Behavioral Econs 101: Bargains and rip-offs, Richard Thaler and mental accounting Part 2

As part of our second installment in our Behavioral Econs 101 series(see part 1 here), we turn now to tie up some loose ends with mental accounting by discussing how behavioral economics helps us understand when we think of a deal as a bargain or a rip-off.

by HK Lim

The key question we want to answer is: “what exactly goes through our minds when we make a purchase?” To make progress on this we need to recognize that we experience two distinct kinds of utility: acquisition utility and transaction utility, something that the 2017 Economics Nobel Laureate Richard Thaler devoted much of his early career to understanding. What exactly is the difference between the two?

Acquisition utility versus transaction utility

Acquisition utility is what we economists’ term “consumer surplus” in standard economic theory. This can be most simply thought of as the leftover(or excess) utility from an acquired item that remains after we subtract from it the opportunity cost of whatever had to be given up in obtaining this item. Sound a little abstract? Let’s look at a simple example. Suppose you buy a sandwich for $4, the consumer surplus is the excess utility you would derive from consuming that sandwich over and above the value of whatever next best alternative use you could have had for that same $4. A particular purchase would provide a surplus of acquisition utility to a consumer if he or she were to value it more than the market does. If you behave exclusively according to the logic of mainstream economics(and rational choice theory), acquisition utility is the only thing that you would care about when making a decision whether or not to purchase something.

On the other hand, there’s another wholly different aspect to the purchase that we call the “quality” of the deal. This is what the idea of transaction utility captures, and is the difference between the price one actually pays for an object or service(or the value one attaches to the price one pays) and the price that one would normally expect to pay for it. This normally expected price is often also referred to as the reference price. A good example of this can be seen when you visit a movie theatre. When you buy a large soda at the movies for double the price that it would cost at a fast food outlet($5 versus $2.50), while the soda per se is fine, you probably do feel like you just got a little bit ripped-off. What happened here is that this soda deal has generated negative transaction utility because you paid a price in excess of your reference price. On the other hand if your paid price is below your reference price you actually generate positive transaction utility and consequently enjoy the feeling that you’ve scored a “bargain”.

How much would you pay for a beer on the beach?

We turn now to discuss a famous example distinguishing these two utilities from a survey questionnaire given to participants by Richard Thaler(1983):

“You are lying on the beach on a hot day. All you have to drink is ice water. For the last hour you have been thinking about how much you would enjoy a nice cold bottle of your favorite brand of beer. A companion gets up to go make a phone call and offers to bring back a beer from the only nearby place where beer is sold (a fancy resort hotel) [a small, run-down grocery store]. He says that the beer might be expensive and so asks how much you are willing to pay for the beer. He says that he will buy the beer if it costs as much or less than the price you state. But if it costs more than the price you state he will not buy it. You trust your friend, and there is no possibility of bargaining with (the bartender) [store owner]. What price do you tell him?”

Before we reveal the study participants’ responses, we should note two key points. First, there is no difference whether the beer is from a fancy resort hotel or the small grocery store, so in effect, the consumption is identical for all intents and purposes as it is consumed on the beach(and there can hence be no ambience effects). Second, since there is no negotiation with either the bartender or store owner, there is no incentive for respondents to disguise their true preferences. [This is what economists term incentive compatibility, where every participant can achieve the best outcome for himself or herself just by acting according to their true preferences.]

What were the actual responses like? As expected, participants were willing to pay more for beer from a fancy resort than for beer from a grocery store. In fact the median responses were $7.25 and $4.10 respectively after adjusting for inflation(Thaler(2015)). These results reveal a peculiar finding(at least from the perspective of standard economic theory), participants were willing to pay different prices for the exact same beer consumed on the same spot on the beach depending on where the beer was purchased!

Now, this wouldn’t be so surprising if you weren’t studying this through the lens of neoclassical economics and rational choice theory, for in our everyday lives, it isn’t at all surprising to have different expectations for the price of the same item depending on where it is sold because of expected differences in underlying costs. Nevertheless, this example demonstrates an extremely peculiar feature that illustrates the departure of actual people’s behavior from what standard economic theory predicts. If you were homo economicus subscribing to behavior according only to the rules of rational choice theory, you’d only care about acquisition utility and would completely ignore transaction utility when buying a beer. The actual purchase location of the beer would be a supposedly irrelevant factor. But in the real world, this isn’t quite true, is it?

