Predictably Irrational

I just finished listening to a great book called Predictably Irrational, by the acclaimed professor of behavioral economics, Dan Ariely. As I listened, I kept thinking of the irrational factors we deal with every day in the machine tool business.

Ariely says that standard economics assumes people are rational, thus they can make logical and sensible decisions, and quickly learn from past poor decisions either on their own or with the help of standard market forces.

However, his research has shown that people are much less rational than we assume. He says that people make the same mistakes over and over because of how our brains are wired, so we need to look at economics based on how people actually behave rather than how we think they should behave.

One concept Ariely discusses he calls “anchoring.” This often relates to prices as well as other benchmarks people encounter in business. Anchoring refers to how people’s minds set a standard based on the first figure they hear. For instance, if I’m selling a used machine and the first price I quote a customer is $100,000, that figure will guide the customer to believe that anything higher than that price is too expensive. That’s assuming the customer hasn’t been quoted a different price on that machine previously. If so, he will be anchored to that price instead. For an Acme-Gridley that is 40 years old, it is difficult to objectively assign a value based on market factors, so the experience of receiving a starting price can have a strong impact on the brain. At Graff-Pinkert one of our greatest struggles is figuring out the “right” value to put on a machine. In the end, the right price is when the customer’s irrational brain is in sync with our own irrational ones.

It works the same when quoting a cycle time to a customer. If the first figure we estimate for a customer is 15 seconds, any cycle time significantly higher than that will likely seem to him unacceptable. There may be plenty of logic and calculations which show that the 15 second cycle time first quoted was a ridiculous estimate, but after 15 seconds was mentioned, good luck pleasing the customer with a 25 second cycle time.

Restaurant owners have found that raising the prices of items on a menu can significantly increase revenue. People may want to stay away from the filet mignon that costs $60, so they settle on the prime rib, the second highest price on the menu for $50, which they are made to feel is a better value. If the restaurant owner is clever he could make the second most expensive item the one with the highest profit margin.

Another concept the book covers is how expectations will cause one item to seem superior to another. Ariely conducted an experiment in which for several days he served MIT students cups of coffee from a makeshift cafe. He served the students coffee in plain styrofoam cups and offered condiments like sugar and cream in simple containers sometimes made to look extra shabby by labeling them with felt tipped pens and cutting off their edges. The students then filled out surveys rating their satisfaction with the coffee. Other days the condiments were put out in fancy glass and metal containers on nice trays with silver spoons. When the condiments were served with the better presentation, the students rated the coffee better quality. Upscale presentation made them believe the they were drinking upscale coffee. When you walk into a shop or an office of a customer, does cleanliness and nice presentation give you more confidence in the quality of the products? Do clean machines actually produce more accurate parts? Maybe not, but I’ll admit there is a distinct positive feeling I get when I walk into a shop where we dealers say “you can lick the floor.”

To further study the effects of expectations, Ariely revisited the famous “Pepsi Challenge.” I’m sure you all remember when Pepsi conducted blind taste tests against Coke, from which they claimed their drink was preferred. Coke also conducted their own taste tests from which they claimed their drink was preferred. What is interesting is how the companies differed in their taste test procedures. For Pepsi’s taste test, the participants were supposedly blindfolded. While in Coke’s test, the subjects could see which beverage they were drinking.

Some neuroscientists conducted an experiment in which participants tasted the two soft drinks while using an MRI to test how the drinks stimulated the brain. By the way, it’s pretty difficult to drink while lying in an MRI tube. The scientists had to inject beverages into tubes running into the participants’ mouths. The participants were told before each gulp whether Pepsi, Coke, or an unknown drink was coming. The neuroscientists found that when the name of the drink was told to participants it stimulated the part of the brain known as the ventromedial prefrontal cortex (vmPFC), which is associated with strong feelings of emotional connection. Another part of the brain called the dorsolateral prefrontal cortex (dLPFC) was also triggered when the participant knew the brand of drink. This region can produce dopamine and activate the brain’s pleasure center. Both beverages had this effect, but significantly more participants drinking Coke stimulated the dLPFC, which produced dopamine, than those drinking Pepsi because more people had fond memories drinking Coke. Who knew — great branding actually has the power to stimulate people’s brain chemistry. Personally, drinking Pepsi is a last resort for me — blind taste test or not. Coke is delicious, and I think I’d prefer to drink water over Pepsi.

Will parts produced from your company produce more dopamine in your customers’ brains than those made by your competitors? You better have some good branding like Coke.

Questions:

Coke or Pepsi?

Does it bother you to pay $5 for a drink at Starbucks?

Read the interview Noah Graff did with Dan Ariely in 2009 here.