Kicking off a series of posts about reference points, the implicit benchmarks that determine the choices we make about the lives we lead and the sales we shop

Coming to a fictional mall near you, a new clothing store aims to revolutionize the industry with a transparent pricing scheme.  Absurdistan—it’s “like Banana Republic, but with the flair of Eastern Europe”—will label its clothes with the lowest price they will ever sell for.  Absurdistan's down jacket will have a sticker price of $100, but it will only cost $100 when it's sitting on the end-of-season clearance rack.  At all other times, clothes will include a fixed markup that starts at 100% at the beginning of the season and decreases over time.  There are no sales at Absurdistan; there are only temporary decreases in the markup.

Absurdistan will fail.  Customers are more likely to buy a $250 jacket on sale for 20% off at Banana Republic than a $100 jacket with a 100% markup at Absurdistan.  Banana Republic’s $200 jacket seems like a steal, while Absurdistan’s $200 jacket seems like a raw deal.

Reference points are the key to understanding how a $200 jacket can be viewed so differently.  It’s true that people care about their final outcomes, how much they pay for a jacket or what their starting salary is.  But it’s also true that they care about whether their outcome is better or worse than its reference point, a different outcome that was likely to occur, something else they can imagine experiencing.  People care about how the final price of a jacket compares with its sticker price, how their starting salary compares to their previous salary.

The tricky thing about reference points—the reason that psychologists, rather than economists, have traditionally studied them—is that there isn't a single, objectively correct reference point for a given situation.  There are multiple reference points that a reasonable person could use.  When you’re considering your starting salary at a new job, you don’t have to compare it to your previous salary; you can compare it to the average salary for your new position, the salary of a friend in a comparable job, or the salary you expected to get, based on a subjective assessment of your awesomeness.   When you’re rating Argo on Netflix, you can compare it to other dramas, thrillers, Best Picture winners, or every other movies you’ve seen.

Although reference points are somewhat arbitrary, the comparisons that people make profoundly affect their behavior.  People will accept a $90,000 job offer if they compare it to the industry average of $80,000, but they’ll turn it down if compare it to their friend’s $100,000 salary.  People will rave about Argo to their friends if they compare it to the mediocre sequels they saw over the past few months, but they’ll offer muted praise if they hold it up against The Departed and The Godfather.

Reference points are a potent way to change behavior because they aren’t optional.  There’s something visceral about them; they are hard wired in how our brains perceive the world.  Even when you know that a sale is just a lower markup, it’s not a real bargain, you shouldn’t get excited by the line on your receipt telling you “You saved $16.12 on this trip to Banana Republic” – you can’t help yourself.  Your brain compares this world to one without $16.12 of savings, and feels pretty darn good about what it just told you to buy.

It’s worth noting that reference points affect our character as well as our economic behavior.  They make us resilient and inure us to complacency.  When we suffer failures, we lower our reference points.  This allows us to feel good about baby steps of progress, giving us the motivation to bounce back.  When we have a string of successes, we raise our reference points.  This keeps us from resting on our laurels, regenerating our hunger to move forward.

Reference points are a mental shortcut, a way to simplify decisions.  It’s hard to evaluate how the quality of our life will change if we buy a down jacket.  It’s much easier to ask how the plaid jacket compares to the charcoal, how the sale price today compares to the sticker price.  This mindset generates odd behavior, making a $200 jacket on sale look better than an identical $200 jacket that isn’t discounted.  It also opens the door for manipulation, rewarding salesmen and marketers who can alter customers’ reference points to make their products seem better by comparison.

We’ll see how these implications play out in future posts.

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Photo:  Flickr