probability would choose b for the higher expected value.)

RIDDLE TWO: this time your choices
a. an 11% chance to get $1m
b. a 10% chance to get $2.5m
Allais believed most people would choose b for the small difference in chance.

RIDDLE THREE: now you have a sealed box in front of you, and you do not know the content.
a. 89% chance getting whatever in the box, 11% getting $1m
b. 89% chance getting whatever in the box, 10% getting $2.5m, 1% nothing.

In a typical rational decision arguement, since the box exist in both choices, it should be irrelevant to the decision, so in this sense RIDDLE THREE is the same as RIDDLE TWO. Thus b is the preferred choice to most people.

But what if the box contains $1m? Then RIDDLE THREE is the same as RIDDLE ONE, but with contradicting preference. This set of riddle revealed a certainty effect. The conclusion is that "smart people are influenced by mere words, by the way the choices are framed", thus "we choose between description of options, rather than between the options themselves."

More examples in the book illustrated how framing works. Lottery advertisement tells you how big the prize is, but not the (slim) chance of winning. Insurance salesman tells you how bad a catastophe can be, but not the remoteless of the odds. People are being directed to focus on the dollar amount but not the probabilities. In a rational world, both numbers are required to make a logical decision.

(A side story. I have many heated arguments with my friends why most people should not buy any insurance besides those required by law. Most people couldn't believe how bad a gamble insurances are, especially life insurance. My initial objection came from the believe that nothing is free and many financial products are fixed sum games. My conviction was strengthened when doing a M&A deal on a smaller insurer. A industrial standard of 50% or less payout rate means policy holders are expecting to get back only half the value.)

[chin]

The above are just some of the tidbits on the formation and reasons behind the study of behavioral economics. Part 4 of the book, which accounted for about half of the total pages, included many chapters in the applications of anchoring and exploitation of our irrational valuations.

For my friends who is running their own business, you should read this book. Even if you are not interested in the historical context of behavioral economics, the case studies in Part 4 should be interesting enough for any business person.

[q]

One of my experiences with anchoring is when I made my last trip back to Tasmania.  My notion of prices in Tasmania is stuck 10 years in the past, so I find myself thinking everything is really expensive.