4 January 2013

How Do We Judge (absolute) Values... Everything Is Relative

Whether we like it or not, we live in a world full of numbers. In the XXI century we have to handle a huge quantity of information consisting of numbers. The easiest example is money, but by far it is not the only one. Quantity, volume, surface, annual income, costs, credit costs, interest rates and many more are present in each person’s life. However, humans are not designed to be particularly good with numbers.

During its evolution, human kind has developed exceptional verbal skills that come naturally. Think for example of a young child around 4 years of age. This small human can speak correctly and fluently in one or two languages (if raised bilingual) without even knowing that grammar and its rules exist. At the same time, this young human can’t compute mentally 75*32 – 398. In fact for most adults it is challenging to mentally compute the aforementioned mathematical sequence. Most of us need at least pen and paper to find the result.

Psychology and Behavioral Economics have found during the years very interesting effects on how people evaluate and perceive values and numbers. One very nice example is the “Pond effect”. In essence, the pond effect proves that what is big or what is small is in fact very relative.

Imagine a fish, let’s say a carp (or any kind of fish) measuring 50cm from head to tail. If we place this carp in an English garden pond it will seam huge and compared to the colorful decorative fish already existent in the pond it would look like a real monster. Now, let’s take the 50cm long carp and place it in the biggest lake on Earth which is the Caspian Sea. In this “pond” the carp seams small or at best below average.

The pond effect shows us that people don’t evaluate size of the carp as being 50cm per se, but rather as being a big or a small fish compared with its environment and fellow fish.

The “pond effect” has numerous consequences in our lives. I believe that the most important one is that we don’t realize in what kind of pond we are in. One might be the best student in school A but be a mediocre student in school B. Being the “biggest fish in a small pond” can give some sense of self-worth. At the same time the status of “the biggest fish in a small pond” lives little awareness of the need to improve and little room for growth. When moving to a bigger pond, the former “biggest fish in a small pond” will have a shock.

Another example comes from the area of prices and money. Let’s make a thought experiment:

Imagine yourself in the following situation: you want to buy a nice new suit and go shopping. After exploring the options in the city center shopping area, you decide to buy a suit that costs 300 Euros. Just before you take it in your hands to go to the cash register, an alien drops out of the sky and sits on your shoulder. The alien tells you that exactly the same suit is on sale at the mall right outside town (30 minutes drive) for 240 Euros. What do you do?

Most people think something like this: “Saving 60 Euros out of 300 just for a half an hour drive, sure! Let’s go there!”

Now, forget everything about the suit and money. Clear your head and let’s do another thought experiment. Imagine that you want to buy a car. You’ve saved some money and decided to get a new car since the old one turned 20 last February. You go to a dealer in the East of the City and look at all those gorgeous pieces of technology. Yes you can imagine yourself driving casually in one of them on a sunny Sunday afternoon and the trunk is big enough to fit in all your (significant other’s) shopping bags.

You go to the sales agent (or consultant as they like to call themselves) and ask how much is the car that you so much can imagine it to be yours. The “consultant” that this is your lucky day because this week there is a Limited Offer and you can buy the car for ONLY 18.990 Euros (yes… psychological price and a lot of bull sh*t sales talk). In that moment a flash appears in the sky and an alien comes and sits on your shoulder. The alien tells you that exactly the same car you want to buy is available at a dealer in the south of the town (30 minutes drive) for 18.930 Euros. What do you do?

Most people think something like this: “What?!? I’m spending over 18.000 euros here and you expect me to drive for half an hour just to get a 60 Euros discount? No way! It’s not worth the effort.”

OK. Now, let’s cool down and breathe. In the first scenario, the alien brought super good news. Our shopper was happy to drive for half an hour to the mall outside town to buy the suit and save 60 Euros. “Man, 60 euros is not spare change!”. In the second scenario the alien was just annoying and really spoiled the magic moment of purchasing a car. How could have the alien suggested that is in any way rational to drive for half an hour just to save 60 Euros???

Again, let’s switch on reasoning. In both scenarios the buyer would have saved 60 Euros at the price of driving for 30 minutes. But in one scenario he was happy to do so, while in the second he was annoyed even by hearing the suggestion. Is this guy stupid or what? After all 60 Euros are 60 Euros and they can buy exactly the same things in either situation.

