How Behavioral Economics Can Boost Your Bottom Line

Question: Are businesses rational?

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DAN ARIELY: But there’s a general assumption that businesses are smarter. That they know better, and I have to say that as long I was in kind of, academia with no connection to business I assumed the same as well. But in the last two years I had some instances where I got to observe companies. I got to see what they’re doing and I think companies are actually much less rational than people, and it’s not because they’re bad. It’s because they are working in a more complex environment. Imagine that you don’t know if you like brussel sprouts or not. How difficult would it be for you to test it out, quite easy right? You spend a dollar fifty, you try it out. Imagine that business doesn’t know if one of their business processes is optimal or not. How will they test it out? Very, very tough. Not only that, but they’re testing depend on how consumers react to it.

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So when they change something it’s not only that they change something, the competitors could be changing something as well. So it’s a very, very hard environment to learn something about. So we as individuals have a relatively easy time to vary things in our lives. You know, sometimes we tell this joke we see if people laugh, sometimes we tell that joke, we see how people react to it, we see what works. Businesses actually have a very hard time; they work in a competitive environment, static environment. They have a very hard time doing any experiments and because of that businesses are mostly stagnant, they’re mostly doing the same thing over and over, and they mostly work on intuition. On top of that they do one of the things I hate the most which is to use focus groups. In which part of your life would you invite 12 people that have no idea about the question in mind, to come and tell you what they think and then adapt to a decision? Would you ever do it in any domain of your life? Of course not! It sounds crazy, but for businesses it’s their way of operation, and they do it because it’s so hard to do. So, businesses I think have a huge problem, and I wish they would do more experiments.

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Question: How can companies use behavioral economics to their advantage?

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Dan Ariely:     So I think businesses are starting to learn something about behavioral economics. I can tell you a couple of examples. Procter and Gamble for example is facing a very interesting dilemma. They tried to create more and more concentrated laundry detergents. It’s good for everybody, it’s less plastic, it’s less shipping, it’s less space, easier to carry. But if you have this big bottle, with 90 loads, or this little bottle that’s supposed to be 90 loads, people are just not willing to pay the same amount for it. Technology is different; it’s actually more complex to do and so on. But you see this little bottle and you say, well I used to pay the same amount for this big bottle, I’m not willing to do it for the little bottle, and that’s really about consumer perception, and their association of size with value and their inability to do it. So Procter and Gamble had just started doing all kinds of experiments to try and figure out how they overcome it.

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Another company is Express Scripts, they basically send you your medications in the mail and they try to get people to take generic rather than take a branded medication and to get people to be compliant with the drug and so on, and they have done recently a very nice experiment. So we know a lot about the power of default. If you had a particular way in which you’re doing something, deviate from that is going to very tough, right. If you basically saving a thousand dollars a month and I say, why don’t you settle for a thousand and ten and here’s a form for it. You’re not going to do it. So what happen is, people have branded medication and you said, you want to switch, they say no, right. It’s good for everybody, it’s good for the patient, it’s good for the company, it’s good for the insurance company but people don’t do it.

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So instead of basically tempting people with switching, they said, it’s over. We don’t asking you if you want to switch. Your prescription is over, now we asked you want to go for the branded at this price or for the generic at that price? So no way you could do is just keep only what you had, you had to fill a form and you had to make a decision. They call this active choice, and they increased dramatically the number of people who are using generic medications.

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So in one of our experiments we found out that when people sign an honor code in a beginning of the test they don’t cheat. But if they sign at the end of the test, it’s kind of too late, they finished cheating, and you can think about your taxes, right,  if you sign in the beginning of your taxes you might think, ‘ooh, how do I want to be, how important is honesty.’ If you finished filing all your taxes and now you’re signing something, you’re not going to go and change what you’ve cheated. You kind of made peace with it anyway. So we got an insurance company to mail people a letter asking them to report how many miles they drove last year. They do it every year, they mail these to people, but we changed the form, some people sign at the top, I declare that everything I say it will be the truth and then they reported the mileage, some people reported the mileage and then said, I declared that everything I’ve said here is the truth. The difference was 15%: the people who signed first reported to be driving 2700 miles more.

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Recorded on: July 29, 2009

It’s a challenge for companies to get feedback that allows them to make changes, says Duke economist Dan Ariely.

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