Behavioral Economics: Negotiating Prices and The Anchoring Effect

COMPELLING QUESTION

Can arbitrary numbers stick in our minds and affect our decision making?

Students will participate in a trading game in which students are either a buyer or seller in a market. In this market students will be exposed to a particular number to serve as an anchor. The goal is to see if the students who are the sellers were able to get a higher price from the students with the higher anchor than the students with the lower anchor. This activity will be an introduction to analyze and discuss one of the most powerful tools for negotiation and a widely discussed topic in behavioral economics.

The anchoring effect is one of the most robust topics studied in behavioral economics. We tend to rely quite heavily on the first piece of information to which we are exposed. This information becomes a reference point for all subsequent decisions that we make. The challenge is questioning the first piece of information to see if it is in our best interest to stick with it.

When making a large purchase such as a car, we immediately have a reference point by looking at the sticker price. In making the final decision on the price to pay, the reference point is a significant influence. Paying below the reference point feels good for consumers. Getting caught up in where they stand relative to the anchor can divert consumer attention away from how much they are really paying. What is being saved in cost might not be as relevant as what is being spent.

Even random anchorscan influence decisions! Many experiments have shown that the simple exposure to a random number can induce individuals to provide estimates that are biased towards the initial (random) number. In some of these experiments, when subjects are asked if they believe the random anchor played a role in an estimate or value they were asked to place on something, they will state that it did not—even when the data suggests that it did. These experiments document a cognitive bias called anchoring. The evidence shows that those exposed to higher anchors produced a higher estimate or value, and those exposed to lower anchors produced a lower estimate or value. Understanding how anchors can influence our behavior can help us make better economic decisions.

Behavioral Economics concepts in this Lesson: System 1 and System 2, Econs versus Humans, Reference point

• Explain how arbitrary numbers affect our decision making.
• Describe how anchors are used in negotiation.
• Analyze and explain how retailers of goods and services use anchors to sway our purchasing decisions.
• Define and explain how the relativity trap is used in the retail market.
• Describe how economic decisions should be based on weighing costs and benefits.

• Slides 2.1-2.12 (ppt) or (pdf)
• Activity 2.1, one copy, cut apart, separated into buyer and seller cards.
• Activity 2.2, one copy for every eight students, cut apart, separated into buyer and seller badges.
• Activity 2.3, one copy for every four students, cut apart, separated into information sheets and seller information sheets.
• Activity 2.4, one copy for every eight students, separated into transaction sheets and seller transaction sheets.
• Activity 2.5, one copy for the teacher.
• Activity 2.6, one or two copies cut into five parts, one part for each group of three-to-five students.
• Paper clips (or tape): one for each student to be used to place their badges on their shirts.
• Five blank sheets of paper (one per group).
• Five sets of colored pencils or crayons or markers (one per group).
• Foreward and Acknowledgements

