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Ron Baker: So, Ed, who are you more like, Mr. Spock or Homer Simpson?

Ed Kless: I'm a Dr. Spock kind of guy, which I know is different. We got all of the Trekkie fans mad at us originally right out of the gate. No, it's Mr. Spock, not Dr. Spock, I know. I would say, Ron, I am honestly more Homer Simpson.

Ron Baker: Really?

Ed Kless: Yeah. I can be sucked into stuff pretty easily, and I like doughnuts. What you know is actually one of the reasons why I'm a libertarian, which we've mentioned in the show, because I look at it this way, I don't even know what's always good for me so for me to impose it on somebody else would be really outrageous of me.

Ron Baker: That's a very good point. You know the difference between these two things is it's kind of like this internecine war going on in the economics profession between "the rationalists and the irrationalists," and that's a very simplified distinction that's probably technically not even correct but that's kind of what we want to explore today because I think both sides have very interesting insights into human behavior.

Ed Kless: Absolutely. I think the other way to put this for the [inaudible 00:01:19] is, we have homo economicus which is the classic way of thinking of the rational man, right? Then we do have Homer economicus too and I think ... I'll give away the end here, but we think that both are valid but I think it's important to explore why those things are.

Ron Baker: Right, because I know a lot of listeners are probably very familiar with the book Freakonomics by Steven Levitt because that was a very popular book.

Ed Kless: Great book.

Ron Baker: Yes, excellent book. I just finished his following book, Think Like A Freak, and that was actually very good too. They are definitely in the rationality camp that were more like Mr. Spock, that were able to take in and process a lot of information, look at a lot of facts and figures, compute return on investments, and optimize or maximize the utility or the value of every decision. There's no doubt that even our good ... The economist that we like a lot, Steven Landsburg, says most of economics can be summarized in four words. People respond o incentives, the rest is commentary, right? You don't ask your barber if you need a haircut and nobody I know washes a rental car. There's no doubt that incentives do play a role in rationality. The only issue is, is it the entire story? 

Ed Kless

Ed Kless: Before we get into one versus the other, let's clarify a couple of terms here. The term that we keep seem to be using is rational or irrational.

Ron Baker: Right.

Ed Kless: I think it's important for us to make a distinction here that when we say rational/irrational, especially when we say irrational, we don't mean crazy. The classic definition of rationality is the laws of thought, which I think were put forward by Plato or Aristotle, were definitely refined by Aristotle. There's three. There's the law of identity. The thing is the thing, A is A. That's the classic way of thinking about it. The second law that comes into play there is non contradiction, right? Nothing can be A and non-A. Transformers have to transform, right, from one thing to the other?

Ron Baker: Right.

Ed Kless: They can't be both things at the same time. Then, of course, the last one is called the law of the excluded middle, which is everything must be either A or non-A, which is the either-or situation. It's really those three things together that make up what is classically thought of as rationality. Rationality, ratio, logic. These are all the same type words and what is interesting is that there is even ... I remember one story about Abraham Lincoln who when he would give an intelligence test, when he was interviewing somebody he would ask them if you call a dog's tail a leg, how many legs does it have? 

Ron Baker: Right.

Ed Kless: The answer is four, right? A dog has four legs. You can call it anything you want, it's still only four legs. That was kind of his way of testing to see if somebody was a rational thinker. It was because you could apply these three laws to the conversation. When we say irrational we don't be crazy, insane, or non-thinking. That's not what we mean.

Ron Baker: And we're certainly not saying that Mr. Spock is better than Homer Simpson. Take the characters out of it. Homer Simpson is the spontaneous one, the romantic one, the one that writes poetry, the one that's spontaneous, all of those things. In other words, I guess we as human beings are comprised of both and that's what makes us a human being, that we have both of these capacities in our brain at the same time.

Ed Kless: Right, but some people say that we never behave irrationally. I think that that's not necessarily true. I think I'm living proof that I think I behave irrationally sometimes, though. 

