Author and professor Dan Ariely has gained fame from being able to make his behavioral economics research accessible to the general public. We all want to understand better why we do what we do. His newest book is The Upside of Irrationality. You can read sample chapters from his books for free via the eBook Taste of Irrationality.

One of the problems he’s trying to address is saving for retirement. Why do so many people save less than they need to? Here’s what Ariely says, via a recent interview on the Betterment blog:

The world around us (wants) us to spend money now. The incentives (to spend) are always very high. It’s hard to resist that, and sadly, after being tempted towards spending, spending, spending, what we have left for savings is not enough.

Investing is between now and later. It’s about the trade off, and because people are not making these trade offs correctly, we’re basically in the (bad economic) situation that we’re in.

Money is fungible. Any time you spend money on anything, it could be spent on something else. The $10 lunch, the $1,000 TV, the $20,000 car. We all know this is true, but in practice we tend to weigh things differently. Here is a thought experiment taken from a recent talking engagement (paraphrased):

Imagine being presented with the decision to either by a $700 Sony speaker set or a $1000 Pioneer speaker set. Most people go for the better and more expensive Pioneer speakers.

Now, what if the same people were instead presented with the decision between the $700 Sony set + $300 in CDs and DVDs or a $1000 Pioneer speaker set? Ariely found that now most people go for the Sony set and music package.

Why? It’s easier to imagine the value of $300 of CDs as opposed to the diluted value of $300 spread across all the possible things in the world to buy.

Perhaps it would help us to remember a list of things at different price points that are really important to us, so that we can better judge our daily spending. For example, if I really enjoy my daily $3 coffee, then I could think of other small purchases in terms of giving up that coffee. Now, getting everyone to agree to delayed gratification is something for which I don’t think there is a simple solution.

I’m currently reading the book Cheap: The High Cost of Discount Culture by Ellen Ruppel Shell, which is very well researched and a good read so far. One of the major themes of the book is how our culture is losing the ability to discern quality for ourselves. As a result, we use brand names and prices as shortcut indicators of quality.

First, take brand names. In general, we love brand names, because each of them allows a mental shortcut as to what to expect. Mercedez Benz. Rolex. Nike. This is why outlet malls are so popular. Since brands = quality, and outlet = low prices, we get insanely excited. Outlet malls are greater tourist attraction draws than national monuments.

As for prices, how often do you see a huge number on a shirt price tag, but with a slash through it? Retail Price: $80. Your Price: Only $19.99. Even better, make it one-day only like Groupon or Woot.com. The Manufacturers Suggested Retail Price (MSRP) is often purely a marketing scheme to make you feel like you’re getting a deal. This is called the reference price. You may not know anything about fabrics or stitching, but hey, this shirt used to cost $80, so it must be pretty good quality. I’m saving over 75% off the original price, how can I lose?

Coach is given as a great example of a well-recognized brand name that uses these tendencies to its advantage. Starting out in 1941 as a small leather workshop in New York, Coach is a maker of “affordable luxury” leather purses and other accessories complete with trademarked logos. Most manufacturing is now done in China and other cheap-labor countries. In fact, the gross margins across the company are now a huge 70-75%. (Gross margin is the difference between selling price and the cost to produce.)

Traditionally, outlet and factory stores sold slightly damaged or defective examples of their regular products at a steep discount. However, it may surprise you that now many brands make goods designed specifically for their outlet stores. At a Coach Factory Store, 80% of the stuff inside is sold exclusively in those stores. These are lower-quality versions, intended to be sold only at outlets for a lower price. You can’t return outlet purchases at a regular store, because they aren’t the same thing and are subtly marked as such (also because they want to make it harder to return).

Would it surprise you further to know that Coach makes more profit from its factory stores than its full retail stores? Per this article, Coach had 347 retail stores and 129 factory stores in North America. In a way, you could say that the main purpose of the full-price Coach stores in upscale shopping centers is to keep up the facade of quality. Meanwhile, the Coach Factory Outlets provide all the profit. The glitzy stores create that critical reference price ($800 purse!), so you think the Factory Store price is a good one. A $149 Coach? What a deal. If you own Coach bags or know people who do, think about it. How many did you buy at a “real” store vs. a Factory store?

Over time, this practice should dilute Coach’s brand equity. However, if we are indeed unable to judge quality and are just interested in brand names anyway, then it will take a while.

After two days of polling for my Frugality and Decision Making question, here are the results of my casual survey. As with my monkey poll question, each visitor was randomly given one of two different poll questions. I really love that you all put so much thought into your decision, but in fact the point I was trying to get across was a bit different.

As you can see, the only difference between two questions is the original price of the item being purchased. In both cases, you are deciding whether you want to save $7 by spending 15 minutes of your time. $7 is $7. Or is it? The vast majority of readers would take the 15 minutes for a $25 pen, but the vast majority would also not spend the 15 minutes for a $455 suit.

The Answer is Relativity.

Humans are trained to base our decisions in a relative manner, and compare them to whatever is available. We hate making decisions in a void. In this case, your mind may have trouble deciding if a $7 savings is worth it, so it goes straight for the price. In this case, $7 is savings of nearly 30% for the pen, and less than 2% for the suit. The decision is now easier, even though it may not make rational sense. We should think about money in a more absolute manner, but we tend not to.

More Examples of Relativity

• Think about how happy you are with your current salary. Now, imagine your co-worker who is junior to you gets paid $5,000 more a year. Much less happy now, right? H.L. Mencken noted that a man’s satisfaction with his salary depends on whether he makes more than his wife’s sister’s husband. 😯
• Rome or Paris? Let’s say you love Paris and Rome equally, but have to decide between a Paris trip with hotel/airfare/free breakfast, a Rome trip with hotel/airfare/free breakfast, or a Rome trip with hotel/air but no free breakfast. Most people will proceed to pick Rome with free breakfast, because in that case you can make a comparison where you are making a clearly “superior” choice.

  Given three choices, A, B (distinct, but equally as attractive as A), and A- (similar to A, but inferior), we will almost always choose A, because it is clearly superior to A-.

  When Williams-Sonoma started selling a bread machine, sales initially were slow. But after they added a new “deluxe” version that was 50% more expensive, they started selling a lot. People now saw the first bread machine as a bargain.

• Have you ever rationalized an additional purchase because you’re already spending so much? When catering a large event that costs $5,000, a person may not think twice about adding a soup entree for an additional $200. The same person may get really excited when saving 50 cents on a can of soup.
• Which dot is bigger?
  

Often, simply acknowledging our tendencies and trying to think more broadly can help up make better decisions in the future.

As some of you have figured out, the idea for this week’s poll question and many of the examples above came from a book called Predictably Irrational by Dan Ariely, which explains how humans don’t always respond perfectly logically. (The actual poll question is from a study by well-known researchers Amos Tversky and Daniel Kahnemann.) I hope to put up more poll questions from this book (so don’t spoil them please :)), as I find it much more fun and interactive than a book review.