For much of the last week, I have been reading the book Predictably Irrational by Dan Ariely. One of the chapters displays the crazy decisions people make when they hear the word 'free'. In one experiment, he compares how many people will pay $.15 for a Lindor Truffle or $.01 for a Hershey's Kiss. The bulk of purchasers choose to buy the truffle. Each customer was limited to one chocolate.
In a subsequent experiment, he reduced the price of each by a penny. He found that despite the fact that each chocolate was reduced by the same amount, there was a huge shift in demand and customers overwhelming purchased a Kiss instead of a Truffle.
Ariely calculates utility as the difference (in some sort of unit) between the benefit received from the item purchased and the cost required to purchase it. Using this definition, the gap in utility between the Truffle and the Kiss will remain constant.
In the micro classes I have taken, the relationship between two products is the amount of one you would have to give up to purchase the other. Therefore, in the first experiment, a customer would need to forego 15 Kisses for one Truffle. However, when the Kiss is free, there is no amount of Kisses that could be foregone to earn the Truffle. Using this calculation to determine utility results in the customers being less irrational.
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