The IKEA Effect

In a previous Behavioral Economics – related article (see article ‘The Power of $0.99’), we talked about what, and by which means, behavioral pricing strategies influence our brain. However, you might have realized that those strategies do not always succeed, especially when you are aware and start noticing them. It is important to understand to what extent we are sufficiently attached to a good or product, in order for that attachment to matter in our decision-making. It is equally important finding out why we value it so much. Michael I. Norton (Harvard University), Daniel Mochon (University of California) and Dan Ariely (Duke University), studied this phenomenon, naming it the IKEA effect.

In fact, it is fairly easy to understand that we give value to both things we make and to the completed end-products we buy. However, it may not be as easy to acknowledge that our neurology influences us to overvalue what we make, even if objectively it is not true. This is a cognitive bias dating way back in history.

One example puts us back in the 1950s, when cake mixes first emerged in common supermarkets. A high demand was to be expected, for a product of easy use that would facilitate every home baker across the world, saving precious time. However, in reality, the precise opposite occurred. In the process of understanding why people didn’t react well to such a time-saving product, it was discovered that consumers found it too easy. Unsurprisingly, marketeers went blue and struggled to understand why the product made people feel unattached. What they uncovered related exactly to this: attachment. Common, not-so-rational human beings give higher value to things they put a certain level of effort in. Following this theory, marketeers changed the recipe, requiring now that bakers add an egg to the mixture (instead of dried eggs being already included in the recipe). This led to an outstanding increase in sales, since the egg addition established an effort level sufficient enough to change consumers’ perception from being too easy to facilitating.

The big question lies in what that turning-point effort level is. It is a very difficult problem to solve, since its answer depends on the products, consumers and circumstances. Notwithstanding, this rationale is currently being used alongside behavioral pricing to spark consumers’ internal need for the companies’ products.


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The IKEA effect name derived precisely from the extraordinarily intelligent strategy of the IKEA brand. By being an easy “build it yourself” brand, it captivates consumers’ attention for its products – even though it would be easier to buy already made furniture – regardless of the product quality. Buyers tend to view their IKEA furniture as theirs from the moment they spend time following the instructions and assembling the product themselves. The whole mechanism relies on personal investment in the creation that later tends to develop into a personal pride symbol that ultimately leads to an overvaluing of the final product. We might be aware or completely ignorant of this unconscious trick of our brains, but the truth is that we bake a ready-mix cake or build a ready-cut armoire and we take pride in it, giving us greater pleasure than eating or passing by the same readymade products. We smile when the cake is at the table or when we pass by the armoire in the living room. It is not related to our individual appreciation or gift for baking or building, it is in fact a general human bias.


In ‘The Upside of Irrationality’, Dan Ariely later discovered that we are largely unaware of this quotidian tendency and expect others to take as much awe in our cake as we do. It may be a paining truth to understand that others don’t think greatly of our cooking, designing, family, house, company or strategy as we do, but it is actually a very useful knowledge. Allowing this reality to sink in can be life-changing in the way that we look at our developed creations and subsequently it allows a more objective, real perception on them. The notion that our ideas are not always the most desirable to follow and the power of an objective perception are crucial for managerial success. Thinking greatly of made investments, even if they continually provide loss, can be an avoidable mistake through the recognition that not always our created and baked strategies are the most valuable ones.

An impartial and unbiased reasoning may lead us to understand that others’ ideas are not only not inferior, as they may be better adjusted for our current company operations.


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On the other hand, acknowledging that ‘greater effort ultimately leads to greater love’ (given that labour is successful) will encourage you to foresee relaxation over effort in completing your desired activities on the certainty that in the end you will be farming long-term satisfaction. In Economics, the labour market model leads us to believe that greater effort is the root of unbearable responsibility, frustration and stress, and that real happiness lies in immediate relaxation and no work. However, the human inheritance is to be proud of our deeds and accomplishments. Seeing a completed weekly objectives list makes us understand that all the sweat and tears given to that week’s work was why we felt the overall final enjoyment. 

