We do know that building a solid revenue base before the season started accomplished the goal of getting the resort out of debt and reducing its dependence on the amount of snowfall during the season. Both Michael‡ and I moved on, but I can report that Greek Peak is still in business.
My day at GM
For years, American automobile manufacturers had a seasonal sales problem. New car models would be introduced in the fall of each year, and in anticipation of the new models, consumers became reluctant to buy “last year’s” model. Manufacturers did not seem to anticipate this pattern and would reliably have a substantial inventory of unsold cars on dealers’ lots in August, taking up the space needed to show off new models. Inevitably, car companies offered sales promotions to move the excess inventory.
One innovation was the rebate, introduced by Chrysler in 1975, and quickly followed by Ford and GM. The car companies would announce a temporary sale whereby each buyer of a car would receive some cash back, usually a few hundred dollars. A rebate seems to be just another name for a temporary sale, but they seemed to be more popular than an equivalent reduction in price, as one might expect based on mental accounting. Suppose the list price of the car was $14,800. Reducing the price to $14,500 did not seem like a big deal, not a just-noticeable difference. But by calling the price reduction a rebate, the consumer was encouraged to think about the $300 separately, which would intensify its importance. This bit of mental accounting was costly, at least in New York State where I was living, because the consumer had to pay sales tax on the rebate. Using the numbers in the example above, the consumer would pay sales tax on the full purchase price of $14,800 and would then get a check back from the manufacturer for $300, not $300 plus the 8% sales tax. But more to the point, rebates were starting to lose some of their luster, and cars were again piling up in dealers’ lots.
Then someone at GM headquarters got an idea. Ford and Chrysler had been trying discounted auto loans as an alternative or supplement to rebates. What if GM tried offering a highly discounted rate as a sales inducement? At a time when the going interest rate for a car loan was 10% or more, General Motors offered a loan at just 2.9%. Consumers could choose either a rebate or the discounted loan. The loan offer had an unprecedented effect on sales. There were news reports of consumers sprawled on the hoods of cars at a dealership claiming a particular car before anyone else could buy it.
Around this time, I noticed a small story in the Wall Street Journal. A reporter had crunched the numbers and discovered that the economic value of the low-interest-rate loan was less than the value of the rebate. In other words, if consumers used the rebate to increase the down payment they made on the car, thus reducing the amount they had to borrow (though at a higher rate), they would save money. Taking the loan deal was dumb! But it was selling a lot of cars. Interesting.
At this time, one of my Cornell colleagues, Jay Russo, was consulting for GM, so I went to talk to him. I told Jay about this puzzle and said that I might have a simple psychological explanation. The rebate was a small percentage of the price of the car, but the car loan being offered was less than a third of the usual rate. That sounds like a much better deal. And few people besides accountants and Wall Street Journal reporters would bother to do the math, especially since this was in an era that predated spreadsheets and home computers.
Jay asked me to write up a brief note about my observation that he could share with people at GM. I did, and to my surprise about a week later I got a call from General Motors headquarters. My note had found its way to someone in the marketing department, and he wanted to talk to me about it in person. I said sure, come on by.
This gentleman flew from Detroit to Syracuse and drove the hour and a quarter down to Ithaca. We chatted about my idea for about an hour, at most. He left, spent a few hours strolling the campus, and went back to Detroit. I went to Jay to find out what this was about and he put it bluntly. “He was here to count your heads.” What? “Yeah, he wanted to see if you had two heads, didn’t bathe, or were in some other way unsafe to bring to see his bosses. He will report back to HQ.”
Apparently I passed the test. A few days later I got a call asking whether I would be willing to come to Detroit. This had the potential to be my first paid consulting gig, I could use the money, so I quickly agreed. Besides, I was damn curious.
If you have seen Michael Moore’s documentary film Roger and Me, you have seen my destination: the GM headquarters building. I found it very strange. It was huge, and new cars were on display everywhere inside, in the hallways and lobbies. In my first meeting, a vice president of marketing gave me my schedule for the day. I had a series of half-hour meetings with different people in the marketing department. Many of them also seemed to be vice presidents. In that first meeting I asked who was in charge of evaluating the low-interest-rate promotion, which reduced the price of the cars sold by hundreds of millions of dollars. My host was not certain, but assured me it had to be one of the people I would be meeting. By the end of the day I would know.
During the day several people described how the interest rate of 2.9% had been determined. Apparently Roger Smith, the CEO, had called a meeting to determine how they were going to deal with surplus inventory that year and someone had suggested a promotion based on lower interest rates. Everyone agreed this was a great idea. But what rate should they use? One manager suggested 4.9%. Another said 3.9%. After each suggestion, someone would be sent to make some calculations. Finally, someone suggested 2.9%, and Roger decided he liked the sound of that number. The whole process took less than an hour.
