Behavioral Economics and the Emergency Order Fee
In Predictably Irrational and What Money Can’t Buy, Dan Ariely and Michael Sandel make compelling arguments that show us the limits of monetary incentives.
One is about a day care center that was having a parents-arriving-late problem. The rate of parents picking up their kids after closing time was high and the teachers–who had to wait until the last kid was picked-up–were not happy. So the researchers tried to put an end to this by fining late parents $15 an hour. This monetary fine was designed to discourage a specific behavior: every time a parent showed up late, they had to pay a fee.
What do you think happened then? Did the rate of late parents drop like classic economic theory would predict?
Another is about family dinners. Say you are invited by your mother-in-law to a dinner party. Understandably, you are not enthusiastic at first. But to your surprise, you end up spending a very pleasant evening. Everything was perfect: from the delicious home-made dinner and selection of wines, to the decoration and music, and even the guests and seating. “What a delightful evening,” you think to yourself, “the last time I had this much fun, I was in a three-star restaurant in southern France. It cost me 600€. And I was more than happy to pay because of the pleasure it gave me.”
“Mmm. I want to show my mother-in-law how much I appreciate all the effort she’s put into this dinner.” And you reach for your wallet, take 600€ out, and hand them to her saying: “Thank you so much Diane for such a wonderful evening!”
What do you suspect happens next? Does she think to herself: “What an honor to compare my cooking with that of a three-star chef,” as she puts the 600€ in her purse?
The Insight #
In fact, in both cases, what happens is the exact opposite of what conventional economic wisdom would predict.
In the case of the day care center, the plan actually backfired. Instead of increasing punctuality, the change made parents less punctual. They now arrived more late, more often.
And in the second case, your mother-in-law would feel offended and ask you to put your money away. And it’s not a question of supply and demand. Even if you pay her 650€, 700€ or 1000€, chances are she’s still going to throw you out of her house.
What’s happening in both cases is a sudden shift in the nature of the relationship: from a social link to a business transaction.
In the first case, before the fee, teachers were being helpful and parents had the occasional last minute emergency at work. After the fee, the nature of the relationship changed. The parents now considered that they are buying a paid service: for someone to wait with their children at the rate of 15$ per hour.
In the second case, what started as a social event was quickly transformed into a business exchange: money against food and service. And it broke the social dynamic.
Application to Industry #
A logistics company (Company X) has low rates of on-time-delivery. It is seeking to turn the situation around. So in addition to adapting stock levels (Supply), it is looking to influence customer orders (Demand).
In fact, the more customers anticipate their orders and the higher the chance of delivering on-time. So Company X starts by re-writing its order management algorithm to get rid of LIFO (Last-In-First-Out) in favor of a FIFO (First-In-First-Out) ordering system. Indeed, the old system favored last-minute orders over planned orders. And this led to low on-time-delivery and penalized the customers who anticipated their orders—because they became more likely to suffer from stock shortages.
Company X goes even a step further and commits on delivery lead-times. It does this by giving customers discounts in case of late delivery. The further in advance an order is placed, the higher the discount. So those customers who plan in advance now get their parts in priority and they get a higher commitment of on-time-delivery.
So far, so good.
But what about Emergency Orders?
Emergency Orders are special orders reserved for parts that can put a customer’s business continuity at stake. And Company X has always had an exception for those situations. When a customer orders a part through the Emergency channel, it is treated as a first priority so that the part can be delivered within a few hours. And Emergency Orders have always been free-of-charge.
With all the changes Company X is making to its ordering system, it is concerned that some customers may try to bypass the normal channel and order excessively in Emergency so that they get the parts in priority. If this happens, the whole system breaks down because customers who plan their orders will find themselves systematically put at a disadvantage.
The Trap #
So Company X decides to implement a symbolic Emergency Order fee, designed to incentivize customers to use the normal channel, except when they truly encounter a business continuity problem.
What do you think happens next?
Will customers start anticipating their orders more, or will they increasingly game the system like the late parents did in the example above?
And how will those customers who genuinely have a business continuity issue react to the newly introduced fee? Will they feel betrayed like the mother-in-law?
How would you react if your phone operator starts charging you a fee for a service that has always been free-of-charge?
Author: E. Dib #
Further Reading #
- Michael J. Sandel, What Money Can’t Buy: The Moral Limits of Markets
- Dan Ariely, Predictably Irrational