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.
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