But when I asked people who would evaluate the promotion and decide what to do next year, I got blank stares followed by, “Not me.” The day ended in the office of my host. I reported that, as far as I could tell, no one would be thinking about these questions, and this struck me as a mistake. He suggested that I write him a proposal for what might be done.
After what I had learned during my visit, I was pretty sure I did not want this consulting job, but I did send him a short proposal making two suggestions for what I thought they should do. First, figure out why the promotion had worked so well. Second, make a plan for the future, especially since they should expect that Ford and Chrysler were likely to copy GM’s successful promotion.
After a month I received a curt reply. My recommendation had been discussed by top management and was rejected. The company had instead resolved to better plan its production and avoid excess summer inventory. This would eliminate the need to evaluate the promotion and plan for the future, since there would be no more end-of-model-year sales. I was astounded. A huge company had spent hundreds of millions of dollars on a promotion and did not bother to figure out how and why it worked. Michael Cobb at tiny Greek Peak was thinking more analytically than the industrial behemoth General Motors.
As I have learned over the years, and will discuss further in subsequent chapters, the reluctance to experiment, test, evaluate, and learn that I experienced at General Motors is all too common. I have continued to see this tendency, in business and government, ever since, though recently I have had the chance to try to change that ethos in government settings.
Oh, and about that claim that they had a plan to eliminate excess inventory in future summers? It was violated the next summer, the summer after that, and, as far as I know, every summer since. Overconfidence is a powerful force.
________________
* In mental accounting terms, going to Greek Peak and paying the retail price did provide positive acquisition utility for most customers, especially the locals who were able to drive just thirty minutes, ski for a day, and be home for dinner, without paying for a hotel room. That is a luxury available to residents of Salt Lake City and other places in close proximity to ski resorts, but not to most people. The problem was in the perceived transaction utility, since the price did not seem reasonable compared to bigger resorts that were not charging much more.
† Of course, not everyone falls for
this trap. Before Michael started giving us free lift tickets, I had purchased an after-school skiing program for my daughter Maggie, who was in seventh grade. One week Maggie announced that she was going to skip skiing to go to a dance at the school. The next week, she said she was also going to skip because a friend was having a birthday party. “Hey Maggie,” I said, “are you sure about this? We paid a lot for that after-school ski program!” Maggie just said: “Ha! Sunk costs!” Only the daughter of an economist would come up with that line.
‡ Alas, Michael passed away just as this book was being finished. We both enjoyed comparing our distant memories of this episode as I was writing this passage. I already miss him.
IV.
WORKING WITH DANNY:
1984–85
After our year in Stanford, Amos and Danny decided to immigrate to North America. Amos stayed on at the Stanford psychology department and Danny moved to the psychology department at the University of British Columbia in Vancouver. Part of the allure of UBC was that Amos and Danny would be a two-hour flight away from each other and in the same time zone. They continued to work together, talking daily and visiting each other often.
Because we all started new jobs the same year, we were on the same sabbatical schedule. In 1984–85 I would get my first one, and Amos and Danny would be on leave too. Our year at Stanford had been so transformative for me that when it came time to think about my research leave, I naturally hoped to hook up with one or both of them. After various machinations, I ended up in Vancouver with Danny. Amos, meanwhile, headed off to Israel.
I got an office at the UBC business school, which was a good place for me to hang out since it had an excellent finance department and I was in the midst of trying to learn more about that field. But the main thing I did that year was work with Danny and his collaborator, the environmental economist Jack Knetsch, who taught at nearby Simon Frasier University. Like the year at Stanford, this year in Vancouver offered me the rare opportunity for full immersion in research. Apart from the year in Stanford, it would be the most productive year of my life.
14
What Seems Fair?
Danny and Jack invited me to join them in a project they had recently started that was closely related to my “beer on the beach” question, which investigated what makes an economic transaction seem like a “good deal” (i.e., what makes people willing to pay more for a beer purchased at a fancy resort than at a rundown shack). The topic Danny and Jack had begun to study was: what makes an economic transaction seem “fair”? Someone might resist paying as much for a beer sold at a shack as for one sold at a fancy resort because, in his or her mind, it’s not fair for the shack owner to be charging such a high price.
This project was made possible by an arrangement Jack Knetsch had made with the Canadian government, which gave us access to free telephone polling. Apparently there was a program that was training the unemployed to be telephone interviewers, whatever that entails, and they needed questions for the trainees to ask. If we faxed a bunch of questions each Monday morning, they would fax us back the responses Thursday night. That gave us Friday and the weekend to figure out what we had learned from the week’s questions and to write some new ones for the following week. Today this sort of research can be done online using services like Amazon’s “Mechanical Turk,” but back then weekly access to a random sample of a few hundred residents of Ontario (and later British Columbia) was an incredible luxury. We were able to try out lots of ideas, get quick feedback, and learn in the best possible way: theory-driven intuition tested by trial and error.
Here is an example of the kind of question we were asking:
A hardware store has been selling snow shovels for $15. The morning after a large snowstorm, the store raises the price to $20.
