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Predictably Irrational

HS151: April 10

The Rationality Assumption

Foundation of microeconomic theories
People (includes both consumers and
producers) make rational choices by
maximizing their benefits and minimizing their
Our reasoning abilities are perfect
What happens if we make a mistake and do
something irrational?

Behavioral economics and Irrationality

Irrationality: deviation from perfection
We are really far less rational than standard
economic theory
Irrationality is systematic (happens same way
again and again), not random or senseless,
hence predictable
Tools for analysis: Experiments

The Cost of Zero Cost

Zero is an emotional hot button-a source of
irrational excitement
Experiment 1
Irrationality/bad decision when we have to
compare between a free item and another item
Lindt chocolate truffle (15 cents)
Lindt chocolate truffle (14 cents)


Hersheys Kisses (1 cent)



Hersheys Kisses (FREE!)



Chocolate Experimentcontd
Repeated the experiment in other settings
(MITs cafeteria)-- students overwhelmingly
went for the FREE! Option
Why do we have the irrational urge for a FREE
There is no visible possibility of loss when we
choose a FREE! item

Other cases of FREE!

Free exchange instead of a free price
Zero cost is not limited to monetary
Quick quiz: a free $10 Amazon gift certificate
and a $20 gift certificate for $7?
Most people jumped for the free
$10 certificate ending up forgoing a
$13 profit

Other cases of FREE!

Concept of Zero applies to time as well
(opportunity cost of time)
Example: free-entrance day at a museum
Zero affects food purchases
Example: zero calorie coke

The power of Zero!

How can we use FREE! to drive social policy?
Examples: environment; health
Forbes piece: usefulness of a free trial
Free trial : a smart marketing tool and a solid step toward
establishing good will with new customers (think of
Opportunity to improve the product based on customer
What is the Caveat?

Test your understanding

The idea behind the cost of zero cost is:
a) People believe that they deserve to get
things for free
b) People undervalue what they get for free
c) People get overly excited by free items when
conducting cost-benefit calculations

Test your understanding

Based on behavioral economics, which offer will
be most successful for an online shopping site:
a) Send customers an offer for one item at 50% off
the retail price
b) Send customers an offer where if they buy one
item at full price, they get another one for free
c) Send customers a coupon for free shipping with
a purchase over $20

The Story of Bottled Water

How manufactured demand pushes what
we dont need and destroys what we need
Watch the video: