Behavioral Economics - Prof. Ranjan Banerjee ( IIM C )

  • Prof. Ranjan Banerjee is the founder of Renaissance and is currently heading the ship as its CEO. He did his B.Tech from IIT-B, MBA from IIM-C, & in 2010 completed his Ph.D from Carlson School, University of Minnesota. He is an ardent foodie and follows cricket religiously. He  is always game for exploring new ideas.

    When I talk to students and corporates about behavioural economics for the first time, they find it both cool and disturbing. Cool because the behavioural economics phenomena are interesting; and disturbing because they break a myth. What’s the myth that they break?  The dominant theory that we have had about how people make decisions is that people are rational. When we say that people are rational,it kind of assumes that we know exactly what we are doing. But we have always known that in the real world, it is natural that human beings make mistakes.

    Behavioural economics, put simply, is the science of how people make mistakes. Let me give you a simple example. Suppose I give you two choices for a new treatment for a disease. You are told that in the first case 200 people will definitely be saved by the treatment. In the second case, there is a one- third probability that 600 people will be saved and there is a two third probability that nobody will be saved. In this case, most people will take the sure option. Now, let’s suppose I give you a second choice in which I tell you that the first option is that 400 people will die for sure. In the second choice I tell you there is a two-third probability that 600 people will die but there is a one-third probability that nobody will die. Interestingly, when it is framed in a positive manner, everybody would want to save 200 people. However, when it is framed negatively, everybody gets scared at the thought of 400 people dying.

    This brings us to the first and primary tenet of behavioural economics. The way people make decisions depend on the way those decisions are framed. You can observe this in many situations. When we used to come home from school with our marks-sheet, the first question was about the highest score. There is always a frame of reference; and decisions are judged based on whether they are gain or loss making against that frame of reference. The interesting insight here is that just by changing that frame of reference; you can change people’s decisions. So what we realise is that reference points can be manipulated.

    Now let’s say I’m a marketer. What can I do with this insight? Let me tell you about a simple experiment on a bunch of graduate students. They were given two choices. The first choice was an online subscription to The Economist at 58.Thesecondchoiceincludedboththeonlineandprintversionstogetherat125. The second choice included both the online and print versions together at 125. Since graduate students like to save money; they chose the online option. Another group of graduate students were given three options. First option same as before 58,secondoptionprintonly125, second option print only 125, third option print plus online 125.Nowwhathappens?Interestingly,becauseprintonlybecomesareferencepoint,themajorityofthestudentschoosetheprintplusonlineoption.Thisiswhatwecallthedecoyeffect,whereyouintroduceachoicewhichchangesthereferencepointandhencechangesthedecision.NowimaginethatyouareheadingPizzaHut.Ifyouwanttoselladish,allyouhavetodoistointroducethreechoicesinthemenu,oneofthembeingadecoy.</span></span></p><p><span><span>OneofthecraziesteffectsinthisareaofBehaviouraleconomicsiswhattheycallanchoring.ThereisthisremarkableexperimentwithstudentsatMIT.55studentswereaskedtowritedownthelasttwodigitsoftheirsocialsecuritynumber.Thentheywereaskedtoguessprices.Nowhereisthefunnything.Whentheywereaskedtoguessthepriceofamouse,thestudentswhohadlasttwodigitsbetween0and20,guessedaround8. Now what happens? Interestingly, because “print only” becomes a reference point, the majority of the students choose the print plus online option. This is what we call the decoy effect, where you introduce a choice which changes the reference point and hence changes the decision. Now imagine that you are heading Pizza Hut. If you want to sell a dish, all you have to do is to introduce three choices in the menu, one of them being a decoy.</span></span></p><p><span><span>One of the craziest effects in this area of Behavioural economics is what they call anchoring. There is this remarkable experiment with students at MIT. 55 students were asked to write down the last two digits of their social security number. Then they were asked to guess prices. Now here is the funny thing. When they were asked to guess the price of a mouse, the students who had last two digits between 0 and 20, guessed around 8. Students who had their social security number between 80 and 100 guessed 26.</span></span></p><p><span><span>Nowwhydoesthishappen?Weallknowthatthelasttwodigitsofoursocialsecuritynumberareactuallyprettyarbitrary,soitshouldntmeananything.ButIdontknowtheprizeandIhavethelasttwodigitsofmysocialsecuritynumberwritteninfrontofme.SoIstartcountingdown,andIthinkabouthowmuchIshouldadjust.Soinonecase,Istartadjustingdownwardsfrom20,inanothercaseIstartadjustingdownwardsfrom90andthatexplainsthedifferenceintheresult.</span></span></p><p><span><span>Butthenalotofpeoplemightsayokaythesearestudents,doesithaveanypracticalapplication?SteveJobssawthepracticalapplication.WhentheIPadwaslaunched,therewasalotofspeculationabouttheprice.Thedominantpriceasreportedbythemediawas999.</span></span></p><p><span><span>Now why does this happen? We all know that the last two digits of our social security number are actually pretty arbitrary, so it shouldn’t mean anything. But I don’t know the prize and I have the last two digits of my social security number written in front of me. So I start counting down, and I think about how much I should adjust. So in one case, I start adjusting downwards from 20, in another case I start adjusting downwards from 90 and that explains the difference in the result.</span></span></p><p><span><span>But then a lot of people might say okay these are students, does it have any practical application? Steve Jobs saw the practical application. When the I-Pad was launched, there was a lot of speculation about the price. The dominant price as reported by the media was 999. This figure was not from the company or from Mr. Jobs. This was what trade press was saying. And then at the I-pad launch, Steve Jobs says, “what’s the price going to be?” And he puts up a slide with 999.Everybodyislookingatit.Thereisamagicalcrashand499. Everybody is looking at it. There is a magical crash and 499 appears. Now why 999? This to me is a marketing application of anchoring. The only purpose of 999 was to introduce 499. Therefore the MIT students and the consumers of the I-Pad both are subject to the anchoring effect.

    Ok so here is my parting shout. Here is a question for you. How many animals did Moses take on the Ark? Think carefully… well here’s the answer. Moses didn’t take any animals on the arch, Noah did.

    Please find the source here

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