Ed Kless

Ron Baker: So, Ed, my understanding of the economists who assume rationality, a great succinct way of putting this is how David Friedman, and that's Milton Friedman's son, said it in his textbook actually. He said economics is the way of understanding behavior that starts from the assumption that people have objectives and tend to choose the correct way to achieve them. That's very useful because to devise a theory that said that people weren't going to figure out the correct way to do things probably couldn't stand up to reality because we are learning creatures. We'll figure out the best way to drive to a new work location. After a week or so we'll figure out the traffic patterns and figure out the way to go because that's what we do, we learn. So, having that assumption grounds economists in assuming not necessarily because it's correct but assuming that people are going to act rational, they're going to act in their own self interest, and it provides incredible insights to human behavior.

Ed Kless: Yes, and I think it's clear that in the business world where people are living and breathing every day, it's the default assumption for most things. When we're designing systems, when we're designing a pricing structure, which I know we're going to get into, we're have to assume some amount of rationality in that people are going to look at things and try to at least compute to some degree whether or not they're making a good or a bad decision for themselves.

Ron Baker: One of my favorite examples to assume that people are rational is this idea of 99-cent pricing and why do we do this. When I've asked this question of audiences around the world people say well, psychologically it sounds less than the dollar. If you hold on to the assumption of rationality, like a lot of economists do, you can't believe that. You can't believe really that you're fooling Mr. Spock that 99 cents is a lot less than a buck. He's not going to be fooled by that psychological trick so there must be something else going on. One theory is that that something else that's going on is 99-cent pricing came about in the 1880s when the cash register was invented and cash register is a great tool, great piece of technology for tracking sales rung into it but it's not so great for tracking sales not rung into it. If you price things at a dollar and your employees take the dollar they just put it in their pocket and nobody's the wiser. If you price at 99 cents now they have to ring up the till and make change and so it was a very rational response to employee theft which is a big problem in the retail industry. That's just one example of the type of insight you can get to human behavior by assuming that people are rational.

Ed Kless: Here's where that kind of thing manifests itself. Not long ago, this was about five years ago, there was a restaurant here in my town that on Fridays they had a happy hour during the summer. I kid you, this is absolutely true. I think I took a picture of it. I'll try to get it up on the website. It was $1.99 margaritas or $2.00 draft beers. 

Ed Kless

Ron Baker: I remember that, Ed. I remember [crosstalk 00:08:57]

Ed Kless: It's just like wait, wait, wait, wait.

Ron Baker: Yep, yep. No doubt about it. That's an interesting anomaly. The other example I love to point out, and maybe it's just because I've been to Australia so much, but when the British sent convicts down to Australia, they started by paying the ship companies for every prisoner that boarded the ship in the UK. This was a pretty treacherous journey and even though there was adequate food and even medical supplies on board, there was a one-third mortality rate among the prisoners because the crew and the captains figured out hey, we can hoard the food, the medical supplies, not give it to the prisoners, but when we get to Australia we can sell it and make that much more money. I think this is a great illustration, Ed, of the difference between accountants and lawyers and economists. Accountants and lawyers when they're confronted with an issue like this they tend to look to compliance. They'd say oh well, we need to pass a Sarbanes–Oxley law and put internal auditors on board, make sure that every prisoner gets a certain caloric intake per day and certain amount of sunshine and lemon juice and medical supplies and solve the issue with compliance whereas economists go right to the incentives and say no, no, just change the incentive. Pay the shipping company for every prison who shows up alive in Australia, and that's exactly what they did, by the way. After they made that change, only three prisoners died on the journeys to Australia as opposed to one-third.

Ed Kless: Quite frankly I'm surprised it was only one-third. The incentive would be to just dump them all overboard.

Ron Baker: That's true, that's true. There's no doubt that people do respond to incentives and that they can act very rationally in their own interests because, again, I think a lot of this is because we learn. We make errors, we miss the mark, but we figure out how to do it better. These assumptions of rationality really do explain a good chunk of human behavior.

Ed Kless: Clearly. Like I said, we have to do that in business. I have never been in a meeting where somebody said to me let's assume that our customers are irrational here. Let's assume that they don't understand anything. You couldn't even begin from that assumption, could you? You'd be stuck.

Ron Baker: Right. It reminds me of David Ogilvy's famous line, "The consumer's not an idiot, she's your wife."

