Money illusion and euro pricing W. Fred van Raaij and Cecile L.A. van Rijen Tilburg University and Fontys Hogescholen, Tilburg, The Netherlands Corresponding author: W. Fred van Raaij, Tilburg University, Department Social Sciences, P.O. Box 90153, 5000 LE Tilburg, The Netherlands. T. +31/13/4662434; F. +31/13/4662067; e-mail: [email protected] Abstract With the introduction of the euro consumers have to develop a sense of value for euro prices. Consumers may be the victim of a money illusion effect, in which they evaluate euro prices as cheaper than they actually are. For retailers, psychological or odd pricing may be less effective for euro prices than for guilder prices. In this study, we find some support for the money illusion effect. We also find support for less psychological pricing for euros than for guilders. Key words: euro, money illusion, anchoring, psychological/odd pricing Introduction The introduction of the common currency, the euro, in twelve member-nations of the European Monetary Union on January 1, 2002, demanded quite a number of adaptations of consumers. Salaries, savings, prices, loans, insurances, mortgages, pension plans, and other financial contracts are now in euros. Consumers have to learn new prices in euros rather than in the former national currency. They have to calculate and to think in a new value metric for their income and other amounts they receive, and for the prices and payments they have to make. Consumers have to develop a new reference system in euros for economic and psychological value and prices. According to the ‘invariance axiom’ (Tversky and Kahneman, 1988) people should not be influenced by the currency and give the ‘same’ answers irrespective the currency in which the information is provided. In The Netherlands, the conversion rate of the euro is ƒ 2.20371 (Dutch guilders), in practice rounded to 2.2. If someone wants to convert a euro price into Dutch guilders, he/she has to multiply by 2 and to add 10 percent. If someone wants to convert a guilder price into euros, he/she has to divide by 2 and to subtract 10 percent. People may not be too accurate to do this calculation. They may forget to add or to subtract 10 percent. Or they may do a quick rounding rather than a 10 percent addition or subtraction. In Germany, this calculation is easier, because one euro is about two German marks. In The Netherlands, the nominal amounts in euros are more than twice as low as the equivalent amounts in Dutch guilders. Thus, salaries and prices seem to be more than twice as low as they were in Dutch guilders. The low nominal prices give the impression that products are cheaper than before. This could lead to more spending and an increase of purchases. At the same time, the lower nominal income amounts could lead to a decrease of spending. Research objectives Fisher (1928) introduced the concept of money illusion. This is the tendency to think of economic transactions in nominal terms, because the nominal value is a salient and natural unit of money. Dutch consumers are familiar with the guilder and know what is cheap and expensive in guilder prices. They may apply this reference frame to euro prices and tend to consider small amounts of euros as being cheap. They may consider a price of ƒ 51 a reasonable price for a dinner and € 24 as cheap, while actually € 24 is more expensive than ƒ 51. Scitovsky (1986) gives the example of workers that are satisfied with an income increase of 2 percent, while the inflation is 3 or 4 percent. Shafir, Diamond and Tversky (1997) distinguish nominal and real assessment of prices and conclude that people often use a combination of real and nominal assessment in their evaluations. Van Everdingen and Van Raaij (1999) expected that the introduction of the euro may also lead to a money or price illusion effect, if Dutch consumers apply their guilder reference frame of nominal amounts to the new currency. One of the objectives of this study is to find empirical support for the price or money illusion, when consumers evaluate products priced in euros or in guilders. It is expected that consumers will evaluate prices in euros as being ‘cheaper’ than prices in guilders. The second objective of this study is to investigate psychological prices in guilders and in euros. Psychological or odd prices are prices just below a rounded price such as € 2.95. The price of € 2.95 is perceived as a lot ‘cheaper’ than € 3.00, while the difference is only minor. The consequence of this is that the negative price elasticity is discontinuous just below a rounded price. This effect may occur for euros as well as for guilders. The third objective is to study the highest accepted prices for products in guilders and in