1. Write the compelling question on the board. Direct students to the question and have them write it down on a sheet of paper. Tell students that at the end of the lesson they will write a response to the question based on what they learned from the lesson. To help them with their response, suggest to students that they take notes summarizing the concepts that they learn.
2. Tell the students that they will be participating in a trading game. Half of the class will be the sellers and the other half will be the buyers. This will be a one-round, one-time trading game.
3. Assign half of the class to be buyers and the other half to be sellers.
4. Distribute to each seller a seller card (one letter per student), a seller information sheet, a seller transaction sheet, and a seller badge (one number per student).
5. Distribute to each buyer a buyer card, a buyer information sheet, a buyer transaction sheet, and a buyer badge. Be sure to distribute the buyer numbers so that half of the buyers represent 40-50 and the other half of the buyers represent 80-90. Hand out one card (one number) per student. For larger classes you can have a volunteer pass out the materials and be the recorder of the prices.
6. Show slide 2.1. Tell the students to look at their respective seller or buyer card. Explain to the students that the sellers are represented by a letter and the buyers are represented by a number. Instruct students to write their corresponding letter/ number on their badge (Activity 2.2) and attach it to their shirts. Tell the students this is how they will be identified in the market.
7. Give students a few minutes to read over their information sheet. Instruct the buyers to read “b” and fill in questions “c” and “d” on the information sheets. They should do so without discussing it with others.
8. Show slide 2.2. Remind the students that in the market sellers are only selling one textbook and buyers are only buying one textbook.
9. Tell the students that in a few moments the market will open. Tell the students that once the buyers and sellers have chosen a negotiation partner, they must make a deal with that individual with no shopping around. Remind the students to fill out the transaction sheet once they are done with the transaction.
10. Once students understand the instructions, tell them that the market is open. Give them about five minutes to complete their transaction.
11. Tell the students the market is closed after five minutes and have them return to their seats.
12. Ask the buyers with the low anchor (40-50) what price they agreed to buy the textbook for and record this information on the Activity 2.5 recording sheet
    • Do the same for the buyers with the higher anchor (80-90). Have the students calculate the average price for each of the two groups.
13. Display Activity 2.5. Note: The expected result is that the buyers who were assigned the higher numbers paid a higher average price while the students who were assigned the lower numbers paid a lower average price. There may be some students who will offer a price that is way above or way below their given anchor. Ask the students why they paid that price. Some students may state that they did not feel the product was worth that much, wanting to save, or that the seller really talked up the product.
14. Ask the buyers who offered a higher price why they offered that high price. (Answers will vary, but students should point out that the fact that they were asked to consider their buyer number (80-90) as a price likely played a role when they placed a value on the item.)
15. Ask the buyers who offered a lower price why they offered that lower price. (Answers will vary, but students should point out that the fact that they were asked to consider their buyer number (40-50) as a price likely played a role when they placed a value on the item.)
16. Referring to the information filled out on Activity 2.5, tell the students that the buyers were exposed to an arbitrary number. This number then became an “anchor” value for the price that they were willing to pay for the textbook; they might have paid more or less than the anchor, but most ended up paying a price closer to their arbitrary anchor than a price closer to the arbitrary anchor of other students in the class.
17. Show the students slide 2.3. Explain to students that this activity demonstrates a type of cognitive bias which is defined in the slide. The activity shows how the anchoring effect can affect people’s judgment.
18. Show students slides 2.4-2.5 and discuss how the activity is an example of anchoring as described in the next steps.
19. Ask the buyers what number they were exposed to prior to starting the negotiation process. (Students should point out the range of numbers between 40-50 and 80-90.)
20. Ask the students if they believe that the numbers they were given influenced the final prices for the textbook. (The students may be quick to say “no,” pointing out that the numbers were not initially introduced as a price for the item. Some may have interpreted the numbers as prices as well.)
21. Explain to the students that the use of the buyer number seemed arbitrary. It was not given as a reference point; it was just a number that represented the student in the market.
22. Ask one of the students who was a seller to share with the buyers what the minimum price they were willing to take was. This information is the fourth bullet point on their instruction form.
23. Explain to the students that when they were asked to write their buyer number in the form of a price for the textbook, either $40-$50 or $80-$90, this may have caused them to think of that number being the price they would pay for the textbook. This created a willingness to pay that price or somewhere around that price.
24. Show slides 2.6-2.7. Explain to the students that in the marketplace retailers have many ways they can anchor consumers on paying a certain price or buying a certain quantity. Ask the students for some examples (buy-one-get-one-free, 50% off, three for the price of one, four for a dollar, etc.) Explain how the anchors help establish the selling price as a great “discount.” The discounts can entice consumers to make purchases that do not stay within their budget simply because the discount is considered too good to pass up. Explain how a special type of cognitive bias occurs when consumers place excessive importance placed on the original higher price and then evaluate a lower sales price relative to the “original” price. This form of anchoring is known as the relativity trap.
25. Show slide 2.8. Explain to the students that this 500cc ATV is selling for about $6500. Ask the students if this ATV is a good price. (Accept any answer.) Show slide 2.9. Explain to the students that now the MSRP has been posted on the ad. Ask the students if they believe this ATV looks like a good deal now. (The students may agree that the deal seems better with the reference price.) Show slide 2.10. Ask the students to explain what the ad has done now to make the price seem even better than before. (The added features may entice the students further.) Ask the students how these slides illustrate anchoring and the relativity trap. (The MSRP is given in the second slide and provides an anchor. The MSRP suggests the current sale price is relatively low. The third slide reinforces this notion with words like “crazy” and illustrations of a punching dog.)
26. Show the students slide 2.11. Tell the students that some behavioral economists like to use the terms “Econs” and “Humans” to refer to the different ways people make decisions. Econs weigh the costs and benefits of alternatives before making their choices. Humans also use costs and benefits but can be influenced by other factors when making choices.
27. Ask the students how they predict an “Econ” would react to a discounted price on an item? (An Econ is not influenced by an anchor. Econs already know what they are willing to pay. Acquiring the good itself is satisfaction enough.) Ask the students how they predict a “Human” would react to a discounted price. (Humans are influenced by anchors. The idea of getting a good deal is satisfaction enough. They may not place enough weight on the benefits of what they are purchasing relative to the price paid. Instead, they get caught up in getting a good deal by paying less than the “sticker price.”)
28. Show slides 2.12-2.13. Explain and discuss the information on the slides with the students: Ask the students if they remember a time when they overpaid for a good or service. (Answers will vary.) How did they become aware that they overpaid? (Answers will vary, but generally students will compare the price they paid to other prices.) Ask the students if they think knowing about anchors will help them be better shoppers. (Students will probably say they will be more aware of anchors. Some students may point out that anchors still may work to some degree even when consumers are aware of the idea of anchoring.)
29. Explain to students that anchors cannot be avoided. We are often completely unaware that we are influenced by them. Anchors refer to the point of reference we use in decision making and, whether we intend to or not, we have a tendency to go back to reference points when we are comparison shopping.
30. Tell the students that behavioral economists have run many experiments using the idea of anchors. Show slides 2.14-2.15. Explain that anchors do not only pertain to prices in the market for goods and services. Read over the experiment that is stated on the slide. Ask the students to predict, using their knowledge of anchors, the result of the experiment.
31. Show slide 2.16 to reveal the results of the experiment. Review with the students that when participants were asked the question, no one really knew the answer. Their answer was really a guess, although the participants did not really feel that it was a guess. The wheel was a random number generator that provided something concrete to work from. The anchor could not be avoided when they adjusted their estimates.
32. Tell students that they will now work in groups (no more than four) to create an ad like the one they were just shown (refer back to slides 2.5-2.7 as you explain the activity to the students). Each group will be given a particular product and the cost to produce the product. Their goal is to create an ad that will anchor the consumers of their product to a higher price so that the price they intend for them to pay looks like a good deal.
33. Hand out a sheet for Activity 2.6 so that each group of three-to-five students is assigned only one product. In large classes, some groups may be given identical cards. Give students about 10 minutes to complete their ad. After completing their ad, have them briefly present and explain the high anchor on their ad, the sales price that they intend for the customer to pay, and how much profit they hope to earn.