Ed Kless: Yeah. 

Ed Kless

Ron Baker: It might make us feel good to say, "Oh, the rest of humanity is just irrational," but you might learn something if you assume that's not the case first and then try and dig deeper like they did with 99-cent pricing or with the convict ships.

Ed Kless: This goes back all the way to the beginning of economics and perhaps even before that. It was the assumption of Smith and the early economists of rationality.

Ron Baker: That we're going to act in our own self interest. We've been breathing happily since we've been doing this show. If you took a prescription drug this morning you acted in your own self interest. That's not to be confused with greed. Self interest is a good thing and we do act in our self interest and we do try to optimize, or however you want to say it. The question is how far can you drag that assumption and is it really true in all cases and I think that's the interesting part of this discussion.

Ed Kless: Self interest is not selfishness.

Ron Baker: Right.

Ed Kless: Those are two distinct topics as well. I think those get convoluted and are a problem for many people.

Ron Baker: Even like we talked with Deirdre last week about greed, the idea of greed. Self interest is not greed either.

Ed Kless: Yep, yep. We started off the show by talking about the assumption of rationality in business and one thing that's always been perplexing is a pretty interesting story about the difference between a Coke machine and why you have to put your money to get a Coke machine, you get only one, and the old newspaper racks. There's still a couple of them in my town for the Sunday papers where you go and you put your eight quarters or whatever it is and you take out the paper. Whenever I do that there's like seven or eight papers in there. I could just take them all.

Ron Baker: Ed, this is another, I think, key insight, assuming that your customers are rational. What do the newspaper companies know, and what does Coke know about human behavior that makes them spend so much less or more money to build these machines? If you were a sociologist or maybe a criminologist and you were looking at this you might conclude erroneously that, "Well, it's obvious that New York Time readers are more honest than Coke drinkers." That's kind of a crappy theory. It doesn't really explain what's going on here. What's going on is a second New York Times isn't worth very much at the margin. The marginal value 

Ed Klessto you of a second New York Times is zero practically. I would argue the first one is too but that's a different story.

Ed Kless: Now, now.

Ron Baker: The marginal value of a second or even third or fourth or fifth Coke is the same because you can store them and enjoy them later so Coke has to devise these Rube Goldberg machines so only one Coke dispenses at a time. It's so funny, just parenthetically, there a gal, Wendy Northcutt, here in Berkeley. She's a scientist and she puts out the Darwin Awards, in fact I think she invented them. Every year it seems, or every other year, somebody dies having a Coke machine tip over on them because they're trying to shake it or get out a free Coke. It just cracks me up because it's just really funny.

Ed Kless: It makes total sense, though, because if you think about it, now restaurants, and I think this started in the mid 90s or so, your McDonald's, Burger King, even some of the higher end of the fast food type stuff, you can get as much soda as you want, free refills from the soda machine. If there were a way to store it they wouldn't do that because they're going to assume that after you've taken two big things of Coke that your third or fourth one is really not going to be worth it.

Ron Baker: Exactly right and, Ed, that brings up one more just issue, kind of along the lines of the cash register and the 99 cents. You walk into a lot of fast food places today and there'll be a little note somewhere near the cash register that will say if you don't get a receipt with your meal, it's on us. 

Ed Kless: Um-hmm (Affirmative).

Ron Baker: That's not because the restaurant, The Burger King owner is interested in the fastidiousness of your home accounting system. It's because they're engaging you to keep a check on their employees, to keep their employees honest. That's very rational behavior.

Ed Kless: Most people don't give that a second thought as to why that is. There's a couple restaurants that have that. I've seen that relatively frequently.

Ron Baker: You see it in airports and at fast food and food courts, things like that, but I do see it quite lot. Its just really intriguing and it's another argument for assuming that people are pretty rational and they'll figure out the best way to do something.

Ed Kless: Yeah, but are they, Ron? 

Ed Kless

Ron Baker: Let's talk about one more thing that I think really does illustrate and it has a lot of implications, certainly, for pricing, or just businesses in general, but that's the four ways to spend money.

