Misbehaving: The Making of Behavioral Economics

by Richard H. Thaler

  One principle that emerged from our research is that perceptions of fairness are related to the endowment effect. Both buyers and sellers feel entitled to the terms of trade to which they have become accustomed, and treat any deterioration of those terms as a loss. This feeling of ownership of the usual conditions of sale is particularly true when a seller starts to charge for something that has traditionally been given away for free or included in the price. In this way, the status quo becomes a reference point. If restaurants started charging extra to be able to sit down while you eat, that would be violating the existing norm that dinner meals include a chair, although it does not have to be comfortable. Nevertheless, citizens think that firms and employers are entitled to make a (reasonable) profit. Firms are not expected to give away their products. One implication is that raising prices because costs have increased is almost always judged to be fair.

  Perceptions of fairness also help explain a long-standing puzzle in economics: in recessions, why don’t wages fall enough to keep everyone employed? In a land of Econs, when the economy goes into a recession and firms face a drop in the demand for their goods and services, their first reaction would not be to simply lay off employees. The theory of equilibrium says that when the demand for something falls, in this case labor, prices should also fall enough for supply to equal demand. So we would expect to see that firms would reduce wages when the economy tanks, allowing them to also cut the price of their products and still make a profit. But this is not what we see: wages and salaries appear to be sticky. When a recession hits, either wages do not fall at all or they fall too little to keep everyone employed. Why?

  One partial explanation for this fact is that cutting wages makes workers so angry that firms find it better to keep pay levels fixed and just lay off surplus employees (who are then not around to complain). It turns out, however, that with the help of some inflation, it is possible to reduce “real” wages (that is, adjusted for inflation) with much less pushback from workers. The next pair of questions illustrates this point.

  A company is making a small profit. It is located in a community experiencing a recession with substantial unemployment but no inflation. There are many workers anxious to work at the company. The company decides to decrease wages and salaries by 7% this year.

  Acceptable 38%    Unfair 62%

  A small company is making a small profit. It is located in a community experiencing a recession with substantial unemployment and inflation of 12%. The company decides to increase salaries only 5% this year.

  Acceptable 78%    Unfair 22%

  Notice that the spending power of the employees is the same for the two versions of the problem, but the reactions are quite different. An actual cut in the nominal wage is viewed as a loss and is therefore unfair, whereas failing to keep up with inflation is judged acceptable since the nominal wage is still going up. This is one of many reasons why some economists (including me) felt that central banks should have been willing to tolerate a bit more inflation after the financial crisis. Even 3% inflation might have allowed firms to effectively cut real wages enough to speed the jobs recovery that has been so slow in most of the world.

  Of course, it is one thing to discover what actions by firms make people angry, and it is quite another to ask whether firms obey these fairness norms. I do not know of any systematic study of this question, but I suspect that most successful firms intuitively understand the norms we uncovered and at least try to avoid giving the appearance of behaving unfairly.

  The value of seeming fair should be especially high for firms that plan to be in business selling to the same customers for a long time, since those firms have more to lose from seeming to act unfairly. In fact, after a hurricane, the cheapest place in the country to buy plywood is often the area that has been hardest hit. For example, after Hurricane Katrina devastated New Orleans, Home Depot and other chains loaded up trucks with emergency supplies of food and bottled water to give away. At the same time, such a natural disaster will induce some entrepreneurial folks to load a truck with plywood in a nearby city and sell it in the devastated areas for whatever price it will fetch. In this case, both sellers are profit-maximizing. The chain store is establishing a reputation for fair dealing that will have long-term payoffs, whereas the “temporary entrepreneurs” will be back home in a couple days with a tidy profit and either a slightly guilty conscience or pride in their efforts to help improve the allocation of scarce resources, depending on their point of view.

  But firms don’t always get these things right. The fact that my MBA students think it is perfectly fine to raise the price of snow shovels after a blizzard should be a warning to all business executives that their intuitions about what seems fair to their customers and employees might need some fine-tuning.

  Consider the case of an initiative taken by First Chicago in the mid-1990s, when it was the largest bank in the Chicago metropolitan area. Top management was concerned that the retail banking division was not making enough profits. To trim costs, they decided to encourage customers to make greater use of recently introduced automatic teller machines (ATMs). Although most people had become comfortable taking money out of such a machine, some customers were reluctant to use an ATM to deposit checks. Instead, they would go to a teller for that service, and full-fledged technophobes continued to go to the teller to get cash (and perhaps chat with a favorite teller). The bank decided to give customers an incentive to switch to ATMs by charging three dollars to use a teller for a transaction that could be done at an ATM.

  The bank was proud of this innovation and announced it with great fanfare, along with a new lineup of checking account options. The public reaction was immediate and fierce. A local paper’s front-page headline read: “FIRST CHICAGO LOSES TOUCH WITH HUMANS.” The story went on to say: “The First National Bank of Chicago today introduced an innovative lineup of checking accounts designed to bring its products up to date with the way customers prefer to bank in the 1990s. And what is it the bank thinks customers prefer in the 1990s? Paying a $3 fee for the privilege of doing business with a bank teller.”

