Freemium Business Models: Taking Advantage of Cognitive Bias

Psychologists have described a number of cognitive biases that affect our decision-making processes. These biases are systematic errors or traps that we encounter as we make choices.  Put another way, these biases are ways in which actual human behavior deviates from the assumptions economists make in their models of "rational" choice. 

In this terrific blog post titled, "The Psychology Behind Freemium," Alex Mayyasi describes how one such bias may explain the success of many freemium business models.   For those not familiar with the term, a freemium business is one in which customers can use a service for free at first, but must pay for upgraded versions or additional features.  

Mayyasi attributes the success of freemium business models in part to something called the "endowment effect."  If humans were perfectly "rational" in their choices, they would be willing to pay the same amount for a product or service they did not have as they would demand to be paid for giving up a good that they already possessed.  However, many individuals actually demand more in compensation for giving up a good they already have than they are willing to pay for that same good if they do not already possess it.   Mayyasi cites a study by Ziv Carmon and Dan Ariely in which they examined how people behave with regard to NCAA Final Four men's basketball game tickets.  They asked people what the highest price was that they were willing to pay for such tickets.   They also asked them the price at which they would be willing to sell their tickets if they already owned them.  The selling price was more than 10 times the buying price! 

Psychologists attribute the endowment effect, in part, to a cognitive bias called loss aversion.  As Mayyasi says, people "generally react more strongly to losses than gains."  Selling something you already have is a "loss" in many people's minds.  Loss aversion may kick in when you experience a freemium product or service and face the decision about whether to pay a fee to continue enjoying the service. 

I would argue that you can think about this effect in terms of sunk costs too.    Sunk costs are not just investments of dollars.  Sunk costs can be investments of time and energy as well.  If you have put a great deal of time and effort into a video game, you don't want to "waste" those resources that you have invested.  Therefore, when faced with the question of whether to now pay for additional features of the game to continue playing, you are prone to invest some money.  You put more resources into the endeavor because you don't want to "waste" the investment you have already made. 

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Beware! We Overvalue Growth

Earlier this year, Michael J. Schill, Associate Professor of business administration at the University of Virginia Darden School of Business, wrote a terrific column for the Washington Post.  He offered a simple example of two mining companies. One had embarked on a growth strategy that involved expanding its balance sheet through major asset investments.  The other had embarked on a contraction strategy, spinning off certain parts of its business and shrinking its balance sheet.  Schill asked the question:   In which firm are people likely to invest?

Schill explains that many investors tend to flock toward the growth company.  They are attracted by the prospects of expansion and the new opportunities that those recent investments may bring.  However, that tendency to prefer the growth company may be a mistake.  Here's Schill explaining the potential bias that may be hampering investors' efforts to maximize returns:

Do investors have a good track record in pricing rapidly expanding or contracting companies? History tells us that investors tend to overprice expanding firms and underprice contracting firms. As an example, take a person who systematically invested over 35 years an equal amount of money in the stocks of firms whose balance sheet growth put them in the top 10 percent each year of U.S. public firms. That investor would find that the average annual performance of that portfolio would barely match the returns achieved by U.S. Treasury bills over the same period: about 4 percent. On the other hand, an investor who systematically bought the stocks each year of firms in the bottom 10 percent of balance sheet growth would be delighted to find average portfolio performance over the same period to be more than 22 percentage points above the returns achieved by Treasury bills: about 26 percent. The pattern suggests that expanding firms tend to be overpriced and contracting firms are systematically underpriced.

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Strategy by Rule of Thumb

UNC's Christopher Bingham and Stanford's Kathy Eisenhardt have produced some fascinating new research on entrepreneurial firms make decisions in turbulent environments (building on a long stream of excellent research Kathy has done in this area).  These scholars found that the more successful firms frequently rely on heuristics – simple rules of thumb (example: for international expansion, enter English-speaking countries first).   These heuristics become more cognitively sophisticated as managers gain experience and the firm grows.  Moreover, managers learn how to eliminate some rules of thumb over time, as they recognize the limitations or flaws of certain heuristics.   Bingham and Eisenhardt argue that such simple rules of thumb help guide organizational action more effectively than complex processes and procedures. 

Interestingly, this work seems to stand in stark contrast to the psychological research on cognitive biases.  That stream of research suggests that many heuristics can be problematic.  They can lead to highly flawed decisions.   Bingham explains the dichotomy between his work and most of the studies conducted by cognitive psychologists (excerpt from UNC business school's research insights magazine):

He argues that psychologists reached this conclusion by testing people in lab settings and asked binary choice questions that have a definitive correct answer, such as: Which German city has the higher population, Munich or Dusseldorf? Psychologists say that people often base their answer on the city that is most familiar to them, creating a heuristic of answering what first comes to mind, which might not lead to the correct answer.  “Yet in real life, strategists rarely face such clear-cut situations,” Bingham said. Lab studies often stack the deck against heuristics by putting people in unrealistic situations. But by viewing heuristics in the context of the unpredictable environments in which firms compete, Bingham argued that heuristics can be rational and even optimal strategy.

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Overconfident CEOs and Earnings Forecasts

Executives must have confidence to succeed, but how much is too much?   How specifically does overconfidence affect organizational actions?   Wharton Professor Holly Yang and Iowa Professor Paul Hribar have written an interesting new paper regarding CEO overconfidence.   They examined 974 CEOs from Fortune 500 firms in the 2000-2007 time period.  They first examined the extent to which the CEOs were overconfident, based on descriptions and quotes in news articles, press releases, etc.  Then they examined those firms' earnings forecasts.  Yang describes their findings: "We found that if a CEO is classified as overconfident, then his or her chance of missing the forecast is 10% higher than for a manager who is less confident."  The authors wrote in their paper: "Overconfident CEOs are more likely to issue optimistically biased forecasts because they overestimate their ability to affect their financial results and/or they underestimate the probability of random events."  

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We Reason to Win, Not to Find Truth

Today the New York Times profiles a provocative new stream of research, with important implications for those interested in how we can improve our decision-making as leaders.    In the article, :Patricia Cohen examines the work of Hugo Mercier and other cognitive scientists.   Cohen explains that many philosophers and scientists have argued over the centuries that humans developed their ability to reason so that they could search for "truth."  Cognitive biases, such as the confirmation bias, get in the way of the search for truth.  They have always been viewed as flaws to be corrected.  However, this new stream of research suggests that perhaps humans developed their thinking and analytical skills simply because they wanted to, and needed to, win arguments to survive and thrive in the world.  Traps such as the confirmation bias aren't really traps according to this view; presenting only the data that confirms your existing view of the world can be one strategy for winning an argument, for instance. Cohen writes,

"According to this view, bias, lack of logic and other supposed flaws that pollute the stream of reason are instead social adaptations that enable one group to persuade (and defeat) another. Certitude works, however sharply it may depart from the truth... What is revolutionary about argumentative theory is that it presumes that since reason has a different purpose — to win over an opposing group — flawed reasoning is an adaptation in itself, useful for bolstering debating skills."   

I must say that I'm always intrigued by these sorts of evolutionary arguments, though often I find the evidence underwhelming.  In my view, I'm not sure why it must be either/or in this case.  Why couldn't evolutionary adaptation have led humans to develop reasoning skills for both the search for truth and the winning of important debates? 

 

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