Why human beings are predictably irrational

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The man's satisfaction with his salary depends on whether he makes more than his wife's sister's husband –H L Mencken.

Human beings like to compare, and comparisons can make them miserable. Be it the man on the street or chief executive officers (CEO) of big companies.

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CEO salaries in the United States were never really public information, until 1992. "In 1993, federal securities regulators forced companies, for the first time, to reveal details about the pay and perks of their top executives," writes Dan Ariely in Predictably Irrational – The Hidden Forces that Shape Our Decisions.

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"The idea was that once pay was in the open, boards would be reluctant to give executives outrageous salaries and benefits. This, it was hoped, would stop the rise in executive compensation, which neither regulation, legislation, nor shareholder pressure had been able to stop. And indeed, it needed to stop: in 1976, the average CEO was paid 36 times as much as the average worker. By 1993, the average CEO was paid 131 times as much."

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So did that really help? Not really. These days the average CEO makes 369 times as much as the average worker. And how did that happen? "Once salaries became public information, the media regularly ran special stories ranking CEOs by pay. Rather than suppressing the executive perks, the publicity had CEOs in America comparing their way with that of everyone else. In response, executives' salaries skyrocketed," writes Ariely.

And that's what explains to a large extent, why any increase in salary is never enough, until of course the increase is much more than that of the people we compare with.

And since human beings like to compare themselves to people around them, they also like to do what others are doing. This Ariely refers to as behaviour herding. "It happens when we assume that something is good (or bad) on the basis of other people's behaviour, and our own actions follow suit."

But, there is another kind of herding at work as well, which gets people to move up in life, literally. This is known as self-herding, and "this happens when we believe something is good (or bad) on the basis of our own behaviour."

Take the case of expensive coffee shops that have appeared all over the place. People who were not used to paying Rs 10 for a cup of coffee are now paying Rs 50-100 to have coffee. How did this change come about?

"Recall your first introduction…You are sleepy and in desperate need of a liquid energy boost as you embark on an errand one afternoon. You glance through the windows…and walk in. The prices of coffee are a shock. But, since you have walked in and are now curious what coffee at this price might taste like, you surprise yourself. You buy a small coffee enjoy its taste, and its effect on you, and walk out," writes Ariely.

Now, it does not stop here. You have had an enjoyable first experience and go in there again, reminding yourself that the first time you went there, you really enjoyed it. "Now that you have gotten used to paying more for coffee, and have bumped yourself up onto a new curve of consumption," writes Ariely.

And given this you don't mind from moving up the so called value chain, by moving to ordering a bigger cup of coffee than you had done before.

Businesses obviously realise this. As Ariely writes, "Starbucks did everything in its power, in other words, to make the experience feel different…When the coffee ambience looked upscale, in other words, the coffee tasted upscale as well." And because of this different experience, customers are willing to pay much more for a cup of coffee now, than they were in the past. And why do we fall in love with what we have already?

"Why does the seller of a house usually value that property more than the potential buyer? Why does the seller of an automobile envision a higher price than the buyer? There's an old saying, 'One man's ceiling is another man's floor'. Well, when you're the owner, you're at the ceiling; and when you're the buyer, you're at the floor," writes Ariely.

Businesses obviously understand this and try to cash in on it. "Often, companies will have "trial" promotions. If we have a basic cable television package, for instance, we are lured into a 'digital gold package" by a special "trial" rate…After all, we tell ourselves, we can always go back to basic cable," writes Ariely.

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"What we fail to appreciate is how our perspective will shift once we have it at home, and how we will start viewing …as ours - and consequently start viewing returning it as a loss."

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