Implications of transaction utility

With our newfound understanding of transaction utility, and recognizing that it can be either positive or negative, we see why the mental accounting that distinguishes between acquisition and transaction utility is so important. Our impression of whether we are getting a good deal or being gouged can also discourage purchases that are utility enhancing as well as prompt purchases that are an unnecessary waste of money. Coming back to the example of the beer on the beach again, suppose that you inform your companion that you will be only willing to pay at most $4 for a beer from a run-down grocery store and at most $7 for a beer from a hotel. Your companion would be able to enhance your utility even if he bought the beer at the grocery store for $5 but told you it was purchased from the hotel instead! Only your aversion to being price gouged stops you from agreeing to this transaction provided if you were told the truth.

I. Deals too good to pass up

Good deals that are “too good to pass up” on the other hand, can lead to situations where we end up purchasing something we don’t really need. How often have you been in the situation where, shopping during a sale, you try to convince yourself that you can fit into a pair of shoes either a half size too big or small? It’s almost certainly true that we all have embarrassing examples of such purchases gathering dust in our closets.

II. Infrequently purchased items
There is another angle from which the psychology of transaction utility can be used to induce a purchase more easily. In the category of infrequently purchased products like mattresses, suits(see Fig.1) and carpets, it’s a common sales tactic to always have a “sale” in progress year-round. Chances are you won’t pay attention on a regular basis to this, and won’t notice that whenever you seem to be in the market for such products, there always conveniently seems to be a sale going on.

Fig. 1: Suit, I see what you did there.

And whenever an infrequently purchased product’s quality is difficult to assess, the old trick of “suggested retail price” or MSRP can be bundled in to help seal the deal by both suggesting that a product is of high quality(because high suggested retail prices can imply high acquisition utility) and/or combined with a sale to scream out that there’s lots of transaction utility to be had here as well.

III. Everyday low pricing – Macy’s and JC Penny
It can also be the case that shoppers can become addicted to the high from from positive transaction utility. A key example of this can be seen in Macy’s and JC Penney’s separate experiences in trying to reduce the extensive offers of discount pricing as part of their sales strategy in an attempt to shift to an “everyday low pricing” strategy.

In Macy’s case, a 2006/2007 rebranding effort coupled with a plan to reduce the dependence on coupons as a discount strategy backfired spectacularly. Following a cut in coupons by 30% in 2007, a subsequent sharp decline in sales forced the company to return to its original extensive coupon program by the holiday season of 2007.

In the case of JC Penney, in 2012, then CEO Ron Johnson announced an end to what he termed “fake prices” (via the use of suggested retail prices) and a shift to a simpler pricing scheme. Aside from getting rid of traditional coupon sales, prices ending in .99 were also rounded up to the next dollar on the basis that that the overall prices paid by consumers was the same after all the changes. This entire episode will be remembered as a total disaster, with both aggregate sales and JC Penney’s stock price taking a nosedive as consumers now lost out on much of their good old transaction utility. Notably, the positive psychology boost of just paying under a given dollar amount in the well-known .99 pricing strategy was also lost by consumers.

You might ask how this might apply to big discount retailers like Walmart and Costco in contrast? While they may operate under an everyday low pricing strategy, transaction utility is very much integrated into the entire shopping experience as these retailers go the whole nine yards in convincing customers that the entire shopping experience there is one big bargain hunt. (Walmart even has a savings catcher app that allows shoppers to scan in their receipts and receive a refund if a lower price is available anywhere else.)

Ain’t nothing wrong with a bargain and a simple lesson for businesses

We should also carefully note here that standard economic theory doesn’t say that homo economics are immune to bargains, but rather that the positive effects of buying a high-end cup coffee for a discounted price of $1 accrues only from acquisition utility(consumer surplus). Conventional economics has trouble addressing the terms of the deal. To sum it all up, there really isn’t anything fundamentally wrong with being on the hunt for bargains except when we end up buying something we don’t really need because the price was too good to pass up. On the other hand, businesses should remember that everybody likes a good bargain, whether via a sale or via genuinely low prices, high transaction utility will always drive customers through your doors. If you need a reminder of this, just take a glance at the large number of expensive cars parked out front of any TJ Maxx or Nordstrom Rack any day. Remember, ain’t nobody gonna pass up a good deal. In our next installment of Behavioral Econs 101 we will discuss the well known but often misunderstood endowment effect.

References
1. Thaler, R. (1983). Transaction utility theory. Advances in Consumer Research, 10, 229-232.