Concluding with the same reasoning, it is often heard that the easy way is not always the best road to happiness and the IKEA effect came to prove it. The next time you feel like buying a cake, buy a ready-mix and complete it yourself, or the next time you need a new desk, take the time to assemble it. You might come to discover that you will take pride and a little bit of happiness from it, cherishing your success in a much deeper sense. At the same time, be aware that just like your valuing sentiment may not be equally perceived by others, our particular intuitions and ideas are not always the rational and most beneficial approach to the problem.

In today’s world, it is very difficult to be the best, but some strategies can make you feel the best while knowing it.

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Bibliography:

  • Ariely, Dan; The upside of Irrationality; London; 2010;

  • I. Norton, Michael; Mochon, Daniel; Ariely, Dan; The “IKEA Effect”: When Labor Leads to Love; 2011; Harvard Business School;

Money, the most powerful motivator of all times. Or maybe not…

Imagine you were a manager and wanted to improve the performance of your team. What would you do? Let me guess, you would try to minimize the principle-agent problem by aligning the interests of the workers with the ones of the corporation, in a way which fitted all employees. You would take a look around, study the most commonly used sources of extrinsic motivation and finally come with the answer “money”. Why not? Who doesn’t like seeing its salary being increased and wouldn´t work harder for it? Higher salary, more effort, better performance, more profit. Pretty straight forward, right? Wrong!

Motivation is the reason for people’s actions, willingness and goals. It’s the “power” which allows us to wake up in the morning and perform difficult tasks, such as studying or going to work. There are two main types of motivation: intrinsic and extrinsic. Intrinsic motivation is the motivation which comes from “inside”, i.e., we perform a task because we enjoy it or find it interesting. Extrinsic motivation is the motivation which comes from the “outside”, i.e., when you do something for external rewards or to avoid negative consequences. Both intrinsic and extrinsic motivators can be either positive or negative. All intrinsic and extrinsic motivators, positive and negative, have its weaknesses and strengths. Intrinsic motivators differ from person to person, which makes it really difficult to apply them in large teams. However, they are much more long-lasting. Extrinsic motivators are easier to generalize. However, they may be only effective in the short-run or they may worsen the environment inside a team (in the case of negative motivators, such as threats to be fired or demoted).

Money is generally seen as a powerful extrinsic positive motivator, as it can be successfully used for motivating almost everyone. At least that’s what people believe and behave accordingly. However, they couldn’t be more wrong.

The MIT (Massachusetts Institute of Technology) conducted a study in which some of their students had to perform different tasks and received one of three levels of monetary rewards (few money, some money or a lot of money).

The students who received mechanical tasks increased their performance as the monetary rewards increased, i.e., the students who received higher rewards did a better job. However, if the challenge called for rudimentary cognitive skills, larger rewards conducted to poorer performance. In order to eliminate possible wealth variables, the researchers repeated the study in Madurai, rural India, where the purchasing power is way bellow the United States’ . Again, the study showed that, when the challenge involved cognitive skills, higher rewards led to worse performance.

This way, they concluded that the “carrots and sticks” approach (giving punishments and rewards) only works when the tasks that the employees perform are purely mechanical.

“So, the amount of money employees receive is not important?”, you may ask. Of course it is. However, it’s not the most important. If, as a manager, you don’t pay people enough for their effort, they won’t be motivated. However, if you incentivise them with monetary rewards, they may worsen their performance. This way, you should pay them enough to take the issue of money off the table, letting them focus on the work, rather than on receiving their salary.

And the question stands. What is the best way to motivate employees?

According to some scientific studies, there are three factors which lead to better performance and personal satisfaction: autonomy (the desire to be self directed), mastery (the urge to get better at performing a job) and purpose (the aim to do what we do in service of something higher than ourselves). Actually, if we look into some industry benchmarks, such as Google or Atlassian (an Australian software company) we see that these factors are taken into consideration in their management. In Google, engineers can use 20% of their working time to develop their own projects and, on a typical year, about half of the company’s new products are born during that 20% time. In Atlassian, a few times a year, employees have 24 hours to think of some new ideas and present it at a relaxed party at the end of the day. It comes that a whole array of software fixes was created during that period and may never had been created otherwise.


