Price Anchoring
Price Anchoring
also called the anchoring effect or anchoring biasPrice anchoring is the tendency to judge what something is worth by comparing it with the first number you see, even when that number has little or nothing to do with its real value. Sellers use it on purpose with list prices, "was" prices and expensive options that are there mainly to make the next one look reasonable.
What Is Price Anchoring?
When people have to put a number on something, whether it is a price, a valuation or a fair offer, they rarely work it out from scratch. They start from whatever number is in front of them and adjust up or down from there. The trouble is that the adjustment is usually too small, so the final answer stays closer to the starting number than it should. That starting number is the anchor.
In shopping, the anchor is often a price you never actually pay: the manufacturer's suggested retail price, the crossed-out "was" price on a sale tag, the $1,200 jacket on the rack next to the $400 one, or the top tier of a subscription plan. Once you have seen the high number, the lower one feels like a deal, whether or not it is one.
The Wheel of Fortune Experiment
The idea was named by the psychologists Amos Tversky and Daniel Kahneman in a 1974 paper in Science on how people make judgments under uncertainty. In their best-known demonstration, participants watched a wheel of fortune that was rigged to stop on either 10 or 65. They were then asked whether the percentage of African countries in the United Nations was higher or lower than that number, and then to give their own estimate. The median guess was 25% among people who saw 10 and 45% among people who saw 65. The wheel had nothing to do with the question, and everyone knew it, but it still moved the answers by 20 points.
A second test in the same paper used arithmetic. Given five seconds, people estimated the product of 8 × 7 × 6 × 5 × 4 × 3 × 2 × 1 at a median of 2,250, while people shown the same numbers in the other order, 1 × 2 × 3 up to 8, estimated 512. The real answer is 40,320. Both groups anchored on the first few steps they could work out, and both fell far short.
What People Will Pay Depends on a Random Number
In a study published in 2003, Dan Ariely, George Loewenstein and Drazen Prelec asked 55 MBA students at MIT to write the last two digits of their Social Security number next to a list of products, including a cordless trackball, a cordless keyboard, bottles of wine, a design book and a box of Belgian chocolates. Each student said whether they would pay that many dollars for each item, then wrote down the most they would pay, with a real chance of having to buy at that price.
Average most-they-would-pay, by fifth of the last two digits of their Social Security number. Source: Ariely, Loewenstein and Prelec, "Coherent Arbitrariness," Quarterly Journal of Economics, 2003, Table I.
Students in the top fifth offered roughly three times as much as those in the bottom fifth for the same items. The researchers also found something that matters just as much: the students still ranked the products sensibly. Nearly all of them valued the keyboard above the trackball and the better wine above the ordinary one. The anchor did not scramble their sense of which item was worth more; it set the overall level of what they were willing to pay. That is exactly what a list price does in a store.
Real Estate Agents and the Listing Price
It is tempting to think anchoring only fools people who do not know the market. In a 1987 study, Gregory Northcraft and Margaret Neale took real estate agents in Tucson, Arizona, through a house that had been officially appraised at $135,000. Every agent got the same 10-page packet about the house and the neighborhood, except for one number: the listing price, which was set at $119,900, $129,900, $139,900 or $149,900.
Mean appraisal of the same house by the listing price each group of agents was shown. Source: Northcraft and Neale, Organizational Behavior and Human Decision Processes, 1987.
The agents' appraisals rose with the listing price, from $114,204 at the lowest to $128,754 at the highest, a gap of $14,550 for the same house. Asked to list the most important factors in their appraisal, few mentioned the listing price at all. They did not believe the anchor had affected them, and it had.
The Option Nobody Is Meant to Buy
Sellers often put a high price on the menu not to sell it but to change how the other prices look. Dan Ariely described a subscription offer from The Economist with three choices: web only for $59, print only for $125, and print and web together for $125. Nobody sensible would pick print only when print and web cost the same, and when he offered the menu to 100 MIT students, none did. But when he removed that option, the choices flipped.
Share of students choosing each subscription. Source: Dan Ariely, Predictably Irrational, 2008.
Strictly speaking, this is the decoy effect, a close relative of anchoring: the $125 print-only option made the $125 bundle look like a free upgrade. Restaurants use the same trick with one very expensive bottle on the wine list, and software companies with a top tier priced for almost no one.