Ed Kless: This is a Milton Friedman concept, right Ron? Is he the one who first put this forward. I saw it in his book, anyway.

Ron Baker: It's in his book and it's also on his TV show that he did, that you can access for free, by the way, I believe on Idea TV, his Free to Choose series. That's where he first, I think, did it, and then he put it in his book, Free to Choose. Yeah, four way to spend money. Go ahead and I'll let you ..

Ed Kless: You can to this in a 2x2 which, of course, if you had the right 2x2 you can take over the world. The first one is I'm spending money on myself. I'm going to spend my own money on me and I'm going to be pretty cautious about that. I want to make sure that I get the best deal. I'm going to be careful about how I go about spending money. The second way is I can spend my money on somebody else and this is a gift around Christmas time. I still want to get a good deal but I'm not so concerned with it. I'm going to make sure that I'm getting the right thing, maybe assure a higher quality than I might normally pay for just myself because I want the gift to be well received. The third way is I can spend somebody else's money on me. This is my favorite way to spend money. It's all of our favorite way to spend money because this is an expense account. Yes, I will have that lobster tail, as a matter of fact.

Ron Baker: Absolutely, or going out with a large group. For a restaurant where you're going to split the tab evenly, what happens. Your choices escalate.

Ed Kless: Always increase on that and nobody feels guilty about it because we know we're out for a good time. Then fourth, and the least effective way of spending money, is spending other people's money on other people. Of course, this would be government spending. It's like, "Oh, yeah. Ron, I think you should spend more money on your neighbor. Go ahead, give him more money."

Ron Baker: Yes, yes. Not only, Ed, does the person who's taking the money from A and then handing it to D, not only does he to have to worry about what A thinks, he doesn't even have to care what D does with the money. There's no feedback mechanism when you're in that fourth category, is there? 

Ed Kless

Ed Kless: No, and I can even figure out a way to maybe even take a cut.

Ron Baker: From a pricing standpoint this brings up many very interesting things, like airline pricing. Those people sitting in first class and business class, they're not in category one. For the most part they're on an expense account. They're in our favorite category three and therefore the airlines charged them a lot more money. If they didn't do that, think about how much money they'd be leaving on the table.

Ed Kless: The same thing with Saturday night stays and if you want the cheapest price at a hotel well stay on a Sunday night, that's going to be the cheap one. Nobody wants to fly on a business trip and have to spend Sunday night away so that's going to be the cheapest night to stay at a hotel.

Ron Baker: Absolutely. Then if you start thinking about just medical care as another great example. We've kind of moved medical spending from category one and two to category three and four, either through private insurance or government insurance like Medicare and other types. If you think about that, it's one of the reasons why healthcare costs have exploded because if you're not paying for it then you have no reason to care how much something costs. I think this is the logic behind the health savings account, put it back into category one and two, make doctors and hospitals compete for your dollar just like every other business and that would keep a check on prices and competition would help keep the prices in check.

Ed Kless: Healthcare is just a crazy place. It's the only place where in the last 30 years technology is blamed for increasing prices. Every place else in the world technology is considered to be the great cost decreaser. It subtracted costs. We sucked costs out because of automation. Not in medicine. Nope, that's crazy. Why is it so expensive? Well, because we have a lot of technology. No, that's not it at all. It's because it's a different category. [crosstalk 00:20:59]

Ron Baker: Yeah. Go ahead.

Ed Kless: The whole idea of even co-pays. Co-pays made it that much more enticing for people to say okay, do I really need to go to get the second opinion if I've got to pay a second co-pay.

Ron Baker: Ed, that's especially true if you look at medical procedures that aren't covered by insurance like LASIK or plastic surgery, things like that. What's been happening in that market is prices have been dropping. That's because of technology and competition, and price transparency, I might add, as well. 

Ed Kless

Ed Kless: I think that's key. You cannot ask your doctor, or even anybody at the office, what's the price for this. They don't know. I got, I won't know the price until I submit it. What?

Ron Baker: We certainly wouldn't buy a car that way. It's crazy to buy medical services that way. It is interesting because I think if you think about this, and David Friedman has given us a really interesting heuristic, I believe, here, a mental shortcut about rationality. He thinks it explains about 50% of human behavior. He said, "That's not perfect but, if I could do that well at the track I'd be a rich man," which is a fair point.

