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Your Customers Don’t Make Rational Decisions

February 9, 2011

From American Express Open Forum

Written by Mike Periu, EcoFin Media

Original Post Feb 08, 2011

 

Behavioral economics and behavioral finance are some of the most fascinating areas of study today. The disciplines combine economics, finance and psychology in ways that better model how consumers actually make decisions. In general, the study of economics is based on theoretical models that only remotely resemble the complexities of the real world. These models assume that individuals behave like machines that always know what is in their best interest, always do what is in their best interest, have complete self-control, and only care about themselves.

 

That doesn’t sound like anyone I know.

 

These models, on which many pricing decisions, investment decisions, and management decisions are based, leave out the “human element.” Leaving out this element paints a two-dimensional picture of the world and doesn’t provide the kind of actionable information of interest to business owners.

 

Behavioral economics, by including the study of psychology, adds the “human element” and can provide very valuable and actionable advice to business owners with respect to pricing and other important decisions. Let’s take a closer look at the key elements of behavioral economics and how they apply to business decision-making.

 

First: Understand your customer’s rules of thumb

Behavioral economics shows us that people make most of their decisions based on rules of thumb. A rule of thumb is an assertion that is true in many cases, but not in all cases. It also tends to be easy to remember and simple to apply. Common examples include:

 

  • It’s cheaper to buy a car than to lease one
  • You can get the best deals by shopping right after Christmas
  • Generics aren’t as good as branded products

There is some truth to these statements, but they absolutely do not apply to every circumstance. Yet once consumers internalize a rule of thumb, it is extremely difficult to convince them to change their minds.

 

Why not leverage these rules of thumb?

If your customers believe that shopping right after the Christmas holidays offers the best deals, then use that as an opportunity to sell higher margin products or to test new products and gauge the response. Even better, if your company can establish its own rule of thumb and spread it virally, it could be one of the most lucrative investments ever made.

 

Second: Frame your offering

Behavioral economics research also proves that how information is presented has a material impact on how consumers respond. Consumers, for example, respond more favorably to discounts when presented in percentage format instead of dollar format. An $18 entrée at a restaurant that is offered at 50 percent off will receive a greater response than advertising it as a $9 discount. Even though the economic benefit to the customer is identical, framing it as a percentage instead of a dollar amount will provide enhanced results.

 

Think about how many discounts and inventory clearance events your company has offered that didn’t perform as expected. Did you frame the benefit correctly for your customers? Did you try different framing techniques and then compare the results? If not, then it would be highly advisable to do so next time.

 

Third: Markets are not efficient, so don’t pretend they are

In an efficient market, identical products will sell at the same price because no one will pay more for something without justification. This, of course, assumes that buyers have perfect information about sellers and prices. It also assumes that all buyers value products in the same way. It doesn’t take into account the individual perception that a consumer may have toward a product or service.

 

In the real world, it’s clear that markets are not efficient. Consumers don’t have perfect information and they don’t value products identically. It’s true that price comparison websites, group buying websites, and other online services have done much to enhance the amount of information available to buyers, but this is far removed from the “perfect” efficient market that economic models espouse.

 

The implications for the pricing of your products are enormous. Lower-priced competitors don’t always have the advantage. For most businesses, it doesn’t pay to be the lowest price competitor in the market. You just don’t need to be.

 

Finally: People tend to act like sheep

Another key insight from behavioral economics is the fact that individuals do not always act individually. They are influenced by decisions made by their peers. Of the 7.5 million iPads that have been sold in the past six months, how many consumers bought one to take advantage of its functionality? How many bought it because all of their friends at work bought one? To Apple it may not make a difference why they buy, but the initial group of early adopters may have played a key role to complement Apple’s great marketing and revolutionary product development.

 

If your company can build a trend around your product or service, then people will follow their peers and buy.

Mike Periu is the founder of EcoFin Media, LLC which develops financial trainingfinancial educationentrepreneurship training and more to small business owners on television, radio, print and the internet. Over the past ten years he has started three companies and advised over 50 companies on financial strategies including fundraising. Post your questions in the comments of this article.

 

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