In Chapter 9 and 10 (I combined them as they’re quite similar) of “Predictably Irrational” by Dan Ariely, the concept of how are expectations affect our decision making is discussed. We are not rational actors making choices in a vacuum but rather we are deeply affected by our expectations. If we expect a movie to be good, then it often is. This placebo effect is always to be found with prices. If we pay more for something, we value it more and get more from it. This creates serious problems for those who claim that market distortions will be corrected by market forces pushing a return to equilibrium.
Ariely conducted an experiment involving free beer (I knew that would get your attention). Students would be given two small samples of beer labelled A and B and asked to choose which tasted better. They would then a get a free glass of their chosen beer. A was a standard beer while B was the same beer with vinegar added. The first group was not told the ingredients of the beer and the majority choose B, beer with vinegar added. However, when the trial was repeated on a second group who were told that B contained vinegar, the majority choose A. This is the power of expectations, if people expect something to taste bad, it probably will.
It gets even more interesting. Ariely did a further experiment where he handed out free cups of coffee on condition that students fill out a survey on the coffee. They were pointed to a table where the usual extra ingredients were placed, milk, sugar etc. But Ariely also added unusual ingredients like cloves, paprika, cardamom etc. What was important was not the ingredients, but how they were stored. Some days they were placed in fancy glass and metal containers set on metal trays with silver spoons. Other days they were in cheap Styrofoam cups with labels written in pen. Regardless of container used, none of the ingredients were ever used. However, students reported higher levels of satisfaction with the coffee on days when the fancy containers were used. The sheer ambiance of the area can affect our level of enjoyment.
The effect of expectations is on display in any restaurant. Menus paint the most luscious picture of the food in an attempt to increase your expectations. Exotic herbs and spices are added not just to add to the flavour, but because they also increase our expectations. The presentation also affects. Even though eating off a quality plate won’t make the food taste nicer in a blind test, when you can see it you will notice the difference. The famous Pepsi Challenge had to do with expectations too. In a blind test consumers said they preferred Pepsi, but in an open comparison they preferred Coke. This is because the power of the Coke brand influenced people’s expectations.
All of this links in with the placebo effect. This well known phenomenon occurs when patients are given a pill that has no effects whatsoever and told it is the cure for their condition. In a surprising (and embarrassing for the medical profession) number of cases this works just as well as actual medicine. This has also been applied to surgeries with similar results (if you think the placebo effect is an interesting curiosity from the past, you’ll be surprised to hear that the debate over the effectiveness over some drugs is still ongoing). It seems the effect of expectations is so powerful that it can even cure disease.
So Ariely set up an experiment to measure it. Students were brought into a room where they were hooked to a machine that would send tiny shocks into their body while they estimated the level of pain. After a while, the students are given a “painkiller” costing $2.50 and then process is repeated. Almost all students reported feeling less pain, which is interesting because the “painkiller” was only a Vitamin C tablet. Ariely then repeated the experiment with one change, the tablet now cost only 10 cent. Instead of almost all people feeling pain relief, only half did. It seems that when it comes to medicine, you get what you pay for.
Now for the really interesting part, Ariely did a further experiment where he applied the placebo effect to the market. He took three groups, gave the first one an energy drink at full price, the second group the same energy drink at one third the regular price, while the control group didn’t drink anything. They were then asked to solve 15 puzzles in a half an hour. The full price group solved 9 puzzles, the same number as the control group. However, the discount group solved only 6.5 puzzles on average. To further test this, Ariely then included some bogus scientific claims on the test paper (such as claims that studies proved the energy drink made you smarter etc). The discount group got an average of 0.6 extra answers right, while the full price group got 3.3 extra answers right.
This (like a lot of behavioural economics) might seem like interesting little experiments that make good trivia, but aren’t applicable to the world of economics. However, in actuality they are deeply important findings disguised in easy, jargon-free, non-mathematical language. The above experiments have serious repercussions for how we view the free market. It is commonly asserted that consumers will push the market in the most desirable direction. After all, if a good is overpriced, people will stop buying it. These experiments show that this is not the case. An inefficient firm can overcharge consumers and stay in business because the effect of expectations and the power of price will make consumers gain an additional utility not based upon the product but due to the price. If high prices bring high expectations which are then interpreted as better quality, then it cannot be claimed that the market will automatically bring prices down to the most efficient equilibrium.