You’re approaching the checkout to pay $50 for a new pen when someone tells you about another store, across town, that has the identical pen for $30. If you’re like most people, you put the pen back and walk for ten minutes to save the $20.

Now, let’s consider the same scenario, but this time you’re buying a $1000 sofa – would you make the journey across town to pay $980 for the sofa instead? Neither would I.

Most of us like to think of ourselves as rational, with a good handle on how to make optimal financial decisions, but as the above example demonstrates, we’re not quite as pragmatic as think we are. After all, are we prepared to walk across town to save $20 or not? If we are to be completely rational about it, we wouldn’t let the total amount, or more specifically the ratio of saving to total amount, have anything to do with the decision.

Another, even more dramatic
flaw in our logic is the power of FREE

Being human though, we are not rational, and we always consider the decisions we face in relation to their context. Another, even more dramatic flaw in our logic is the power of FREE.

When offered the a choice between a paying $1 for a $10 Amazon gift certificate, or $8 for a $20 Amazon gift certificate, most people spot the better deal and pony up for the more expensive certificate seeing that their net gain will be $12 instead of the cheaper certificate’s $9 gain.

But when we modify the options by reducing the cost of each item by a dollar so that the $20 certificate costs $7 and the $10 certificate is free, which would would you choose now?

It turns out that the majority now choose the free deal, blinded from the better deal by FREE! The reason for this is a deeply ingrained aversion to loss. When we consider each option we weigh up the the pros and cons, the wins and losses. The win is the stuff we can buy with the certificate, and the loss is the money we hand over to pay for it.

By reducing the cost to free,
we remove the loss which blinds us
to the advantage of the better deal

By reducing the cost to free, we remove the loss which blinds us to the advantage of the better deal. Let me stay with Amazon to tell you a real life example of the power of loss aversion. A number of years ago they introduced the now common offer of free deliver on all orders over a certain amount.

The take up was huge. When weighing up the pros and cons of shopping online versus a visit to their local bookstore, shoppers placed the cost of delivery as one of the biggest disadvantages of shopping online, so by reducing the cost to free Amazon eliminated the loss aversion.

In their infinite Gallic wisdom,
the French Amazon team modified the offer

Amazon did notice one anomaly though – France. For some reason the offer was making little impact to sales in France, and upon closer inspection, the culprit was found. In their infinite Gallic wisdom, the French Amazon team modified the offer so that over a certain price delivery was reduced to one franc (about 20 cents) a cost considerably less than one might spend traveling to their local bookstore.

Although the offer’s super cheap delivery was nearly free, it was still enough to trigger our loss aversion, and when the deal was modified to make it genuinely free, sales increased in line with the rest of the world.

One more area of financial irrationality comes when we travel between the worlds of social norms and market norms. Imagine you’re a lawyer, and the girl next door asks you to spend an hour next Tuesday looking after her dog while she’s out of town visiting her family. No problem. We consider this in relation to social norms and are happy to help.

Now consider you being asked to spend the same hour to help out, but instead you’re asked to prepare a legal document, the stuff you do in your 9 to 5. We consider this request in relation to market norms and are considerably less likely to want to help.

This flip side of this is, at the end of a wonderful family meal prepared by your mother in law, to stand up and praise her for such a feast and then pull out a wad of money from your wallet to pay for it. The transition for social norm to market norm (and vice versa) is painful.

when a new scheme that asked them
to work for free for the same retired
people was introduced it was a great success

Take the example of the US lawyers asked to drop their fee to $30 an hour for retired people. The scheme was a failure with few legal professionals getting involved, but when a new scheme that asked them to work for free for the same retired people was introduced it was a great success, as their decision was considered within social norms.

If your organisation benefits from a social contract with its customers then be careful to nurture this as it is as fragile as it is valuable, as can be see in this last example.

A few years ago, a children’s day care center did an experiment to see if they could reduce the number of parents that arrived late to pick up their kids by introducing a financial penalty for such tardiness.

before the fines started there was a social contract in place, where the parents would feel bad about the staff having to stay late to wait for them to turn up

This turned out to have the opposite effect than intended with more parents being late more often. Why was this? Well, before the fines started there was a social contract in place, where the parents would feel bad about the staff having to stay late to wait for them to turn up. Now that the cost of being late had a price, this market contract meant that they could simply consider if the extra 30 minutes of child care was worth the cost of the fine.

A really interesting thing happened weeks later though, when the fines were removed. Instead of returning to a social contract, parents instead continued to weigh up the financial cost of turning up late, and now you know how we feel about FREE it will come as no surprise to you to learn parental punctuality became worse than ever!

If you find this kind of stuff interesting then I recommend these excellent books for further reading, as they are where most of my examples come from.

  1. Predictably Irrational: The Hidden Forces that Shape Our Decisions by Dan Ariely
  2. How We Decide by Jonah Lehrer
  3. Yes!: 50 Scientifically Proven Ways to Be Persuasive by Noah J. Goldstein, Steve J. Martin, Robert B. Cialdini