Common Price Anchors
| Anchor | How it works | What to compare it with instead |
|---|---|---|
| List price or MSRP | The manufacturer's suggested price sets the starting point, so any price below it reads as a discount. | What the item actually sells for at other stores and online |
| "Was" and "compare at" prices | A crossed-out higher price makes the sale price look like a saving. | The price history of the item, and whether anyone ever paid the "was" price |
| The expensive option on the menu | A premium version or top tier makes the middle one feel moderate. | Whether you need what the middle option adds over the cheapest one |
| The first offer in a negotiation | Whoever names a number first pulls the final price toward it. | Your own estimate of value, written down before you hear their number |
| The minimum payment on a credit card bill | People who pay more than the minimum but not the full balance tend to pay less when a minimum is shown. | The payment that clears the balance on a schedule you choose |
| What you paid for a stock or a house | The purchase price becomes the reference point for deciding whether to sell, even though the market does not know or care what you paid. | What the asset is worth today and what you would do if you did not already own it |
The credit card row comes from research by Neil Stewart at the University of Warwick, published in Psychological Science in 2009. In his experiment, people who planned to pay part of a card bill said they would pay much less when the bill showed a minimum payment than when it did not, which over time means paying a lot more interest. The credit card payoff calculator shows what the difference between the minimum and a fixed payment comes to on your own balance.
Anchoring in the Markets
Investors anchor too. The most common anchor is the price they paid: a stock that has fallen below the purchase price gets held "until it gets back to even," as if that number meant anything to other buyers. Others anchor on a stock's all-time high, on a round number like an index level, or on an analyst's price target.
One well-known study, by Thomas George and Chuan-Yang Hwang in the Journal of Finance in 2004, found that how close a stock trades to its 52-week high helps explain its future returns. Stocks near their high tended to keep doing well and stocks far below it tended to keep lagging. The authors' explanation is anchoring: traders treat the 52-week high as a reference point and are slow to bid a stock through it even when good news justifies a higher price, so the price catches up later.
Older prices are an anchor in everyday life, too. Many people judge today's prices against what things cost when they were younger. The price history of everyday items and the inflation calculator show how far prices have actually moved, which is a better reference point than memory.
When J.C. Penney Took the Anchors Away
In 2012, J.C. Penney's new chief executive, Ron Johnson, replaced the department store's constant sales and coupons with what it called "fair and square" pricing: one everyday price, lower than the old tag prices, without the inflated "original" prices that sales were measured against. In theory, shoppers paid about the same or less. In practice, they stopped coming. Without a high reference price to compare against, the low prices no longer felt like bargains.
For the year, sales fell 24.8% to $12.985 billion, sales at stores open at least a year fell 25.2%, and the company lost $985 million. Johnson called the pricing policy a mistake and said he took personal responsibility for it. Sales and coupons came back, and Johnson was out by April 2013. The episode is often cited as proof that shoppers respond to the feeling of a discount, not only to the price they pay.
When a "Was" Price Crosses the Line
In the United States, the Federal Trade Commission's Guides Against Deceptive Pricing (16 CFR Part 233) say a former price used in a comparison should be the actual, bona fide price at which the item was openly offered to the public for a reasonably substantial period of time. A price that was set artificially high so it could be marked down, offered only briefly or only in the distant past, is what the guides call a fictitious former price, and the bargain it advertises is false. Some states have their own laws on reference prices, and outlet and online retailers have faced lawsuits over "compare at" prices for items that were never sold at the higher price.
How Strong Is the Effect?
Anchoring is one of the most reliable findings in psychology: large replication projects have reproduced the basic effect. The size varies a great deal, though. Anchors that look like real information, such as a list price, an asking price or a first offer, tend to have strong effects. Purely random anchors, like a Social Security number, have produced smaller and less consistent effects when other economists have repeated the experiments; John List and his co-authors made that point in the American Economic Review in 2014. A useful reading of the evidence is that people are most easily anchored when they are unsure what something is worth and the number in front of them looks relevant.
How to Resist an Anchor
- Decide what it is worth to you first. Write down a price before you look at the tag, the listing or the other side's offer.
- Find an outside reference. Check what the same item sells for elsewhere, what similar houses sold for, or how the stock is valued against its peers.
- Ignore the crossed-out price. Ask what you would think of the sale price if the "was" price were not there.
- Notice the option you were never meant to buy. If one choice makes another look like a bargain, compare only the ones you would actually choose between.
- In a negotiation, consider going first. Research on negotiations finds that the first offer tends to pull the final price toward it, so a well-researched opening number works for you.
- Forget what you paid. When deciding whether to hold an investment, ask whether you would buy it today at today's price.
What You Actually Need to Know
Price anchoring is the pull of the first number. People judge prices and values by comparing them with whatever figure they saw first, and they adjust too little from it, even when the figure is arbitrary and even when they are experts. Retailers use it with list prices, "was" prices and premium options; it shows up in negotiations, credit card bills and investment decisions. The defense is to settle on your own reference point before someone hands you theirs.
This entry is for information only and is not investment advice.