Wednesday, June 24, 2009

Predictably Rational - Part 2

In his book, Predictably Irrational, Dan Ariely tackles a very interesting phenomenon. The inpact of the word FREE in our decision making. With the help of some clever 'experiments', Ariely has 'proved' that human shoppers go beserk when they see the word 'free'. In other words they act irrationally.

The basis of this assertion is what economists term value or relative value. As per the economists the value you derive from any buy, is the value you associate with the satisfaction you obtain from the purchase minus the cost of the product (in same units).

So, if you value the satisfaction from eating a high quality Swiss or Belgian chocolates at 100 units and the satisfaction from a low-priced, non-hyped, Indian chocolate at say 75 units. Also assume that you have to pay 15 units for the high quality chocolate, and 10 units for the Indian chocolate, the value of Belgian chocolate is 100 - 15 = 85 units. The value of the Indian chocolate is 75 - 10 = 65 units. So, you would go for the Belgian chocloate (if you can afford, I presume).

Now, if you drop the cost of both chocolates by 5 units, your buying pattern should not change since the relative increase in value is identical. That is what the economist will say.

Dan Ariely goes on to indicate, in his (very readable, by the way) book, that when the cost is dropped to zero, humans become irrational. In our example, if the cost of obtaining the Indian chocolate is made zero and the cost of the Belgian chocolate is made 5 units, the rational model breaks down. People will shoot for the free chocolates. We behave predictably irrational. (By the way, Dan Ariely is not using the word irrational in a bad way, it is just that the standard economist assume a rational response to incentives and Ariely is 'proving; it otherwise.

But let us see where both stadard economists and Dan Ariely fail.

Before I give my explanation, please do consider that I have no formal (or for that matter informal) training on economics. Having made that disclaimer (ahem!) let us proceed.

I think, the economist evaluate value in a totally different way than the common (sense) person. We derive value not by subtraction but by division.

Here are the formulae ...

Economist's Value = Satisfaction - Cost
Common Person's Value = Satisfaction / Cost

So when the cost drops to zero, the value tends towards a very high value. That is the only reason why we behave the way we do. Absolutely rationally!

By the way, there is no such thing as free lunch. Dan Ariely explains this beautifully in the chapter The Cost of Zero Cost of the book.

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