If we think of Wikipedia, for instance, it has a business model that economically makes no sense: it was created by employed and greatly specialised people completely FOR FREE and anyone can use it without paying. Why did the engineers provide it freely instead of profiting with their creation? On one hand, it is the desire for mastery, to overcome obstacles and create something never seen before. On the other hand, the purpose behind the platform and the free access to knowledge and information.


As a summary, people only perform difficult tasks because they are motivated to do so and, as a manager, it is vital that we keep our employees highly motivated. However, it is really difficult to find an effective motivator which fits all workers.

Money is still seen by a lot of corporations as an effective mechanism to motivate people but science proves otherwise. It may be good to incentivise mechanical tasks but, if the work involves some cognitive skills, higher monetary rewards leads to worse performance and destroys creativity. This way, managers should get rid of this extrinsic motivator, based in the “carrot and stick” approach, and replace it by the intrinsic motivator of autonomy, mastery and purpose. Besides being much long-lasting, this type of motivators engage workers and make them much more satisfied with their job, as they are contributing to a better world.

The Power of 0.99$

“In my opinion, there is no better theoretical and methodological basis than behavioural economics. ”

— Dr. Florian Bauer

Alongside psychologists, behavioural economists understand that there are countless things that influence the human brain, hence there are countless ways of changing its perception. A known approach is Behavioural Pricing. By understanding what influences its customers, companies are finding ways to turn the consumer’s behaviour in their favour, under the premise that, even though they don’t behave rationally, consumers are predictable. And so, over the years, marketing has been designed with the objective of making us go down a specific, well-planned path.

         If companies were to price items only based on traditional economic models, they wouldn’t be maximizing profit margins because these models assume that consumers already know, when buying a certain product, exactly how much they’re willing to pay for it.

However, as Dr. Florian Bauer1 tells us, “Behavioural Pricing has empirically proven that the notion of people having a predefined “willingness to pay” is wrong. Rather than having a willingness to pay, people tend to develop a price acceptance throughout their decision-making process“.


Herewith, one of the most known approaches is one we all have already been a victim of: the .99$ (or .95$) phenomena. This odd way to price items is an important tool to trick our subconscious into thinking that an item is cheaper than it actually is. There are two theories (one doesn’t invalidate the other) about why this has brought such extraordinary results. On one hand, it is thought that, when reading a price tag, our brain only focuses on the first digit, so when the price is something like 29.99$, our brain tends to think of it as being “20$ and something” and not 30$. On the other hand, and quoting Tim Harford2 (Financial Times), “a price ending in 99 is simply a shorthand for good value”. 

On our day-to-day, many situations confuse our objective reasoning with this technique. For example, let’s imagine we are choosing from two exactly equal gyms, only different in price subscription. Gym A costs a straightforward amount of 31$ per month, full time. Gym B costs 65$ per month full time, but only 34,99$ if you choose a less-hour schedule (8am-12am + 2pm-5pm). Rationally, 31$ is lower than 34,99$ or 65$ and full-time is greater than part-time, so a cost-minimizing consumer would choose the cheaper gym without even pondering the other alternative option. However, in reality, consumers think greatly on the subject and even knowing the gyms are exactly equal (same chain and location), there is always the thought in our heads that, if B is more expensive, then it may be better and we can take advantage of it by choosing the part-time option for more or less the same value because 31$ and 34,99$ are both “30$ and something”.

Is this irrational? Yes. Does it make any sense? No. But does it happen? Absolutely.


