This book, Priceless: The Myth of Fair Value (and How to Take Advantage of It), covers rationality in decision making, and how markets and marketers take advantage of the deficiencies in rationality in average people.
There are many in the investment community that admire behavioral finance, and many who say that it might be true, but where are the big profits to be made from it?
This book doesn’t cover behavioral finance per se, but it does cover its analogue in pricing and marketing. In a negotiation, the first person to put a price on the table tends to push the final price agreed to closer to his price. Leaving aside no-haggle dealerships, why do car dealers post high prices for vehicles? Because only a minority does the research to understand what the minimum price is that a dealer will accept. The rest pay more, often a lot more. Personally, I do a lot of research before I buy a car, and it helps me spot dealer errors in pricing.
The book is replete with examples of how there is no “fair” way to price things out. What are the proper damages for a jury settlement? The attorney for the plaintiff is incented to come up with the highest believable amount for the jury, because they will render a verdict less than that. Make the ceiling as high as possible, and the plaintiff will get more.
We call placing the first price on the table “anchoring,” because it pulls the final result toward itself. The book is filled with experiments dealing with anchoring.
The book also spends a lot of time on the “ultimatum game,” where a person gets $10, and must offer some of it to a second person, but if the second person turns him down, the first person gets nothing. The main lesson here is that pride is stronger than greed. Yes, it can be construed as a question of fairness, but when someone gives up money to deny money to someone else, it is not fairness but envy. Why pay to make someone else worse off? To teach him a lesson? What an expensive lesson.
Much of this book was a walk down memory lane for me. I discovered Kahneman and Tversky in the Fall of 1982, and I found their ideas to be more cogent than much of the “individuals maximize utility” cant that was commonly heard from most professors teaching microeconomics. People are far more complex than homo oeconomicus. Small surprise that most tests of microeconomics as a system are not confirmed by the data.
Kahneman and Tversky showed via a wide array of examples that the decisions people make are affected by the way they are presented to them. People can be manipulated in limited ways in order to affect the decisions that they make. (more…)