The Psychology of Economic Choice

Richard Thaler and Cass Sunsteain’s book, Nudge: Improcving Decisions About Health, Wealth, and Happiness (Yale University Press, 2008), is ostensibly about “choice architecture,” or how to encourage people to make good decisions. However, Nudge contains analyses of human behavior which will prove valuable for anybody in marketing, advertising, or other areas of business that deal with the public.
Imagine that you are in a cafeteria, perhaps the one in Berklee’s dining hall. Take a moment to consider what determines which foods you purchase. Really. Take a moment to think about it. “Taste,” “Price,” and “Nutritional content” seen like obvious factors. Maybe you listed others factors, such as how long an item takes to prepare or consume, or whether you are in the mood to try something new
Did you list whether a given option was located front-and-center versus on a lower or further shelf? Probably not. Yet studies repeatedly show that moving a menu item from a back shelf to the front-and-center raises consumption of it by 25%. The book’s authors suggest that, armed with this knowledge, school cafeterias should put their healthiest option front-and-center in order to “nudge” students to choose it. A shrewd businessperson would make sure to feature the item with the highest profit margin in this position.
In another study featured in the book, the Minnesota Department of Revenue wanted to increase the percentage of people who file their taxes honestly and on time. They tested four different messages, each on a separate group of Minnesotans, to see their effects. Consider these messages, and see if you can decide for yourself which one of them was effective (Three of them had no discernible effect on compliance with taxes.)
One group of people was told that their taxes funded good things, such as education, police protection, and fire protection.
Another group of people was told about the heavy punishments for cheating on taxes.
A third group of people was given information on where to get free help filling out their tax forms.
The final group was told that over 90% of Minnesotans paid their taxes honestly and on time.
Before deciding on a final answer, consider the assumptions made in conventional economics — that people are rational, and act with enlightened self-interest at all times. Of course, we know in real life that these assumptions are false—witness the advertising budgets of Coca Cola (over $150,000,000 per year) and Pepsi (close to $1,000,000,000 per year), which promote products which the vast majority of people are already familiar with. In a perfectly rational universe, advertising would only be good for exposing people to new products, as reminding people of a familiar product would have no effect—people who desired it would already be purchasing it, and those who do not desire it would not.
The authors of Nudge have nicknames for this. “Econs” are the (nonexistent) perfectly rational beings in economics class, while the rest us are referred to as “humans.” The first third of the book examines various ways in which humans predictably differ from “econs.” For example, Humans on their first wedding day will never admit that they have a 40% chance of ending up divorced, 94% of college professors consider themselves “above average,” and college students are heavily influenced by the study habits of their roommates. Humans also value things we possess at a higher level than we would pay for them, are likely to answer a question in different ways based on how it is phrased, and indulge in activities which make us less happy in the long run.
Back to the question on taxation: if we were all “econs,” the first message presented to Minnesotans would have little effect. The second message might have a large effect, assuming we thought there was a decent chance we would be caught. The third message could have a major or a negligible effect, depending on how many of us are confused by the tax forms. The fourth message might have a minor effect, since the probability of being caught is presumably a negative function of how many others are cheating.
However, what motivates human? It turns out only the fourth message had any effect, and it was a large one. Humans exhibit a large degree of “herding” behavior, in which people are influenced by what others do. This means that if people’s peers download music for free, they are likely to do so as well. It also means that people are more likely to check out a show or song of a band which is already popular.
The second part of the book focuses on constructing good public policies. The authors have created a philosophy they call “Libertarian Paternalism” in which everyone is allowed free choice, but the choices most likely to lead to long-term happiness for the greatest number of people are subtly encouraged. For example, currently many people suffer and die because they need an organ transplant, but there is a shortage of healthy organs.
Under current law, organ donation is “opt in,” meaning one has actively indicate that one is an organ donor. Changing organ donation from ”opt in” to “opt out,” where everyone would be presumed to be an organ donor unless they indicated otherwise, roughly doubles the percentage of the population which donates their organs (from approximately 40% to 80%), which would save thousands of lives per year. Similar “nudges,” some simply involving providing information in an easily-understandable format, can result in people saving more money, using less energy, eating healthier, paying less interest on loans, and even reducing pollution from both individuals and corporations.
From a policy point of view, obtaining a desired result through subtle “nudging” is both more economically efficient and more politically effective than other options. Distorting people’s choices provides some degree of deadweight loss, but only if this distortion comes from direct financial incentives or outright ban. For example, it’s probably a good idea not to listen to music at too loud a volume. People who genuinely enjoy super-high volume will be annoyed if high-power ear buds are banned or heavily taxed, but do not suffer at all if the high-volume ear buds are kept on a back shelf where they must be specifically requested (while the low-power ear buds are on prominent display). Politically, people are unlikely to be angry when they have free choice. While the authors admit that this approach is not up for solving every problem facing humanity (For example, it is difficult to imagine little nudges alone being sufficient to cut global carbon pollution by the 80% scientists are saying it must be reduced by. Though the authors have some good ideas on that problem which might get us 10% of the way there are almost no cost.), clearly it should be used when possible.
Any strategy by bands, labels, or the industry itself, must take human behavior and biases into account in order to succeed. For example, subscription services for music, which people must actively choose to purchase, have historically not done well. But embedding a subscription directly in the cost of a music player, where the buyer does not have to make any effort to obtain the music, is likely to be more successful. Even packaging the device with a subscription, but allowing the customer to opt out, is likely to generate a much higher level of business.
A careful reading of the book also suggests that it may be hopeless to attempt to stop people from sharing music files while paying nothing—particularly people in high school today, for whom file-sharing has been the norm their entire lives.
The book also confirms that people’s decisions are based on more than the objective merits of a product. As we know, success for a band involves not only producing good music and live shows, but finding a way for people who would enjoy these to find out about these, and creating a structure which encourages these fans to pay for the goods. The way in which people’s musical choices are structured, and what we as a culture define as normal, will have a large effect on whether the industry creates more paying music fans over the long term—it will be easier to sell music (recorded and live) if people do not expect music to be free.
Along these lines, keep an eye on U2, some of the savviest people in the music industry: their new album (due out in March, 2009), is being released at 5 different levels, ranging from the plain CD at the usual price to the deluxe edition with photos, a mini-book, a concert DVD, and other goodies for $99, with several intermediate options in between. This is a brilliant framing of choice, allowing people to get the music for the usual price (including for the piracy-inclined, $0), but this “choice” almost guarantees that real fans will go to the store and pay far more money, lest they feel that they only have a fraction of the “real” product.
In a world populated with humans, understanding human behavior is a precondition to business success. Nudge, while focused on making society better, is also a good tool for your individual ambitions.

By Kevin Block-Schwenk



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