Rate this action as: Completely fair, acceptable, somewhat unfair, or very unfair.
We decided to simplify the presentation of the data by combining the first two answers and calling them “acceptable,” and the last two, which we labeled “unfair.” Here were the responses for this question (each question had about 100 respondents):
Acceptable 18% Unfair 82%
Now, you might be saying, “Duh! What kind of jerk would raise the price of snow shovels the morning after a snowstorm?” But raising the price is exactly what economic theory says will and should happen! This easily could be a question from a basic economics course in business school. “There is a fixed supply of snow shovels, and a sudden increase in demand. What will happen to the price?” In that class, the correct answer is to say that the price will go up enough so that everyone who is willing to pay that price will get one. Raising the price is the only way to assure that the snow shovels will end up being owned by those who value them most (as measured by their willingness to pay).
One of the things MBAs learn in business school is to think like an Econ, but they also forget what it is like to think like a Human. This is another example of Kahneman’s notion of theory-induced blindness. Indeed, when I posed the snow shovel fairness question to my MBA students, their responses were in accord with standard economic theory:
Acceptable 76% Unfair 24%
Ours was a purely descriptive exercise. We did not intend to be moral philosophers or to render judgment about what “is” or “should be” fair. Instead, we were trying to do what you might call experimental philosophy. We were trying to learn what ordinary citizens, albeit Canadians, think is fair. More specifically, we were trying to learn what actions by firms make people angry. It turns out that raising the price of snow shovels after a blizzard really pisses people off. There is even a name for this practice: gouging. The usual definition of “gouge” is “to make a hole or groove with a sharp instrument.” When a store raises the price of snow shovels the day after a blizzard, people feel very much like someone has poked them with a sharp object. And indeed, in many places there are laws against gouging, suggesting that people find the practice offensive. We wanted to figure out what other business practices Humans hate.
Any polling question that produced something interesting would be run again using different variations to make sure there was nothing special about, say, snow shovels. Here is another example, inspired by my three-year-old daughter Jessie and her ever-present doll Joey. Joey was no ordinary doll; he was a Cabbage Patch doll, which for reasons mysterious to me but obvious to many young girls had become a fad among the preschool set. By Christmastime, there were no Cabbage Patch dolls to be found anywhere, and many parents were desperate. Thus, this item:
A store has been sold out of the popular Cabbage Patch dolls for a month. A week before Christmas a single doll is discovered in a storeroom. The managers know that many customers would like to buy the doll. They announce over the store’s public address system that the doll will be sold by auction to the customer who offers to pay the most.
Acceptable 26% Unfair 74%
This answer raises an interesting follow-up question: what is it that makes the auction unpopular? Is it that the doll will go to someone affluent enough to win the auction, or is it that the store owner has opted to extract every possible penny from a desperate parent with a toddler waiting anxiously for Christmas Eve?
To find out, we asked the same question to another group of respondents but added one extra sentence stating that the proceeds will be donated to UNICEF. That yielded an acceptable rating of 79%. Auctioning a doll is fine if the proceeds go to charity, unless the “charity” is the owner’s wallet.
Even this conclusion has to be tempered. In another scenario, we said that a small town was suffering from a flu epidemic, and there was only one package of medicine remaining. Would it be fair for the pharmacist to auction off the medicine? Of course people hated the auction, but in this case they hated it even if the money went to charity. People understand that many luxuries are only available to the affluent. But, at least for most people, health care occupies a different category. Most European countries (as
well as Canada) provide health care to their citizens as a basic right, and even in America, where this view is resisted in certain quarters, we do not turn uninsured accident victims away at the emergency room. Similarly, no country permits a free market in organs, although Iran does have a market for kidneys. For most of the world, the idea that a rich person who needs a kidney should be allowed to pay a poor person to donate one is considered “repugnant,” to use the word favored by economist Alvin Roth to describe such market transactions.
In many situations, the perceived fairness of an action depends not only on who it helps or harms, but also on how it is framed. To test these kinds of effects, we would ask two versions of a question to different groups of respondents. For example, consider this pair of questions, with the differences highlighted in italics:
A shortage has developed for a popular model of automobile, and customers must now wait two months for delivery. A dealer has been selling these cars at list price. Now the dealer prices this model at $200 above list price.
Acceptable 29% Unfair 71%
A shortage has developed for a popular model of automobile, and customers must now wait two months for delivery. A dealer has been selling these cars at a discount of $200 below list price. Now the dealer sells this model only at list price.
Acceptable 58% Unfair 42%
This pair of questions illustrates a useful point that came up in our discussion in chapter 2 of merchants imposing surcharges for using a credit card. Any firm should establish the highest price it intends to charge as the “regular” price, with any deviations from that price called “sales” or “discounts.” Removing a discount is not nearly as objectionable as adding a surcharge.
Misbehaving: The Making of Behavioral Economics Page 14