AP/Bebeto Matthews Businesses use sales and price stickers to change the way we think about spending.
- Royal Caribbean increased revenues by allowing customers to purchase more goods and services they would use during the cruise while they were booking it.
- Doing so makes onboard expenses seem smaller at the time of purchase and changes the way customers think about their spending habits once they're on the cruise.
- The phenomenon is explained by an economic theory that businesses use all the time.
How much should a TV cost?
It seems like a simple question, but it can be a difficult one to answer. Of course, it depends on factors like size and quality, but once you've determined those, it's still difficult to figure out what the price should be without referring to other TVs you seen, owned, or read about in the past.
Even then, a $700, 55-inch Samsung TV might seem more or less expensive based on context. If you're spending $3,000 on speakers, furniture, and video game consoles to accompany the TV, paying $700 for the screen itself might seem like a bargain. But if you're browsing at Best Buy and see the $700 model placed next to a $500 model, the $700 model may seem more expensive.
This tendency contradicts classical economic theory, which says that we determine how much we value goods and services as an absolute dollar amount and evaluate any good or service against that value regardless of circumstance. So if you value a TV with the capabilities of a 55-inch Samsung model at $700, you'd be willing to pay up to $700 for it in any context.
We think about prices in reference to other prices
But behavioral economics, a hybrid discipline that fuses economics and psychology, suggests otherwise. In 1979, economist Daniel Kahneman and psychologist Amos Tversky released an influential paper, "Prospect Theory: An Analysis of Decision Under Risk," that introduced the idea of a reference point, which is a benchmark we use to evaluate investments.
Reference points can arise from a number of factors, which means you might compare a TV against other TVs in a store, the last TV you bought, and the total price of the goods and services you plan to purchase in addition to the TV. So a $700 TV might seem more or less expensive depending on how you think about it.
Royal Caribbean CEO Michael Bayley used the idea of a reference point to increase how much money customers spent on the company's cruises. He did so by allowing customers to purchase more goods and services they would use during the cruise while they were booking it.
The idea was that spending $100 on a drink package would seem less expensive if you made that purchase while you were buying a $1,500 cruise ticket, for example. If your reference point for what that cruise should cost is $1,800, then you still feel like you're getting a deal if the drink package makes your total pre-cruise expense $1,600 instead of $1,500. And once you're on the cruise, you're less likely to consider the cost of the drink package when buying other on-board items, which means you'll spend more overall.
"What we found is if you spend $100 before you sail, that's spent and gone. You don't even put it in your budget for when you're on vacation," Bayley said in an interview with Business Insider. "So every pre-cruise revenue dollar that we generate will often generate 50% more onboard revenue for that customer."
The strategy worked, and it was one of the reasons the company doubled earnings in the three years after Bayley became CEO at the end of 2014.
Businesses influence the frameworks we use to think about prices
Royal Caribbean is far from the only business that uses reference points to influence your spending behavior. Walk into any store, and they're everywhere.
"These are used on price tags. These are used in advertising. This is used inside
When a bookstore runs a "buy two, get one free," promotion, it's encouraging you to use the price of three books as your reference point for buying two, so even if the total cost of the books is more than you would have been willing to pay if each had been discounted separately, you still feel like you're coming out on top. And when a clothing store advertises a $20, discounted shirt by urging you to "compare at" $40, it wants you to use $40 as the reference point for that particular shirt, even if no other store would sell the shirt for that price.
According to Raghubir, the tendency to use reference points is so strong, becoming aware of it won't make you immune to pricing strategies designed to increase your spending. That includes the economists and psychologists who study them. It turns out that dedicating your life to the study of human behavior doesn't protect you from making irrational decisions.
"These biases are really strong," she said. "Even if you are aware, you are unable to control their influence."