Professor Kenneth J. Wisniewski3 (University of Chicago) conducted a study on this topic to test the efficacy of prices ending in 9. In a local grocery chain, he lowered the price of margarine from 0.89$ to 0.71$ and observed an increase in sales of 65%. Then, he lowered it again to 0.69$, they’re increase in sales was 222%. The difference of 0.02$ translated in an exponential increase of 157% that proved empirically that the ending number of a given price is not as relevant as the initial one (0.6$ greatly preferred than 0.7$), even though the real difference being so low. Consumers’ neurological action influences choice as much as their tastes and needs.


In order to have a better understanding on the psychological games corporations like to play, let’s take a look into the Decoy Effect. Essentially, we face this effect when companies insert irrelevant, unprioritized alternatives to a set of options to trick consumers into buying the more expensive one. Imagine the following situation:

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For a subscription of The Economist you have three options:

  • 59$ with access to the online journal;
  • 125$ with access to the printed journal;
  • 125$ with access to both the online and printed journal.

The behavioural economist Dan Ariely4 analysed this set of alternatives and asked his students which one would they pick. Obviously, no-one chose only the printed option since it would cost the same to have both printed and online. Although, 16% chose only the online journal, a majority of 84% of his students preferred the combo. Alternatively, when he didn’t present them the “printed only” option, only 32% chose the combo and 68% chose the “online only” version. Thus, it seems that, when presented a clearly inferior alternative, by comparison, the combo option seemed more attractive.

It is eye-opening how simple tricks can influence our choices without our conscious perception.

Unlike what we previously thought, pure rationality is reserved to mathematics whereas everything that relates to humans and how they behave has a good dose of irrationality behind.

In fact, there are already consulting companies, like Vocatus, that specialize in Behavioural Pricing and advise other multi-sector companies to implement it on their own marketing and placing agendas.

“Behavioural economics demonstrates that people do not decide rationally and are not fully informed. They often behave (and purchase) hastily, forgetfully, illogically, impulsively, emotionally, myopically, or simply with indifference. At the same time, behavioural economics experiments show us that decisions follow clear patterns. So while they are irrational, they are in fact predictable. As soon as you have really understood the decision-making process of your customers, you can begin to influence them. This will give you a clear advantage over your competitors and a lasting edge.”

— Vocatus website, Consulting Company

Overall, the question that arises from this is:

How is this knowledge going to change the way you behave? Are you going to continue being tricked by marketeers?


Simple Biographies:

1 Dr. Florian Bauer is an internationally renowned expert and speaker in pricing psychology and behavioural pricing and is the author of several books on pricing research. He has a PhD in psychology and studied on the MIT and Harvard.

2 Tim Harford, “the undercover economist” is an economist, journalist and columnist for Financial Times.

3 Professor Kenneth J Wisniewski is author of the paper “Price-Induced Patterns of Competitors” with University of Chicago’s Professor Robert C Blattberg.

4 Dan Ariely is a Professor of psychology and behavioural economics at Duke University, he is also author to the New York Times best seller “Predictably Irrational”


Sources:

  • Fast Company

  • Financial Times

  • The Economist

  • OV Blog

Article Written By:


Carmo Romão - Carmo Romão Ana Clara Malta - Ana Clara Malta João Carvalho - João Carvalho

Risk: Are we “Picking up nickles in front of a steamroller?”

When we think about risk usually we do not associate it with biology. “It’s another parameter to consider when making an Investment” – is what we tell ourselves. We tend to perceive risk as an external factor internal to the asset or portfolio we are analysing and not to us. And why is that? Why do we associate risk to an irrational set of things when its existence is solely our making?


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Risk is a very hard concept to define. Some perceive it as being the unpredictability of our returns whilst others are more inclined to defining it as the loss we suffer when we don’t choose the safe bet. Whatever is the real risk definition it surely has lead to absolutely catastrophic situations. Elise Payzan-LeNestour, a behavioral scientist in the field of neurofinance, made an interesting experiment to test whether risk behavior comes from human incapability of perceiving it or human recklessness of taking it either way. In the final stages of her experiment she asked around 400 students to play a game called “The Bowman Game”. The students had to choose between two options: skip – the safe bet – or bet – the risky choice. If they chose to bet, the bowman could hit the mark, and they would win 2$, or miss it, and they would lose 40$. Also, there were two different types of bowmans: a novice – more likely to miss the mark – and an expert – more likely to hit it. After collecting all the experiment data, Elise discovered that students were actually very smart in the understanding whereas their bowman was a novice or an expert.