Ed Kless: Heck, yeah.

Ron Baker: Let's talk about that other 50%. Maybe we can explain all of the other 50% or maybe just a portion of it. Let's talk about how some of the Homer Simpson economists, the behavioral economists, have started to poke holes in the assumption of rationality.

Ed Kless: It's really just if you start to ask yourself a series of questions about certain things. For the first one I'll just lead off with is, why do we pay more prices for goods and services that are endorsed by celebrities? Personally this is not one that I am Homer Simpson on. I really don't care and don't think that if I use Tiger Woods' golf clubs that I'm going to be able to shoot like Tiger Woods at the golf course. I just don't buy that but there are a lot of people who do.

Ron Baker: I might be on the Homer Simpson side of that argument and I have to say I probably have bought some golf paraphernalia because certain PGA golfers use it so, yeah, I'm probably guilty there.

Ed Kless: So this is a good example. Some people are, some people aren't. The assumption still has to be one of rationality but if it were purely rational like that, we would only buy the best golf equipment as put forward by Consumers Reports. We would not even look at who was endorsing it.

Ron Baker: Another thing that the behavioral economists love to point out is why do we leave tips in restaurants in strange towns that we'll never visit again.

Ed Kless: Especially if you're on an expense report.

Ron Baker: Yeah, and I'm very susceptible to this. I do this all the time. Another one of my favorite is I once spoke at a conference here in California when the lottery, I think, was up to 30 million and I asked people if they had a ticket and a few people raised their hand. I said I'll you 100 bucks for it and nobody would sell me that ticket. 

Ed Kless

Ed Kless: A $1 ticket for $100 bucks?

Ron Baker: Yeah. We both know that the odds of winning that type of a lottery are about the same if you buy a ticket as if you don't so the fact that they wouldn't take a hundred-to-one return, does that make them irrational or is something else going on there?

Ed Kless: I think that makes them irrational. I'm sorry, that one's crazy. That's not just irrational, that one's crazy. I'd be like give me the $100 now.

Ron Baker: Deirdre McCloskey even brought up the other week about dying wealthy is not very practical or rational because the richest person in the cemetery, what's the point of that? This is what Andrew Carnegie said, "The person who dies rich dies disgraced," but people die wealthy all the time and leave it to their, what she called, useless heirs, I think.

Ed Kless: I think that that's right. I plan to take it with me, though. I'm taking it with me when I die. It would be wrong of me not to share some Homer Simpson stories. One of my favorite episodes is one in which Homer gets really angry and goes out to buy a gun and the gun broker says to him, "Sorry, Mr. Simpson, but due to the Brady Bill there's a 7-day waiting period for purchase of a handgun," and Homer says, "But I'm angry now." This where Homer is acting perfectly rational. No, he's irrational but he's rational about this idea. The other one is when Marge is chastising Homer for not agreeing to be the coach of Bart's little league team. "You're going to regret not spending time with your kids when you get older, Homer." Homer says, "That's a problem for future Homer." After he says that he takes a big thing of vodka, pours it into a mayonnaise jar, shakes it up and drinks down the vodka and mayonnaise together, and then promptly passes out. "It's a problem for future Homer."

Ron Baker: We could do a whole show on the Simpsons. You just made me think about another one of my favorite episodes, The Trillion Dollar Bill, I think it's called, or something, where Mr. Burns has this trillion dollar bill that was printed by the government and Homer gets ahold of it and I don't know, they're flying into Cuba for some reason, and Homer's trying to put it into a Coke machine. He's really upset that it won't take it. It's hysterical beyond words. It does illustrate that there are sides to us that we don't necessarily think sometimes about the long-term consequences of our actions. Let's face it, Ed, Mr. Spock wouldn't need Gamblers Anonymous. He wouldn't need Alcoholics Anonymous. He wouldn't need a smart credit card because he probably wouldn't be a hundred 

Ed Klessgrand in credit card debt. What makes people do these things that don't appear on the surface completely rational?

