Transactional Utility & 'Good Deals'

Transactional utility is a term to describe the happiness a consumer gets from the perceived value of the deal. 'Transactional utility' was developed by Richard Thaler and is said to be the difference between the actual price and your reference price – the price you expect to pay.

A group of students in an executive MBA program were asked -

You are lying on the beach on a hot day. All you have to drink is ice water. For the last hour you have been thinking about how much you would enjoy a nice cold bottle of your favourite brand of beer. A companion gets up to go make a phone call and offers to bring back a beer from the only nearby place where beer is sold (a fancy resort hotel) [a small, rundown grocery store]. He says that the beer might be expensive so asks how much you are willing to pay for the beer. He says he will buy the beer if it costs as much or less than what you state. But if it costs more than the price you state, he will not buy it. You trust your friend, and there is no possibility of bargaining with the (bartender) [store owner]. What price will you tell him?

The consumption act is identical in the two situations. The respondent gets to drink one bottle of his favourite brand of beer on the beach. He never enters or even sees the establishment from which the beer has been purchased, and thus does not consume any ambience, positive or negative. Also, by ruling out any negotiation with the seller, the respondents have no reason to disguise their true preferences.

It is still noticed that people are willing to pay more for the beer if it was purchased from the resort than from the convenience store. The median answers were $7.25 and $4.10.

These results show that people are willing to pay different prices for the same beer, consumed at the same spot on the beach, depending on where it was bought. Why do the respondents care where the beer was bought? One reason is expectations. People expect prices to be higher at a fancy hotel, in part because the costs are quite obviously higher. Paying seven dollars for a beer at a resort is annoying but expected; paying that at a bodega is an outrage! This is the essence of transaction utility.

A rational consumer does not experience transaction utility. For them, the purchase location is an irrelevant factor. However, If someone was selling beers on the beach for ten cents, then even the rational consumer would be happy, but that happiness would be fully captured by the acquisition utility. Those who enjoy transaction utility are getting pleasure (or pain) from the terms of the deal per se.

Since transaction utility can be either positive or negative—that is, there can be both great deals and awful gouges—it can both prevent purchases that are welfare-enhancing and induce purchases that are a waste of money. The beer on the beach example illustrates a case where someone can be dissuaded from making a worthwhile purchase. Suppose Dennis says he would only pay $4 for the beer from the bodega, but $7 from the hotel. His friend Tom could make Dennis happier if bought the beer at the store for $5 but told Dennis he had bought it from the hotel. Dennis would get to drink his beer thinking the deal was fine. It is only his distaste for overpaying that stops him from agreeing to this transaction without Tom’s subterfuge.

For those who are at least living comfortably, negative transaction utility can prevent our consuming special experiences that will provide a lifetime of happy memories, and the amount by which the item was overpriced will long be forgotten. Good deals, on the other hand, can lure all of us into making purchases of objects of little value. Everyone has items in their closets that are rarely worn but were “must buys” simply because the deal was too good.

Because consumers think this way, sellers have an incentive to manipulate the perceived reference price and create the illusion of a “deal.” One example that has been used for decades is announcing a largely fictional “suggested retail price,” which actually just serves as a misleading suggested reference price. Some products always seem to be on sale, such as rugs and mattresses, and at some retailers, men’s suits. Goods that are marketed this way share two characteristics: they are bought infrequently and quality is difficult to assess. The infrequent purchases help because consumers often do not notice that there is always a sale going on. Most of us are pleasantly surprised that when we wander in to buy a new mattress, there happens to be a sale this week. And when the quality of a product, like a mattress, is hard to assess, the suggested retail price can do double duty. It can simultaneously suggest that quality is high (thus increasing perceived acquisition utility) and imply that there is transaction utility to be had because the product is “on sale.”

Shoppers can get hooked on the thrill derived from transaction utility. If a retailer known for frequent discounting tries to wean their customers away from expecting great deals, it can struggle. Several retailers have tried over the years to entice customers with something called “everyday low pricing,” but these experiments usually fail. Getting a great deal is more fun than saving a small and largely invisible amount on each item.