  The competition was quick to pounce. One bank put a “Free Teller” sign on its branch right off one of the local expressways. Another ran this radio ad:

  MAN: I was looking over my bank statement, and I am wondering . . .

  TELLER: Is that a question?

  MAN: What? Well, yes.

  TELLER: Questions are extra—six dollars.

  MAN: What?!

  TELLER: Nine dollars.

  You get the idea. Even the late night comedian Jay Leno picked up on it: “So, if you want to talk to a human, it’s three dollars. But the good news is, for $3.95 you can talk dirty to her, so that’s okay.”

  The bank attracted all this bad publicity for a three-dollar fee that very few people would actually pay. Yet it took until December 2002, after First Chicago had been purchased by a national bank, for the new management team to announce that they were abandoning the policy. “We’ve been presumptuous about our market share here. We haven’t done a great job in Chicago.”

  The CEO of Coca-Cola also discovered the hard way that violating the norms of fairness can backfire. Douglas Ivester, aged fifty-two, appeared to be on his way to the job of chairman when he abruptly resigned after a push from several board members including legendary investor Warren Buffett. Although several actions contributed to his downfall, one speech in Brazil attracted the most attention. At a press conference, Mr. Ivester was asked about tests Coke was running with vending machines that could change price dynamically. He replied: “Coca-Cola is a product whose utility varies from moment to moment. In a final summer championship, when people meet in a stadium to have fun, the utility of a cold Coca-Cola is very high. So it is fair that it should be more expensive. The machine will simply make this process automatic.” As the Wall Street Journal stated in a story about his downfall, Mr. Ivester seemed to have a “tin ear.” An editorial cartoon captured the feelings
of the general public perfectly with an image of a customer walking away from a Coke vending machine with a can in his hand, looking back to see an arm reaching out of the machine and picking his pocket.

  Firms continue to fail at the basics of business fairness. Consider the case of Whitney Houston, the pop singer who died suddenly on February 11, 2012. It was to be expected that there would be a spike in the demand for her recordings, now largely sold online at sites such as iTunes. How did Apple and Sony (the owner of the recording rights) react to the death? Was this a propitious time to jack up the price?

  Someone (or possibly, some pricing algorithm) seemed to think so. About twelve hours after her death, the price of Houston’s 1997 album The Ultimate Collection increased on the UK iTunes site from £4.99 ($7.86) to £7.99 ($12.58), a 60% increase in price. The price of Whitney—The Greatest Hits later increased from £7.99 to £9.99, a 25% increase.

  The Guardian was the first news organization to break the story. Customer ire was originally directed toward Apple, but later Sony was blamed for the hike. Regardless of who was to blame, fans were outraged. The Daily Mail quoted one customer as saying: “To say I am angry is an understatement and I feel it is just a case of iTunes cashing in on the singer’s death, which in my opinion is totally parasitic.” The anger in this case might have been particularly acute because in the case of online downloads there is no sense in which the albums have become scarce. Unlike snow shovels after a blizzard, iTunes cannot run out of copies of an album to be downloaded.

  This story was not widely known in the United States, where prices did not spike, and certainly it did not appear to affect sales in the U.S. According to Nielsen SoundScan, there were 101,000 Whitney Houston albums sold in the U.S. the week after her death (up from 1,700 the week before) and 887,000 individual song downloads (compared to 15,000 the week before). I do not know whether sales in the U.K. were as strong, but even if they were, a price increase may not have been wise. As usual in these cases when demand has suddenly risen, a seller has to trade off short-term gain against possible long-term loss of good will, which can be hard to measure.

  A reasonable question to ask at this point is whether firms are always punished for acting “unfairly.” Sure, First Chicago got hammered in the media for its three-dollar charge to see a teller, but airlines have been adding fees one after another without appearing to cause irreparable harm to the individual airlines that lead the way, or the industry as a whole. Why not? Airline travelers can’t be happy about the new fees for checked baggage, nor the crammed overhead bins that have become the norm since baggage fees were added. In this case, as in many others, the key is what happens after the first mover adds a new fee that might be perceived as unfair. If the competition follows the first mover’s lead, then customers may be peeved but have little choice if they must consume the product in question. Had the other major banks in the area followed First Chicago’s example and added a teller fee, customers might well have gotten used to the idea and reluctantly accepted it. But any large first mover who takes an action that violates the norms of fairness runs considerable risks if competitors do not follow suit.

  My takeaway from these examples is that temporary spikes in demand, from blizzards to rock star deaths, are an especially bad time for any business to appear greedy. (There are no good times to appear greedy.) One prominent new firm that appears to be ignoring this advice is Uber, the innovative smartphone-driven car service that has entered many markets around the world. One feature of Uber’s business model is that prices can fluctuate depending on demand. Uber refers to this practice as “surge pricing.” When demand is high, for whatever reason, prices go up, and customers requesting a car are notified of the current price multiple. Customers can then choose to accept the higher price, turn it down and seek alternative transportation, or hope that the surge will be short-lived and wait for Uber to notify them that the surge is over. Uber does not make their pricing formulas public, but there have been media reports of surge multiples more than ten times the regular price. Unsurprisingly, multiples this large have led to complaints.