Ed Kless: What makes people be entrepreneurs, which is where this whole show comes from, this soul of enterprise. It's crazy to think that as an entrepreneur that you have influence over the potential outcome of what it is you're trying to do. It's all about faith and belief.

Ron Baker: That's very true. There's a very interesting economist, a guy named Herbert Simon. I think he's a Nobel Prize winner. I think he's the father of AI actually, artificial intelligence. He came up with this term "bounded rationality," that we act rational within a certain boundary, and he added to that this term "satisficing." He said if you think about it, people don't really optimize. We're not really trying to maximize everything, whether it be profit or the value that you get when you buy somebody a gift, like you were saying. What he said was this concept of satisficing is I'll do good enough. It's good enough. It's kind of like don't let the perfect be the enemy of the good. We'll just do good enough. If you think about this in a business context, it's one of the things that we see in a lot of companies that use cost-plus pricing. Everybody knows cost-plus pricing is not profit optimizing because it doesn't take into account value to the customer but, you know what? It's good enough, and why bother to change it. I think that's a really important insight.

Ed Kless: It is and I think that that satisficing is such a great term for that because we do that all the time. We'll say it's good enough for now. My mom used to call that, "We'll just give that a lick and a promise." It's good enough for now. Look, you can get by a lot on that. There's nothing inherently irrational about that.

Ron Baker: It's really not. It conserves resources very well and it will get you by for sure. Absolutely.

Ed Kless: You might get to the point where you would never be able to make a decision then because if you had to have ... This is the whole perfect information theory. If you had to have perfect information about everything you'd never make a purchase decision, never. You need certain shortcuts, mental shortcuts, which we call heuristics, to be able to do that.

Ron Baker: Yep, yep. Another one of Herbert Simon's points was there is a cost to getting more information. How many cars do you have to look at, or houses, and those are two big very ticket items that will have a substantial impact on your life for at least awhile. How many do you have to look at before you finally say, "Okay, enough. This is it. We're going to buy this one." 

Ed Kless

Ed Kless: This is where I'm thankful that my wife is much more of the Mr. Spock in this particular case. When we were house hunting I'd be, "Yeah, this is good." I was Mr. Satisfice when it came to what house we would buy. "It looks okay to me." That's important to have some balance in that and to understand that there are people, and it's not a man-woman thing at all ... It's just that people behave differently given the circumstances and we have to take that into account when we're operating a business.

Ron Baker: Absolutely. It's kind of like the diffusion curve where you've got your innovators and your early adopters and your early majority and late majority and then your laggards, but we're all over that diffusion curve for different things in our lives. We may be a tech-gadget person but for something else like our automobile maybe or golf clubs or whatever it may be, we may be on the laggard side. It's the same way with risk so your entrepreneur point, we have very different tolerances for risk. Some people can sleep, not lose a wink without paying their mortgage or their rent for a month, and other people would be up perpetually worrying about it.

Ed Kless: Let's talk about some of these heuristics or shortcuts that we use to make these decisions. Really, it's not so irrational as it is self preservation because we just couldn't seek out all of the information.

Ron Baker: We couldn't expend the resources it would require to engage our brain like Mr. Spock all the time. We just don't have his constitutions.

Ed Kless: What are some of these, Ron?

Ron Baker: One of the things that we talked about, I think the Second Law of Marketing show, was this idea of the anchoring effect. Let's take a restaurant. If you go into a four-star restaurant and you're looking at a wine list you might see a $10,000 bottle of wine. It might not even be in their cellar but what they know is it's probably going to help you pick a more expensive bottle of wine. You may go for the $500 or $600 Opus. Now, Ed, Mr. Spock wouldn't be influenced by that. Anchor effects would have no sway on him whatsoever because he'd pick the wine that he wanted and that was within his budget but we seem to be heavily influenced by the anchoring effect and you've documented that doing an exercise when you teach pricing, haven't you?