euros. A shirt with a price over € 60 may be considered too expensive. A price below € 25 may be considered cheap, even too cheap. The range of acceptable prices for a shirt varies then between € 25 and € 60 (Nyström, 1970). Students may consider a price of ƒ 100 for a textbook as being acceptable and a price over ƒ 100 as being too expensive. In the same way, students may consider a price of € 50 for a textbook as being acceptable and over € 50 as being too expensive. The upper anchor price is than changed from ƒ 100 to € 50; which is an increase of 10 percent. Consumers have to develop new ranges of acceptable euro prices and anchor euro prices for products and services. Thus, there are several reasons why consumers may estimate euro prices as being lower than guilder prices. First, they may consider nominal amounts of money. Nominal amounts in euros are smaller than in guilders, and thus they conclude that products priced in euros are cheaper than products priced in guilders. Second, consumers may perform an inaccurate calculation to convert euro prices into guilder prices. The conversion factor from euro to guilder is 2.2. They may multiply euro prices by 2 and forget to add 10 percent. Or they may multiply by 2 and do an inaccurate small addition that is lower than 10 percent. Thus, euro prices are underestimated. Third, consumers may apply their guilder reference frame to euro prices. Reference prices may then serve as an anchor for price perceptions, evaluations and estimations (Shafir et al, 1997). The guilder prices are the anchor and consumers adjust insufficiently from this anchor to the euro prices. Northcraft and Neale (1987) found that lay persons’ (students) as well as experts’ (real estate agents) price estimations for real estate property are systematically affected by the listing price of these properties, although they received sufficient information to make their own price estimations. By the way, Dutch real estate agents still (2003) use guilders to estimate real estate value and comparisons over time. A fourth reason to estimate euro prices as being lower may be the consequence of a negative evaluation of the euro. Van Everdingen and Van Raaij (1998) found that many Dutch consumers have a negative opinion about the euro and rather preferred the Dutch guilder. As a consequence, they may evaluate the euro as less valuable and thus euro prices as lower. However, Jonas, Greitemeyer, Frey, and Schulz- Hardt (2002) did not find support for this hypothesis with a German sample. A fifth reason to estimate euro prices as being lower than guilder prices may be the time frame. Because the euro was introduced in 2002, the euro came ‘later’ than guilder. Due to inflation (4 to 5 percent annually in The Netherlands), an amount in euros (before January 1, 2002) is worth less than the same amount in guilders (after January 1, 2002). Euro prices are therefore perceived as being ‘cheaper’ than the equivalent guilder prices. However, Jonas et al (2002) did not find support for the time frame hypothesis. Psychological aspects of prices Hanna and Dodge (1995) distinguish three psychological aspects of prices. The price may be an indicator of product characteristics such as quality, especially if quality cannot be judged directly such as with experience products. Price is also used for the categorization of products into cheap, acceptable and expensive. In the third place, price provides information on discounts. Schindler (1991) found that rounded prices give the impression of high quality and status. ‘Exact’ prices such as € 1,63 give the impression of precision and honesty. Psychological or odd prices, just below the rounded price, such as € 1.99, give the impression of discounting and ‘cheap’ (Schindler and Kibarian, 1996). The idea behind psychological pricing is that the negative price elasticity for a price change from € 4.95 to € 5.00 is larger than for a price change from € 5.00 to € 5.05. The decrease of sales is larger when the price changes from € 4.95 to € 5.00 than when the price changes from € 5.00 to € 5.05 (Gabor and Granger, 1961, 1966). Psychological prices are perceived as being really lower than the rounded price, although the difference is negligible (Dodds and Monroe, 1985; Nagle, 1987). With a price increase from € 4.95 to € 5.00, the price comes in a higher euro unit, the category of € 5 prices. With a price increase from € 5.00 to € 5.05, the price remains in the same euro unit. Psychological or odd pricing is in contradiction with assumptions of rationality, such as: - Price elasticity is a linear function of prices without price thresholds (bubbles). - Consumers have prefect information about prices. - Prices do not affect subjective needs.