However, she also concluded that even when the bowman was a novice, 40% of the students took the risk of losing 40$ either way. With this, Elise was able to extrapolate to the financial market and conclude that, even though we are perfectly aware of the risks of choosing to gamble instead of the safe option, “we are greedy and lack self-control” in the sense that we evaluate those risks and still accept them when the perfectly rational choice would be to back away and choose safely.

After this discovery, Elise went deeper and associated our human need for this risky gamble to our brain functions, finding the culprit in Dopamine, a hormone triggered by potential reward opportunities.


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The presence of this greed makes us put our necks on the line without backup plans or emergency exits. Taking these risks can lead to the loss of irreplaceable or non-recoverable resources, not only financially but also environmentally, for example. Our overconfidence on the market that never goes down is lost when it inevitably does and the public money goes down the drain. When we are taking part in an investment and building a continuous flow of renewable income we have to be aware of the notion of risk and of how it is not exterior to us but actually very much correlated to our reasoning and individuality. Joe Wiggins, winner of the Brian Abel-Smith Prize for outstanding performance at MSc in Behavioural Science at the London School of Economics, tells us that when we manage a set of financial assets, the risk lies as much on the asset’s trading market performance as on how frequently we check our portfolio, our individual incentives, our differences and our past experiences, to name a few. The possibility to trade at any given moment in time makes public equity investments more risky than private ones where we are less faced with price fluctuations and so have less emotional reaction. In sum, the risk of making bad decisions is lower since the immediate forces are less known. On investment, Wiggins states, “We can think of this as our erratic perception of risk continually shifting our personal discount rates”.


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Risk goes beyond the convention of possible capital loss, it goes far from being only related to the asset or market characteristics, it lies much more on the human conscious action to ignore the possible (maybe less probable) consequences of losing it all. Behavioral Science & Economics alerts for the need to find tools able to deter investors from taking actions with possible “collapsing economy side-effects” because with risk “surely you will be harmed, you don’t know when, but surely you will”, says Elise Payzan-LeNestour.  Investors shouldn’t continue to be rolled over for picking up nickels.

Sources:

  • Ted Talks

  • Behavioural Investment

Surprise mechanics: Payment as the new Default

Inertia, a word that makes all the difference. We might be uncertain, the decision might be difficult or we might not even care, we simply follow the recommended or pre-set, and without understanding we are under the influence of default opinions. In a simplified way, default options are pre-defined or recommended courses of action established before any reaction from the decision maker. Even though it can look scary and invasive when presented in a more theoretical perspective, the truth is that examples of this phenomenon are immersed in our reality. They are in our phones in the form of strange ringtones, alarm sounds or even pulse notification lights, they are in the way we pay our purchases and even in the games we play.

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The industry that will be subjected to a more detailed analysis will be the video-game industry which has been startled by an increasing concern with changes in defaults and the way it influences gamers as economic agents. Default, by principal, is all over gaming from subscriptions that renew automatically to more technical details – such as the way games adapt to the user’s individuality.

Nevertheless, the increasing concern is related to the way these practises have become more aggressive and privacy-breaking as a new, premium source of purchases. Since the past generation of video games (that existed and dominated the market between 2004 and 2011- Playstation 3, Xbox 360 and Nintendo Wii) the cost of producing games has increased in an almost exponential rate, tendency which has been aggravated by the required usage of more expensive technologies and techniques. Games are no longer pixelated images, they are fotogenic forms of interactive art and as such require more and more production time and impose proportionally complex cost structures to firms. This is illustrated by the almost unimaginable and gigantic production costs. Let’s use as an example 2015’s game of the year, “The Witcher 3” (Image 1). Its production costs were around 81 million dollars and it took about three and a half years to produce it. As reasonable as it might seem, it puts a lot of pressure on companies, and here is the catch, because of a strong and rigid market structure firms are not able to increase the consumer-end price of their product and so they have to find other ways to do it. They found that if they could incentivize their customers to spend more money inside the game having already purchased it, games would become more profitable. As a consequence practices, such as microtransactions, DLCs (downloadable content) and loot boxes, appeared. First they were used in mobile games – as “Candy Crush” – where users had incentives to spend real world money in the game in order to accelerate progression. Since they proved to be effective, they were moved to “triple AAA” games with high budgets and lots of marketing.