Ed Kless: It's a fascinating thing. We put a picture of three different products on a sheet of paper and they're all products that sell for, I think it's, and this is '95 pricing, $49.99 at Target. Each of the three products are that price. Then we ask folks to put down next to that the last two digits of their social security number just for reference purposes. It's theoretically random two digits, last two digits of the social security number. Then we ask them to say okay, would you pay that price, 

Ed Klessthe last two digits of your social security number, would you pay that price for that particular product? Yes or No? Then they just do yes or no next to it. Then the last thing we say is okay, what would you price that product at? What's interesting is the would you buy it yes or no for that particular price is completely diversionary. It has nothing to do with the exercise. What we do do is we take these sheets, we collect them all, I put them into a spread sheet and then we run just a quick regression analysis on it. We've never run in, even with an audience relatively small, four to five people, and sometimes we're doing this with 30 and 40 people. Even the small audience, their social security, their two-digit social security number will influence and have an impact on what they put a price on it for. In other words, those that had the higher two digits, 80s or 90s, will tend to price the product higher than those with the lower social security numbers because we've given them an anchor of that completely random price. Most folks just do not believe this at all. There are other things that I think are also part of this too. We have this confirmation bias which is this idea that we have a belief or vision of the world and we pay no attention whether the emphasis is there or not. Ron, are you back?

Ron Baker: I am.

Ed Kless: We lost you for a second. Okay, good.

Ron Baker: Sorry about that.

Ed Kless: I moved on to confirmation bias.

Ron Baker: Okay, yep.

Ed Kless: We tend to think that once we see one thing, we look for confirmation around that. Of course, the best example of that is check-ins at hotels. I despise going to Las Vegas, mostly because every time I check into a hotel in Las Vegas it takes forever, just absolutely forever. I've made up my mind that this is a terrible place and I'm not going to like this hotel and then I'm looking for things like look at that, there's carpet stains, or I don't really like the plants, or the sculpture's crappy. We tend to look for things once we have something in our brain about a particular experience.

Ron Baker: That is so true. One of my favorite examples of this, again illustrating how these anomalies come up between rational and "irrational" is, if you look at 401K plans 

Ed Klessamongst 20-year-olds, to opt into a 401K plan at say your first job coming out of college in your 20s, the opt-in rate is like 15%. A very small percentage of 20-year-olds are thinking about their retirement. 

Ed Kless: Um-hmm (Affirmative).

Ron Baker: There's been all sorts of studies done, when the company makes you opt out of the 401K so you're automatically in. You have to now sign five things in triplicate to get out. Then the participation rate goes up four or five times, goes up to almost two-thirds. That wouldn't influence Mr. Spock. He wouldn't care if he had to opt in or opt out. He'd do whatever he wanted to do, but it does influence us and, Ed, this is true even in countries for organ donation. In some countries you're automatically an organ donator unless you opt out. In those countries the organ donation rate is much higher than in countries where you have to opt in like we do here mostly in the United States.

Ed Kless: I find that absolutely fascinating. When you really think about that, and this is where this comes into play as a business owner, is the default values on perhaps forms or websites are so incredibly important. That really says that the default value at the DMV, the guy who designed the form, or gal who designed the form, has the power of life over death based on the form.

Ron Baker: Economists call it choice architecture and there is definitely something to it.

Ed Kless: Whether or not you want to, for example, do you have a base model that you add stuff to or do you have a higher-price model that you subtract things from when you're configurating a product. That makes a difference and you have to think about those things. Of course, one of the more famous ones is the changing of a word on a button to go from register to continue. You can look this up, we'll put it on the website. Three hundred million dollars in increased sales when you said that you wanted to continue versus register and the functionality was the same. It was just the word choice that was different.

Ron Baker: Why is it, Ed, that we hate to be made to register before we buy but we're happy to register after we buy.

Ed Kless: There's absolutely no difference, absolutely no difference. Our brain says okay, I'm happy to just continue on with the sale. After the break we'll explore this idea and some others.

Ron Baker: Ed, back to some of these "irrational" effects. I think you can tell I'm getting more uncomfortable with this term irrational because I don't think that is the accurate description but I'll just stick with that for now. Let's talk about the idea of zero price irrationality. Why is it when we're at a convention, like we were 

Ed Kless recently at Sage Summit ... You walk through the exhibitor hall and all the little chachkies they give away, we've got to just fill our bag with it. It's free.

