Wednesday, 2 December 2009

Applications of behavioural economics part 1a: anchoring

In the East End of Glasgow, as you head from the Tollbooth towards Celtic Park, you'll come across a curiosity out of the 19th century. The Barras is a huge flea market - the biggest in Europe - where everything from second-hand clothes and books to discount electronics and records of doubtful provenance are sold.

And the people selling them are some of the most effective salespeople in the country.

Let's wait by the stall of a chap called Glasgow Harry (why he's called Glasgow Harry when he works in Glasgow is another story). We're among forty or fifty people waiting expectantly for the show to start.

Harry pulls out a radio cassette player (this was quite a few years ago) and starts the pitch. "Now who wants one of these wee stoaters?" [You'll have to imagine the Glaswegian accent] "Latest Japanese technology, double cassette deck, AM/FM, lasts about forty hours on the battery." Elucidation of many more features follows.

And now the key moment...we wait agog, breath bated, to hear what it is going to cost us.

"Now in a shop this'd cost you two hundred quid. I'm not asking that. I don't have their overheads. I'm not even going to ask for a hundred and thirty." Great! A bargain already. "I was selling them last week for a hundred and twenty but I won't even start there. I'm going to save time and start straight in at a hundred and five. They won't last long at that price so get your order in now."

There's always someone who jumps straight in and pays it. Accomplice or sucker? We'll probably never know. But then after a bit more banter the price comes down a little.

"OK, who wants it for a hundred? There's only eight of them left...and this is the last of them, I cleared out the warehouse this morning." Maybe someone else bites, maybe not.

"All right, nobody wants it? Fine. I'm moving onto this set of plates."

And that is that...for about ten minutes. It's good theatre, so most of the audience stick around. Then, inevitable, back comes the radio cassette machine again.

"Right, we had these on last week at 120. Sold two of them just now at 105. Now I don't want to cart them away with me again, so who's ready to take them at 95? You, madam? Excellent, here you go. Anyone else? It's got a one-year guarantee. OK, how about this - I'll throw in the batteries for the next two buyers. Six of these'll cost you £12, I've got a dozen of them spare so how about that?" Probably gets a couple more purchases out of that.

"Right, the batteries are gone so I'll cut the price to £90 - final offer. Anyone? You sir, good, please pay my assistant over there. Who's left?"

If you wait around long enough the price comes down to £60 and the last person to jump gets an excellent bargain - £60 for a £200 piece of hardware. Not a bad deal, eh?

Except of course that the things only cost Harry £20 each in the first place.

Nobody standing around the stall knows the "real" value because nobody has the ability to do a price comparison on the same product. Instead, Harry has anchored his audience. Anchoring is when you become mentally attached to a specific value, and subconsciously start to believe that is an appropriate value for the product. Even though you wouldn't say it consciously, you use it as a reference point and it influences the price you are willing to pay.

Harry isn't anchoring his buyers to the £200 price, because no-one really believes in that. But as soon as you give any serious consideration to buying at some particular price, you're caught. The first time you consider buying, even if you decide against it, that becomes your reference price.

So if you nearly went for the £105 offer, anything cheaper looks like a bargain and you become more and more likely to buy it. If you waited for £90 before deciding against it, then £80 looks like a pretty good deal and £60 is an absolute steal.

Ultimately Harry always gets rid of all his merchandise - nowhere near his original "asking" price, but at a huge profit.

Even experts can easily be caught by this effect.

A few weeks ago Rory Cellan-Jones (@ruskin147) auctioned a phone on Twitter to raise money for charity.

I needed a new phone, so I put in a speculative bid for £50 to see if I might win it. It was a new Google Android phone (the HTC Hero) so I thought it would be a decent handset, and probably worth more than £50 to me. I would be eligible for a new phone anyway by renewing my contract, so I would be buying flexibility of contract rather than the features of the phone as such. Even if it turned out not to bring me £50 of benefit, it was a good cause.

After I placed my first bid, a quick Google search showed me the retail price of the phone: around £380! Much more than I'd expected.

Suddenly I decided it would make sense to place a higher bid. My estimated value of the phone to me was strongly influenced by seeing the retail price. I bid £105, and then as the auction continued, my bids reached the dizzy heights of £245 before someone else won it for £280.

This for a phone I was originally willing to pay £50 for!

I hadn't learned anything new about the features of the phone, or reconsidered how useful it would be to me. I'd simply found out that some random shop charges a high price for it, and suddenly my willingness-to-pay jumped up accordingly.

And I'm supposed to know how this stuff works. If I can be influenced into behaving like this, what hope does a random shopper have?

Not much, if they are buying a bottle of wine. Most people don't have a clear idea of what any specific bottle of wine is going to taste like before they buy it. Instead, they treat the price of the wine as a signal for its quality.

This means that retailers can, to a large extent, set their own profit margins. It's easy to demonstrate how.

Show your friend a nice bottle of wine. Ask them to write down which day of the month they were born - a number from 1 to 31 - and put a £ sign in front of it, turning it into an amount of money. Now ask them to write down whether they would pay that amount for the wine.

As soon as they make the decision - whether the answer is yes or no - the damage is done. They have anchored themselves to that price.

Now ask them how much they would pay for the wine in a shop. If their birthday is at the end of the month - so they are anchored to a price £20 or above - they will, on average, be willing to pay significantly more for the wine than someone who was born on the 5th, and is anchored to the £5 price.

On average, people who were born in the second half of the month will pay 25% more for the same bottle of wine than those born in the first half. If you want to save some money, change your birthday.

The second part of this chapter will outline the cognitive theory behind how anchoring works. And after that, a guide for salespeople on how to apply anchoring in your own business.

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