  Uber has defended surge pricing on the basis that a higher price will act as an incentive for more drivers to work during peak periods. It is hard to evaluate this argument without seeing internal data on the supply response by drivers, but on the face of it the argument does not seem to be compelling. First of all, you can’t just decide on the spur of the moment to become an Uber driver, and even existing drivers who are either at home relaxing or at work on another job have limited ability to jump in their cars and drive when a temporary surge is announced. One indication of the limits on the extent to which the supply of drivers can respond quickly is the very fact that we have seen multiples as high as ten. If thousands of drivers were ready to leap into their cars when a surge is announced, large surges in price would be fleeting.

  Regardless of whether Uber can instantly increase its supply of drivers, the high multiples charged during a blizzard in New York City attracted the attention of the New York State attorney general. (Raising the price of snow shovels is not the only thing that makes people mad during a snowstorm.) It turns out that New York has one of those anti-gouging laws I referred to earlier. Specifically, firms are prohibited from charging “unconscionable excessive prices” during any “abnormal disruption of the market,” which can be anything from a storm to a power outage to civil disorder. Note that the language of the law captures some of the emotions people have about this issue. Excessive would seem to be enough, but this law bans unconscionably excessive prices.

  The State of New York and Uber reached an agreement that in such abnormal disruptions of the market, Uber would limit its surge pricing using a formula. It would first search for the highest multiples charged on four different days during the sixty days that precede the “abnormal disruption.” The fourth highest price would then serve as a cap on the surge that could be charged in the emergency period. In addition, Uber voluntarily offered to donate 20% of its additional revenues during these periods to the American Red Cross.

  I think it showed bad judgment on the part of Uber management to wait until the attorney general forced them into this concession. If they wanted to establish good long-term relationships with their customers, they should have thought of something like it themselves. Just imagine that Uber existed on September 11, 2001, when the planes struck the World Trade Center. Would it have been a smart move for Uber to have a special “9/11 surge special” of twenty times the usual fare, sending many of the cars in the area off to Greenwich?* This insensitivity to the norms of fairness could be particularly costly to Uber since the company has had to fight political battles in many of the cities it enters. Why create enemies in order to increase profits a few days a year?†

  Don’t get me wrong. I love Uber as a service. But if I were their consultant, or a shareholder, I would suggest that they simply cap surges to something like a multiple of three times the usual fare. You might wonder where the number three came from. That is my vague impression of the range of prices that one normally sees for products such as hotel rooms and plane tickets that have prices dependent on supply and demand. Furthermore, these services sell out at the most popular times, meaning that the owners are intentionally setting the prices too low during the peak season.

  I once asked the owner of a ski lodge why he didn’t charge more during the Christmas week holiday, when demand is at a peak and rooms have to be booked nearly a year in advance. At first he didn’t understand my question. No one had ever asked why the prices are so low during this period when prices are at their highest. But once I explained that I was an economist, he caught on and answered quickly. “If you gouge them at Christmas they won’t come back in March.” That remains good advice for any business that is interested in building a loyal clientele.

  One businessman who understands this lesson better than most is Nick Kokonas, the co-owner, with celebrity chef Grant Achatz, of two of the best restaurants in Chic
ago: Alinea and Next. The concept at Next is highly original. The menu changes completely three times a year. The themes can vary as widely as a dinner in Paris from 1906, to Thai street food, to an homage to El Bulli, a restaurant in Catalonia, Spain, that was a foodie mecca until it closed in 2011. When Next was scheduled to open in April 2011, they announced that all their meals (as well as those at Alinea) would be sold by tickets, with the ticket prices varying according to the day of the week and the time of day. Following the usual fairness norms, the prices do not vary all that much. The most expensive price, for Saturday night at eight, is only about 25% more than the cheapest time, 9:45 on Wednesday. As a result, the prime-time tables sell out almost immediately (some to customers who buy season tickets to all three meals that year), and typically the only tables available are at the cheaper off-peak times.

  When Next first opened and the excitement was at its peak, two economists from Northwestern University tried to explain to Mr. Kokonas that he was doing this all wrong, and that he should instead have auctioned off each reservation so as to maximize his profits. Kokonas strongly disagreed with this advice, and has a long blog entry explaining why. Here is the key sentence in his blog: “It is incredibly important for any business, no matter how great the demand, not to charge a customer more than the good or service is worth—even if the customer is willing to pay more.” He felt that even if someone was willing to pay $2,000 to eat at Next, that customer would leave feeling, “Yeah, that was great but it wasn’t worth $2,000.” And crucially, Kokonas believes that such a customer will not come back, and may share his disgruntled experience with other potential diners.‡

  Kokonas is now offering his online ticket-selling software to other high-end restaurants. It will be interesting to see whether the restaurants that adopt the ticket model also adopt his pricing strategy of “underpricing” the (expensive) tables at peak times. The ones that want to stay in business for the long haul would be well advised to do so.