Photo: Les Todd

When making even the most rational of decisions, businesspeople often think in irrational ways.

Why, for example, will managers veto a 10% cost increase for a $1 million project while thinking nothing of a 1% overrun on a $10 million budget—even though the actual amount is the same? Why will they often agonize over choosing between two close candidates for a job when they’re frequently better off just flipping a coin?

Here to explain is Dan Ariely. He is a professor at Duke University’s Fuqua School of Business and a leading expert in behavioral economics, which explores the inner processes we all rely on to make decisions. Dr. Ariely is also the author of “Predictably Irrational: The Hidden Forces that Shape Our Decisions.”

Here Dr. Ariely addresses some of the intricacies of product pricing. He discusses why a product’s price must take into account various irrational human behaviors, including the principles of anchoring (when the initial price of something has undue influence on our future decisions) and relativity (when we infer the value of a product from the prices of similar offerings). He spoke with Alden M. Hayashi, senior editor of MIT Sloan Management Review, for the Business Insight Journal Report.

BUSINESS INSIGHT: Your research suggests that, when selling a new product, companies should always compare it with something that the customer is already familiar with, even if the product is so novel that there really isn’t something similar on the market.

DR. ARIELY: Absolutely, for two reasons. One is because the “space” for a new product in peoples’ minds is ill-defined, and it’s very hard for people to figure out how to place a value on something in isolation. The second thing is that we are mainly creatures of habit and decisions are actually quite tough. How many times a day do we really want to contemplate buying something by analyzing everything, thinking about the opportunity cost and so on? So we rely on our old past decisions, including comparisons to other products.

Take, for example, TiVO. What’s the value of TiVO? How do you compute that? Do you take into account how many minutes of commercials you’re saving, multiply that by your income per hour, deduct from it the breaks you get to go to the bathroom and take a snack, and so on? That would be