Wednesday, September 16, 2009

Financial Relativity

“Filet Mignon Special: Our best filet mignon, perfectly grilled. Includes baked potato with sour cream and bacon bits. Choice of soup or salad, choice of vegetable and desert. $49.95 per person.”

Two fine restaurants, The Cattleman and The Stockman, offered that same special. Both were in similar locations and served primarily upper middle-income business people and their spouses. The chefs were equally talented and dedicated. Yet The Cattleman sold many more of that special than did The Stockman. Why?

The reason was that at The Stockman that special was the most expensive item on the menu while The Cattleman also offered a more expensive item. The Rancher's Special at $59.95 included a serving of lobster tail. Though The Cattleman only sold three or four Rancher's Specials per year, but they kept the item on the menu because it helped sell the less expensive Filet Mignon Special.

At The Stockman, customers would look at the Filet Mignon Special and notice that it was the highest priced item on the menu. Being cost conscious, most would order something less expensive. However at The Cattleman, the Filet Mignon Special was not the most expensive item on the menu. Cost conscious customers could feel virtuous by ordering the second most expensive item available. While few ever bought the more expensive Rancher's Special, it did serve a psychological function, It helped them justify indulging in the Filet Mignon Special.

This and many other human quirks are documented in Dan Ariely's book, Predictably Irrational. The lessons for our personal and collective decision-making are myriad. The most obvious is that we should beware of such marketing sleight of hand. Many business people know of that human tendency and they often use it to get us to buy something more expensive than we would otherwise. They will offer a high priced item even though they know that few customers will buy it. However they also know that the mere presence of that item makes other items look inexpensive by comparison so they sell more of those.

How can we avoid falling into that trap? How can we keep from spending our hard-earned money inappropriately? The only way is to consider prospective purchases on individual terms. We should concentrate on what our real needs or desires are, how much money we have available, and how that relates to the cost of what we might purchase. If we like the Filet Mignon Special enough to justify $49.95, we should buy it. Otherwise we should pick a different meal. That is true regardless of what else may or may not be on the menu.

The same is true of public expenditures. Politicians often pull the same sort of stunt to get us to think of their programs as really not that expensive. All they have to do is propose a more expensive program than what they really want. Then they scale it down and brag about how much money they are saving the taxpayers. That slight of hand distracts our attention from the fact that they are not saving money, they are only spending less than they first threatened to spend.

We don’t save money by purchasing a less expensive item (unless we were actually going to buy the more expensive option). We save money by not spending it at all.

In fact I fear that we are going to see a distraction along that line with “health care reform.” We've had a very expensive program proposed, one that has aroused the ire of voters and almost certainly will not pass. However even as I write this, some in congress are working on less expensive proposals. Those new ideas will seem inexpensive compared to the original proposal. They should not be evaluated in comparison to their more expensive predecessor. Instead they should be evaluated individually. Is each of them, or any of them, worth the cost to the country?

We must resist the tendency to think of the newer proposals as cheap just because they are less expensive than the original. In fact we should do that with all government programs and private purchases.

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1 comment:

OregonGuy said...

In sales parlance, it's called waltzing the customer. Me? Ten bucks for lobster tail sounds pretty cheap, no?

Nice post.