The Financial Lobe

Putting Prices Into Focus

Apple set a reference price of $600 when it released the iPhone last year. Since then, the price has dropped to $200, creating a feeling among more recent buyers that they got quite a deal.
Apple set a reference price of $600 when it released the iPhone last year. Since then, the price has dropped to $200, creating a feeling among more recent buyers that they got quite a deal. (By Damian Dovarganes -- Associated Press)
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By Michael S. Rosenwald
Sunday, June 22, 2008

The day Steve Jobs announced the new iPhone, I drove home from work nervous. I imagine that lots of first-adopter-types felt a similar queasiness at the idea of walking through the front door and rationalizing to their spouses that it wasn't enough to own just the first iPhone. Now we had to have the second.

My wife was watching the network news and had apparently seen a report about the new phone. She said, "You're not getting the new iPhone." I said, "Yes, I am." She said, "Then we're getting a divorce." She was kidding (I think).

"You're not going to spend another $400 or $500 on an iPhone when you have a perfect one right in your pocket," she added. I said, "You are so right. I'm going to spend $199." She stared at me for several seconds, and then she asked me a question that made my heart flutter: "So am I going to get your old iPhone?"

What happened in between the divorce threat and my wife's sudden acquiescence to the new iPhone was the result, I think, of a simple yet remarkable trick in behavioral economics that was played upon me, my wife, and millions of other people by Jobs and his backers at AT&T Wireless. It is a trick that turns up in how we buy stocks, how we think about the price of houses, how we choose entrees on a menu and why we shudder at the new price of gas.

I thought that with our wallets feeling lighter these days, with high gas prices and depleted home values, a discussion of what provokes us to buy and invest in the things we do would be a perfect start for my new monthly column. The Financial Lobe, a play on the region of our brains responsible for decision making, is not about what we should buy or invest in, or how we should go about doing it, but about why we make the financial decisions we make -- and how we can make them better.

So, why am I not getting a divorce?

I asked some behavioral economists, and the answer seems to be that we have no easy way to judge the value of the things we buy, and we especially have no fast and sure way to value the utility we would get from the purchase. So what our brains do is look for easy comparisons to give us answers. In the case of the iPhone, the initial price of the device when it was released last year was $599. Then it dropped to $399. The initial price (and even the first discount) of the phone anchored consumers to the idea that to own this device, you would have to pay a lot of money, substantially more than a typical cellphone.

"It establishes a reference price of $600, and now when it comes down -- that's very, very exciting," said Dan Ariely, a Duke University behavioral economist and the author of "Predictably Irrational," a book about how we make decisions. "We compare it to the higher price. I don't know if Steve Jobs planned this or not, but if he manipulated based on anchoring, he did a very nice trick."

Not only are we getting a perceived deal on the product, but we are also getting a deal on the deal. "You get the iPhone, and you get the deal," said Richard Thaler, a University of Chicago economist who came up with the notion of transaction utility, which he has described as "the difference between the amount paid and the 'reference price' for the good, that is, the regular price that the consumer expects to pay for this product."

So then the deal, at its extreme, looks like this: I'll pay $199 for the iPhone, but I will get a psychological return of $400 from the deal. I'm rich! Of course, it will cost me an extra $10 a month in AT&T service fees, thus wiping out any gains, real or psychological, over the two-year contract period. Thaler said we tend to "underweight" these costs because they are off in the future. "There will be people who crunch the numbers, but the people who fall in love with the phone right away won't," he said.

These kinds of pricing tricks get played on us all the time. In the world of investing, you have to look no further than stock splits. Companies split their stocks every day. Why do they do so? According to the questions-and-answers section of the Securities and Exchange Commission's Web site: "Companies often split their stock when they believe the price of their stock exceeds the amount smaller individual investors would be willing to pay for the stock. By reducing the price of the stock, companies try to make their stock more affordable to these investors."

Those individual investors are usually people like you and me, not the been-there, seen-that, won't-fall-for-it institutions on Wall Street.

If the stock of XYZ Inc. is priced at $70, then splits 2-for-1, it's then $35. It looks like a better value. Sale on XYZ stock! The only problem is that XYZ Inc. is still worth the same amount of money -- there are just more shares outstanding. As the SEC also points out, "A stock split has no effect on the value of what shareholders own." But you still feel as if you made money on the deal, with the transaction utility. Of people who fall for this, Thaler said, "That has to be a very stupid investor."

We get tripped up in restaurants, too. The next time you sit down for a nice meal at your favorite dining spot, take a close look at the prices of entrees. More often than not, there are one or two really expensive items, and then there are a bunch of mid-level ones and then there are a few inexpensive ones. The reason those really expensive items are there -- say, $50 for a seafood platter -- is that they are the reference point. You will consider them, then perhaps consider them too expensive, but instead of trading all the way down for the cheapest options ($19), you will likely settle at the middle ($30), thinking you got a deal relative to the pricey entree.

"Those $30 entrees will sell a lot more," said Gregg Rapp, a menu engineer in Palm Springs, Calif. "Otherwise, they are starting at the $30 one and going down to $19." By having a what he calls a positioning item on the menu -- the reference point -- "average check prices at the restaurant will grow," he said.

"I lay out a menu just like a grocery store lays out its shelves," Rapp said. "It's strategy. We're not playing tricks. We're just being smart about understanding what happens at a restaurant."

The pricing game can have the opposite effect, too, causing us to want to buy less of something. Perfect example: Gas. For as long as I could remember, gas never topped $2 a gallon, meaning that was my reference point. But the other day, I went to fill up, and the price staring at me was $4.09. To be perfectly honest, gas prices had been annoying me at $3.55 and $3.75, but it wasn't until I saw $4.09 that I seriously thought of buying a hybrid or taking public transportation. It was like how I responded to the iPhone going from $399 to $199, only in reverse.

The only upside to the new gas equation is that if prices stay this high long enough, a gallon of gas for $3 -- if we ever see it again -- will feel like a deal.

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