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The most apparent way of how invasive it became is by comparing it to gambling. The most recent cases of such facts are EA’s games like “Star Wars battlefront 2” that had its progression based on loot boxes that could be purchased using real world money or “2k’s 2k20” that had explicit slot machines inside the game (the image 2 illustrates such practise). Recently, this practice has become so invasive that governments felt the necessity of intervening in order to understand if such behavior is not harming consumers. In the end, it all falls into the British government asking EA’s and King’s representatives about these practices and possibly unethical behavior.

To sum up, and making use of the EA’s representative words, “surprise mechanics” represent a shift in the default of this industry from a more consumer friendly to a more aggressive consumption, incentivizing industry, that in its attempt to overcome the pressure created by the market’s structure, has been moving closer and closer to gambling. Consequently, it has been accused of creating structures that focus increasingly more in getting money out of their customers and less in providing value added. As governments started to worry and fans stopped buying these games, the industry is again trying to adapt. Games as a service are proof of this reaction. But until when will we have to sustain and tolerate such economic behavior that set defaults that are no longer recommended actions and are now predefined payments?

Behavioral What?

What is in fact behavioral economics? How is our economic understanding related to human behaviour? Nowadays, more people are beginning to change their reasoning from a ‘strictly mathematical’ point of view to a more ‘humanitarian’ one. Being it around the environment, human rights or the effect of advertising on consumerism, the human brain is evolving into a different stage. Since the 18th century, economics has created itself around theories founded on rational human behaviour. However, are we always that rational? It is taught that it is so.

In order to generalize and begin an understanding of an economic model we first simplify. We teach ourselves and each other that all decisions are in the best interest of the maker in hope for the best possible outcome. However, it is not taken into account rapid changes on our opportunity cost due to context and circumstances.

For example, when we go to the supermarket, the economic meaning for our decision on what to buy lies only our own affordability of the price, tastes and needs, even though we are influenced by our context. For instance, variations of our shopping list may occur if we go in on an empty stomach since we tend to buy more of what we need and other superfluous and not-thought-before goods. But that may only appear as a textbook footnote named Assumptions. Behavioral economics studies what is the mental process behind this reasoning and how can we predict it.

It is difficult to mathematically estimate the “percentage of irrationality” that is present on our personal and economic decisions. Nevertheless, it is remarkably easy to get a hold of the subsequent effects.

As Dan Ariely exposed in his book The Upside of Irrationality, human beings are very conscious of their own tendency to procrastinate, to put off decisions that are in their best interest.

Economically, in a perfectly rational world procrastination wouldn’t be a problem. By comparing short and long-term benefits the decision-making process would be obvious and unquestionable, we would follow the market models and operate accordingly to what was foreseen. Still, actual human actions have caused the implosion of Wall Street in 2008, bringing down entire markets because the financial market is man-made. Actual humans made the wrong, self-interested decisions that crashed the Venezuelan economy when the president and all associated government should be responsible for their people and should have followed what was in the country’s best interest.

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More and more today we are acknowledging both the rational and the irrational of human behavior and decision-making in order to be able to better adjust economic predictions to the actual future stream of events. By analysing how all of us are influenced by irrationality, models are being reviewed and completed. Our assumptions on what rational model-acting humans think and do may not be, under most circumstances, are not wrong. However, the human brain is complex enough to turn the economic thinking around and make textbook decisions different from the real deal.