December 14, 2009

APRrrrrrr

Posted in Rationality and consumer choice at 1:20 am by Eamon Aghdasi

If you’ve been following this blog in the past couple months, you’ll know that I’m a pretty adamant critic of marketing and advertising methods which seem to prey on consumers’ lack of knowledge or judgment. This past summer I wrote an entry about this, in the context of advertising. The premise was that though classical economic models rest on the principle of rationality, recent research (and common sense) argues convincingly that people really don’t behave that rationally. (This is not an indictment of economics, which purposefully simplifies life to provide a useful model, but rather those people who get obsessed with these simplifying assumptions and begin to believe they actually play out in real life.)

If consumers aren’t really rational, I argued, then producers could find ways to exploit that lack of rationality with clever tricks and gimmicks. As I discussed earlier, if you don’t believe this is possible, just one piece of evidence is Bertrand et al’s experiment in South Africa, where men were shown to be significantly more likely to accept a loan offer when a woman’s face appeared on the promotional material. Behavior on the part of firms that targets consumers’ irrationality is so common, I argue, that we barely bat an eyelash at the bikini babes used to sell beer on TV, or asterisks on big “50% off!” signs with fine print at the bottom.

An ad from uvacreditunion.com. Few people, it seems, know the difference between APR and APY interest rates.

This type of behavior would be fine if the influence it has was distributed evenly across types of goods, but that is unfortunately not true. There are some industries or products for which such messages are enormously powerful, and others where they are not used at all. So you end up with a world where the consumption of things that can be effectively advertised with persuasion is too much, and the consumption of things that can’t is too little.

One industry that is great at this is credit cards. I don’t think credit card companies necessarily utilize the emotional cues that I talked about in my earlier post any more than any other industry. But they have mastered the art of confusing consumers and overwhelming them with seemingly impossible-to-understand information. One of the silver linings of the financial crisis (especially relating to subprime mortgages), I think, is that it raised awareness of the need to protect the consumer when it comes to personal finance.

Let’s look at one of the simplest and seemingly most innocuous examples of this: the clever use of APR and APY interest rate quoting standards. If you don’t know already, the principle difference between APR (annual percentage rate) and APY (annual percentage yield) is that the first one doesn’t count compounding in the number, while the second one does.

Read the rest of this entry »

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September 1, 2009

The missing costs of advertising

Posted in Rationality and consumer choice at 3:07 pm by Eamon Aghdasi

CAUTION: Viewing Newport ads may be hazardous to your perception of reality

CAUTION: Viewing Newport ads may be hazardous to your perception of reality

For a while now I’ve been wondering about whether or not certain types of advertising distort consumer choices and welfare. We all know that a lot of advertising sometimes bends the truth and attracts potential buyers indirectly (for example, linking the desire for beautiful women to the desire for beer). But is this actually bad? A lot of us jump to conclude that the answer is yes, based simply on what we see in the news or in our own neighborhoods. The sub-prime mortgage crisis, which among other things succeeded in exposing apparently dishonest practices in lending, certainly added fuel to this fire.

Advertising’s power to sway consumer choices is nothing new. If you’re interested in this sort of thing, I strongly recommend a documentary called The Century of the Self, which chillingly chronicles the nearly century-old history of persuasive advertising and marketing. At its center is the figure of Edward Bernays, a nephew of Sigmund Freud and one of the fathers of public relations. Bernays believed strongly that the actions of the masses could be controlled for economic or political purposes, through the clever use of advertising messages that tapped into normal human desires and fears. In Bernays’s most famous intervention in 1929, he arranged for a handful of attractive young women to march side-by-side in New York’s Easter Parade and, simultaneously, light up what they called “torches of freedom” as a demonstration of women’s rights. Amid extensive newspaper coverage and the resulting dialogue it generated, the simple plan helped turn smoking among women from an unfeminine habit into a symbol of equal rights and female independence.

The skeptical economics student and devout believer in the rationality of human beings may still not see the cause for alarm. After all, aren’t human beings rational actors capable of maximizing their own welfare via their own choices? No matter what advertising messages the individual is exposed to, he or she sensibly processes all the information and acts in a way that maximizes welfare. In this world, advertising is simply the provision of information and a useful tool for signaling, and the only downside is the apparent waste that a “good” product has to go through to prove itself and create a separating equilibrium from the rest.

Unfortunately, the reality is that economics really doesn’t make this claim about human nature, and the concept of “rationality” is more a mathematical arrangement that allows the platform of microeconomics to work in any useful way. In fact, economists (along with psychologists and others) have created an entire branch of their own social science — behavioral economics — to find the places where human beings tend not to behave rationally, as classical economics assumes for the sake of creating models.

Is there any basis in economics to question the potentially detrimental effects of advertising, then? I think there is. Read the rest of this entry »