(credit: clmper)

The largest anchor ever

How do we know what is a reasonable amount of money to pay?

ow much would a rational person be prepared to pay for, say, a cauliflower? They’d go down the ranking of all possible purchases, and for each one compare the utility it provides with that offered by the vegetable, until the utilities are equal. Whatever price they’d pay for these equivalent goods, they’d hand over for the cauliflower.

But we ordinary humans don’t possess the power to determine the price independently. Our willingness to pay — whether for a cauliflower, a used car, a sofa, a haircut or a holiday in the Mediterranean — is strongly influenced by what others are happy to pay. And that information comes to us via the market.

In the supermarket, it is advertised on the shelves. Conventional purchases in shops, certainly in the West, involve little negotiation. In practice, it is generally a binary decision: are we willing to pay the asking price or not? Either something is too expensive (but by how much?) or it is cheap enough (but how much more could it cost before we bail out?). So we’re generally not really aware of the maximum price we’d be willing to pay. Perhaps surprisingly, that means we don’t know how much we truly value the things we buy.

A by now classic experiment by Dan Ariely, George Loewenstein and Drazen Prelec, then at Harvard University, illustrates this very clearly. They showed 55 students six products with an average retail price of $70, without mentioning the price. The students were then asked whether or not they would be prepared to buy each good for a dollar amount equal to the last two digits of their social security number. After this response, they stated their maximum willingness-to-pay (WTP) for each item. Despite being wholly irrelevant, the last two digits of the social security number turned out to be very influential on the WTP. The table shows that, on average, people whose number ended in 80–99 were prepared to pay $37.55 for the rare wine, over three times more than those with a number ending in 00–19.

Source: “Coherent arbitrariness”: stable demand curves without stable preferences

This phenomenon is known as anchoring. The first piece of information (in this case totally unrelated and arbitrary) weighs heavily on the subsequent decision-making. In practice, you can see this effect being used in situations where it is customary to negotiate.

It is telling that sellers on car boot sales or flea markets almost never advertise prices on their stall. This forces the buyer, who is used to seeing prices displayed, to ask for it. And that gives the seller the upper hand, as their ‘asking price’ will then be the anchor in the negotiation. Of course they’ll aim high, so they can concede a little to the buyer, who will immediately get the feeling they’re getting a bargain.

First mover advantage

Intuitively you would assume that being the first to put your cards on the table undermines your negotiating position. But this is not borne out by the research, as Leigh Thompson, a psychologist at Northwestern University’s Kellogg School of Management, explains. On the contrary, several investigations show a powerful first mover effect, especially if both parties are equally well prepared and have similar leverage points.

A steal at DM 5,000!

The uncertainty around the ‘right’ price is not just on the side of the naïve party in a negotiation either. In a 1997 study by Thomas Mussweiler and others at Würzburg University, a 10-year old car with numerous defects was shown to 60 mechanics and car dealers. They could inspect it and were then asked to estimate the selling price, but not before the researcher gave his opinion. In half the cases he told the expert “I thought the car should sell for about DM 2,800”; the other half were told the selling price was “about DM 5,000”. The average estimates of the second group turned out to be DM 1,000 higher than those of the first group.

Even jokingly demanding a ridiculously high salary ($1million) was found to influence the eventual offer in a study by Todd Thorsteinson at the University of Idaho. Certainly worth bearing in mind during your next job interview!

A huge anchor

It is hard not to see last week’s media attention for the UK’s “Brexit bill” in this light. This is the amount that the UK will need to hand over to cover outstanding liabilities when it finally leaves. And in mid-November of last year the EU was first in putting forward the amount of €60 billion ($63 billion, £51 billion at the time of writing).

It then went quiet for a while. Yet the British government didn’t take advantage of this lull to try and regain the initiative: last week the figure was back in the headlines with a vengeance.

Just like in a divorce, this will be the subject of negotiations. The €60 billion is well underpinned and defensible. But there are numerous components to the calculation, many of which are ambiguous. The UK had a chance to develop its own version yet it failed to take the initiative, not once, but twice.

Perhaps the poor preparation of Brexit in the first few months is to blame. It is not surprising that a Brexit ministry without proper accommodation, so that it reportedly had to hold meetings in the local Starbucks, doesn’t have the resources to develop its own calculations.

But maybe there is more to this than meets the eye, and the lack of counteroffer is deliberate. Arguably this scenario plays into the hands of the British government. Just like the naïve buyer on a flea market will walk away with the idea they’ve bargained well if they knock a few pounds of the seller’s anchor price, any reduction to the €60 billion can be sold at home as a victory in the negotiation.

Yet just like it is the flea market seller that has the last laugh, so it is likely to be for chief EU negotiator Michel Barnier — thanks to a €60 billion anchor, the largest anchor ever.

Originally published at koenfucius.wordpress.com on March 3, 2017.

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Accidental behavioural economist in search of wisdom. Uses insights from (behavioural) economics in organization development. On Twitter as @koenfucius

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