Saturday, Jul. 05, 2008

From a meal to an iPhone, prices fool brain

The day Steve Jobs announced the new iPhone, I drove home from work nervous. I imagine that lots of first-adopter types felt a similar queasiness at the idea of walking through the front door and rationalizing to their spouses that it wasn't enough to own just the first iPhone. Now we had to have the second.

My wife was watching the network news and had apparently seen a report about the new phone. She said, "You're not getting the new iPhone." I said, "Yes, I am." She said, "Then we're getting a divorce." She was kidding (I think).

"You're not going to spend another $400 or $500 on an iPhone when you have a perfect one right in your pocket," she added. I said, "You are so right. I'm going to spend $199."

She stared at me, then asked me a question that made my heart flutter: "So am I going to get your old iPhone?"

What happened in between the divorce threat and my wife's sudden acquiescence to the new iPhone was the result, I think, of a simple yet remarkable trick in behavioral economics that was played upon me, my wife, and millions of other people by Jobs and his backers at AT&T Wireless. It is a trick that turns up in how we buy stocks, how we think about the price of houses, how we choose entrees on a menu and why we shudder at the new price of gas.

I thought that with our wallets feeling lighter these days, with high gas prices and depleted home values, a discussion of what provokes us to buy and invest in the things we do would be in order. Not about what we should buy or invest in, or how we should go about doing it, but about why we make the financial decisions we make and how we can make them better.

I asked some behavioral economists, and the answer seems to be that we have no easy way to judge the value of the things we buy, and we especially have no fast and sure way to value the utility we would get from the purchase.

So what our brains do is look for easy comparisons to give us answers. In the case of the iPhone, the initial price of the device when it was released last year was $599. Then it dropped to $399. The initial price (and even the first discount) of the phone anchored consumers to the idea that to own this device, you would have to pay a lot of money, substantially more than a typical cell phone.

"It establishes a reference price of $600, and now when it comes down, that's very, very exciting," said Dan Ariely, a Duke University behavioral economist and the author of "Predictably Irrational," a book about how we make decisions.

So then the deal, at its extreme, looks like this: I'll pay $199 for the iPhone, but I will get a psychological return of $400 from the deal. I'm rich! Of course, it will cost me an extra $10 a month in AT&T service fees, thus wiping out any gains, real or psychological, over the two-year contract period.

These pricing tricks get played on us all the time. In the world of investing, you have to look no further than stock splits. Companies split their stocks every day.

Tripped up by 'affordability'

Why do they do so? According to the questions-and-answers section of the Securities and Exchange Commission's Web site: "Companies often split their stock when they believe the price of their stock exceeds the amount smaller individual investors would be willing to pay for the stock. By reducing the price of the stock, companies try to make their stock more affordable to these investors."

Those individual investors are usually people like you and me, not the institutions on Wall Street.