Managing Expectations, Expecting Irrationality

Behavioural economists are an interesting breed of people. They take classic economics, but add a large element of "human behaviour" study, usually known as psychology. The most famous of these is Dan Ariely, whose bestseller, "Predictably Irrational," is an excellent read, although some of his conclusions violate his premises.

Behavioural economics shows that people are not quite as rational as classic economic theories would expect, and sometimes behave in irrational (but usually predictable) ways. For example, given the choice between two items, the key element that should matter is price differential, but it doesn't work out that way. If one bar of chocolate cost $0.50 and another $0.01, and 70% of people prefer the $0.01, then dropping the price to $0.49 and $0.00 - same $0.49 differential but the cheaper one is now free - the ratio should remain nearly the same. But it doesn't. As soon as it is free, the ratio changes dramatically. Understanding how and when people (especially customers) will behave irrationally is invaluable to setting the right mix of product features, pricing, packaging and promotion.

Here are two bonus examples.

• Breakfast Bonus: I went out to breakfast with my wife recently to a classical cafe, offering European/Israeli style breakfast: 2 eggs any way you like, a plate of dips & salads, breads, a chopped salad, one hot drink and one cold drink. Each place does it slightly differently, varying the dips, for example, but essentially the style is the same across the board. The eggs have a choice of spicing: tomatoes, onion, parsley, mushrooms, sometimes cheese. In the mall to which we went there are multiple cafes. We usually go to one, once in a while varying. This time, we went to a place that we had been to in the past, a place that usually gave one or two free toppings, but charged for more. This time, I was pleased to see, all toppings were free. Let's be honest, if the topping cost an additional $0.50 on top of a $14 breakfast, is it really going to make you decide not to eat there? That would not be rational. But given that other places nearby do not charge, customers felt they were getting ripped off by nickel and dime. The owners viewed it rationally as charging people more for higher value, and customers, acting rationally, should not mind the minimal additional $0.50 for a customized breakfast. But they were not rational.
• Annual Bonus: I have spent most of my life working in industries where bonuses, officially known as "incentive compensation." In most of these places, the amount of bonus that should be received by each individual is known in advance. In other words, they have "set expectations." If the actual payout does not match the expectations, no matter how much it is, then the employee is unhappy and likely to at least consider leaving. I distinctly remember one employee at a place who received a fairly large bonus yet was upset. I asked him what he does with the bonus each year. "I take my wife and kids to _____ (foreign country where her parents live) in style, and put the rest away." The amount he received easily allowed him to do that, yet he was upset, because it was below his expectations."

As a business owner or executive, it is of critical importance that you both set expectations correctly, and that you know where and when people will act rationally and where they will react irrationally. If you don't know it, find someone in your company or outside who does.