Ed Kless: "Going to bring them home for the kids, and I need two. Do you have another one of these?" Because there's something appealing about that four-letter word, free. We just love to get something for free. There's a whole school around this of the idea of freemium and I'm a big follower of it now because almost all of the games on iPad, because my kids both have iPads now ... They're all free but then they have in-app purchases so you get the My Pretty Pony thing and you get the free blue pony but if you want the pink pony you got to, pun intended, pony up another 99 cents for the pink pony. It's the appeal of free. My kids are even into it, "But it's free, Dad, it's free."

Ron Baker: Another interesting one is this idea between how our minds thinks about relative price versus absolute price. If you were in a store shopping for, I don't know, at $25 pen, say, as a graduation gift or something, and somebody came up to you and said, "Hey buddy, this is on sale across town for $20." You might very well drive across town to save that five bucks but if you are looking at a $300 suit and somebody told you it was five bucks off across town chances are you wouldn't care, but it's the same five bucks. Mr. Spock would go both times, wouldn't he?

Ed Kless: Or not. Or not.

Ron Baker: Or not, yes. If he was really just running the numbers, you certainly would because five bucks is five bucks, but we look at the total amount that we're spending which I find very, very intriguing. We've talked about this ... I think another interesting aspect of this is how many times have you looked at thinking about spending money on an app for our iPhone, for your iPad for $3.99, and you agonize over it. Yet we'll drop 10 bucks in Starbucks and not give it a second thought, but we'll agonize over an app purchase. What do you think's going on there?

Ed Kless: I think that one's more opportunity because your feeling is okay, if this is an app for let's say to-dos, managing my to-dos. I don't want to go, and it's not the 3 bucks, cause it could be free. I would even agonize over the free one because if I start playing with this one and I don't like it then I'm going to have re-enter my to-dos. I think it's an opportunity cost one. That's what I think on that one.

Ron Baker: I do think it's the hassle factor. I'm going to spend a lot of time on this and go through this learning curve and I'm going to find out it's not what I want, so we agonize over the decision more, which is very interesting. 

Ed Kless: Talk a little bit about the framing effect too, because that's one that really intrigues me.

Ron Baker: It does. I think we brought up the example of Red Bull, how Red Bull put themselves in a tall skinny can so you wouldn't think it was just another soft drink like a Coke or Pepsi because otherwise how could you charge 3 bucks for a Red Bull. I'll just go buy a Coke or Pepsi. How a company frames its products or services makes a big difference on people's willingness to pay. A great example of this is when cold cuts are packaged, it's much better to say 90% fat free than to say 10% fat. It actually makes a pretty big difference in the sales numbers.

Ed Kless: I think that's something that businesses really should look at, is framing that, especially when it comes to pricing. I perhaps have talked about how the fact that I despise the word discount because I think discount sounds cheap. It sounds like we're doing something that's ... What I love is to give somebody a preferred price or a promotional price. That's just using the framing effect as well. Instead of 10% off we're going to say we'll give this to you at a preferred price of 90% of the list.

Ron Baker: Another effect that behavioral economists talk about is this idea of the endowment effect, that we actually value something much more as soon as it's ours. I won't sell my Super Bowl ticket for $1,000 even though I might've been happy to get that money, but once something's ours we value it more, which is why the pet store will let you take the puppy home or the bed manufacturer will let you try it out for 30 days because once you own it, it feels like it's yours and it's worth more to you.

Ed Kless: Who understands this better than anyone, I think, is Apple with the things that they do. Even the operating system updates. I'm looking forward to iOS 8. I can't wait to own it. I can't wait for it to be on my phone. I want to be the first one to download it, and it's free. It's an example of free but it's all about that I want to be first. I want to be seen as, oh, you are on iOS 8, or whatever, because I want it to be part of me, who I am.

Ron Baker: It says more about me. I'm not doing it for Apple. I'm doing it because I want to say something about me, which is why people line up around the block.

Ed Kless: They understood this. They understood this. This is why the headphones were white.

Ron Baker: They do.

Ed Kless: Just really, really smart.

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