The key is in the (undiscounted) price of the purchase. In the first case, the guy was buying a 300 euros suit and 60 Euros is a lot when compared to 300. It’s 20%. Who in their right mind would not go to the cheaper shop? In the second case, the guy was buying a car priced at 18.990 Euros. Now 60 euros compared to 18.990 is virtually nothing, or at best some spare change. It’s just 0.3%, who cares about that?

Both rationales tend to make sense, but at the same time, they seem flawed. They make sense if we acknowledge that humans aren’t good at processing absolute values, but are OK processing relative values. It’s hard to understand what 60 Euros mean in different contexts. In the “suit” context it means a nice “going out for pizza”, while in the “car” context it means “yeah… whatever”.

After the 60 Euros saving example we could conclude that people are very good at processing percentages. At the same time, there are two shortcomings of this conclusion. First, from an evolutionary perspective there is no benefit of being better at judging percentages and not absolute values. If we imagine our distant ancestors’ lives there is no evolutionary benefit in being good with percentages. In fact before even the appearance of the notion of percentage the human species had already evolved to what it is today.

Second, evidence from research based on prospect theory shows that people are in fact quite bad at judging probabilities which are generally expressed as percentages. Prospect theory tells us that small probabilities are overestimated and medium and large probabilities are underestimated. Moreover, most people don’t really distinguish between 0.001% and 0.0001%, despite the difference being 10 times.

Moreover, the same prospect theory states that people perceive outcomes as gains or losses relative to a reference point. I have discussed this in “Effects of Framing Outcomes”

Up to this point we know that people are not so good at evaluating absolute values and are equally bad at judging percentages or relative values. This leaves us with a big and very important question of “how people evaluate values (numbers)”.

The answer to this question is “comparison based”.

People are shaped to judge values in comparison with other features present either in the mind or simply observed. The observed references have been presented in the earlier examples – environment and other similar characteristics (prices).

To illustrate the mental references imagine yourself taking a trip to Norway and going for a coffee. In most of Europe a coffee costs between 1 and 2 euros. Now, Norway is a special country in many ways. Apart from not being in the EU and not using the Euro as a currency, Norway is THE MOST EXPENSIVE Country on the old continent. A coffee in Norway can cost between 10 and 20 Euros…

If you are not a Scandinavian (all Scandinavian countries are very expensive) and you go out for a coffee in Norway you will find the coffee obscenely expensive. This is because you compare the price of the coffee in Norway with the price of the coffee in other countries such as France (around 2 Euros per coffee, unless in Paris).

Now, I assume that Norwegians do not find the coffee in their country obscenely expensive, but rather they find the coffee in. let’s say, France very cheap.

I believe that we switch from mental to environmental references when the mental ones do not exist or are very blurry. For example, if you would go to a consumer electronics store, in the TV area you will see for sure a giant TV with an amazing surround sound system and a couch to sit on and experience the marvel of modern technology. Of course on that TV there is a movie with exceptional graphics that points out the resolution of the giant screen. If you take a look at the price tag(s) for the TV and sound system (the couch is not for sale) you will realize that for that money you could easily get a reasonable second-hand car.

The trick is that the electronics store does not necessarily want to sell the 5000 Euros TV + Sound system. They wouldn’t mind if someone bought it, but that is not the main purpose of having the eccentric TV in the store. The purpose of the absurd item is to make all the other TVs more attractive and reasonable.

Most people don’t have a very clear idea of how much a new modern TV should cost, nor do they know if they want a 21 or 25 inches diagonal screen. When in the shop, after seeing the giant screen, suddenly it is reasonable to buy the 30 inches screen because compared to the “garage door like” one the 30” is in fact a decent choice.

Similar things happen in other retail areas such as liquor stores. If you see a really fancy bottle of wine on the self with a price tag of 40 Euros (per bottle), it means that the shop does not want you to buy it, but rather to make the 15 Euros ones look like a great deal.

A very interesting and somehow unpleasant effect of judging values through comparisons is that in certain contexts money loses value. A good example for this is when buying something that it is inherently costly such as a house or a car. The “friendly” sales person (consultant as they like to be called) might say something like this: “Yes, it would be nice to change the floors and think that the expense is not that big. After all, what’s another 5000 Euros when you’re buying a nice apartment that costs 300.000 Euros. Plus, you could take a loan for this also.”

In reality 5000 Euros is a big sum of money, but compared with 300.000 seems like spare change.

To conclude, people judge values by comparing the value subject to judgment with either mental references or environmental references. This leads to different judgment outcomes in different contexts, especially because the environmental references can be manipulated.