1. Ask students to refer back to the compelling question that they were instructed to write at the beginning of the lesson. Tell the students to summarize using terms and concepts that they learned about the anchoring effect to answer the question and to provide examples from the discussion and activity during the lesson.
2. Ask the students to think about a purchase or purchases that they have made in the past. Tell the students they may or may not have put a lot of thought into what they were purchasing. They will now take a moment to analyze their decision to purchase their product like behavioral economists.
   1. Instruct the students to draw two columns on a sheet of paper and label one “Econ” and the other “Human.” A checkmark will be placed on either column if the behavior described is that of an Econ or Human. Ask the students the following questions:
      1. When shopping for the good, was there one that you had your eye on and planned to purchase regardless of price? If “yes,” place a checkmark under Econ. If “no,” place a checkmark under Human.
      2. When shopping for the good, did you research the cost of the good at one retailer? If “yes,” place a checkmark under Human. If “no,” place a checkmark under Econ.
      3. When shopping for the good, did one specific price you saw become a reference point for price comparison of the same product from other retailers? If “yes,” place a checkmark under Human. If “no,” place a checkmark under Econ.
      4. In purchasing the good, was acquiring the good regardless of price satisfaction enough? If “yes,” place a checkmark under Econ. If “no,” place a checkmark under Human.
      5. Did you make an impulse purchase just because it was a good deal without regard for whether you needed the good or not? If “yes,” place a checkmark under Human. If “no,” place a checkmark under Econ.
   2. Ask the students to look at which column has the most marks. With a show of hands, ask the students who made their decision more like an Econ (most checkmarks under that column) and then who made their decision like a human (most checkmarks under that column). Reviewing slides 2.6, 2.7, and 2.11, ask for two students that identified as Econs in using what they have learned to explain their approach to why they chose to purchase the product and approached it like an Econ. Do the same for two students who identified as Humans.
   3. Explain to the students that neither approach is necessarily a good or bad approach. As consumers, we individually make decisions based on our personal preferences, approaches, and most of all based on our financial situation. Also point out that it is not that Econs are unaffected by bargains, they just fulfill their satisfaction by acquiring the good itself.

Extension activity not available.

Multiple Choice

1. Why is price discounting such an effective tool for sellers?
   1. Price discounting anchors buyers to the lowest price and consumers are more willing to pay the higher price.
   2. Initially sellers do not know what buyers are willing to pay.
   3. Sellers anchor consumers to a higher price to make any amount lower seem like a good deal.
   4. A higher price becomes a point of reference but is quickly forgotten as consumers shop around.
2. Being exposed to an uninformative number that is then subconsciously used as a reference point when making a decision is known as:
   1. Intuitive predictions
   2. Money illusion
   3. The ownership effect
   4. The anchoring effect

Constructed Response / Activity

1. Think back to the last time that you negotiated with someone on the price of a good or service. Did you pay close to the initial selling price? Why or why not?
2. Explain in one paragraph what the relativity trap is. Support your answer with at least one example of how you have experienced this when purchasing a good or service.
3. For Constructed Response 3, have the students bring in examples of anchoring in print or online media. Basing your answer on the advertisement you brought in, explain how the retailer is using anchoring in the advertisement. Explain how a shopper might avoid being caught in the relativity trap.