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Experts customize markdown optimization software with the understanding that retailers and consumers are necessarily at odds: The customer’s goal is to buy at the lowest possible price while the store owner struggles to keep the price high enough to clear a profit. Balancing these opposing goals requires a continuous gathering of information: past and current sales figures, holiday schedules, and store locations. Weather patterns are also important, but not as important as many of us think. “Retailers blame weather for everything, but other things can matter much more,” Ramakrishnan said; “For example, the level of inventory of a particular item a store has in stock.”

If a store has one hundred of the same style of sweater, the sheer gravity of the display will promote sales. But as the inventory dwindles, sales decrease. All things being equal, it is easier to sell fifty of one hundred sweaters than one of two sweaters, Ramakrishnan said. The fifty sweaters may fly out of the store at full price, but an isolated pair of sweaters of the same style, color, and size may well languish indefinitely unless the price is marked down significantly. This makes the paying of markdown money all the more painful. Merchants may well know a particular item won’t sell out but they order it in large numbers to build a plentiful display, only half of which will be sold at full price. This leaves the other half to be marked down repeatedly, generally at the retailer’s discretion and the vendor’s expense. One marketing scholar wrote: “The pyramid of power puts the giant retail chains, significant manufacturers themselves, in the most concentrated position. They are the price makers, not the price takers.”

Markdown optimization software helps retailers avoid “leaving money on the table” by aligning price reductions with customer demand and automatically lowering prices on individual items when they cease to move. The software is sophisticated enough to allow for variations among individual stores and tells retailers when to move merchandise from one store to another to maximize sales. This means that in many chains the markdown on at least some items will vary from store to store, a phenomenon that few consumers are aware of since retailers are loath to make public that the same item might be available at another store in the same chain at a lower price.

Markdowns come in several varieties, each designed to elicit a different consumer response. “A coupon is less dangerous than a straight promotion,” Ramakrishnan said. “Someone has to physically cut it out and bring it to the store, and not everyone is willing to do that. Coupons are a way of having two prices: A price-sensitive person will use the coupon and get a lower price, while a less-price-sensitive person might be willing to pay the full price.” Essentially, coupons are an attempt to solve the fixed price dilemma by offering different customers different price options. And we seem to love them: A 2005 study found that 83 percent of us redeem coupons, for a total of roughly 5 billion and a combined savings of $3 billion.

Rebates do something similar, using a very different strategy and offering a rich source of insight into both discounting and human frailty. Like coupons, they are an enormously popular form of discounting, especially in the high-technology sector where in 2004 roughly 25 percent of all purchases—and nearly half of all computer sales—involved them. The catch is that no matter how much we enjoy the idea of rebates and account for them in our buying calculus, few of us enjoy filing for rebates—and for very sound psychological reasons. Filing for a rebate is anticlimactic, an afterthought demanded of us after the thrill of the hunt is long behind us. It makes perfect sense to seek a rebate and deduct that amount from the mental price of the purchase: A $150 printer with a $100 rebate becomes a $50 purchase in our minds. The rise of rebates offers evidence that the thrill of the now can easily trump the prospect of a long-term payoff. “We play a game of funny math with rebates,” Daniel Ariely told me. “If we buy a fifty-dollar item that promises a thirty-dollar rebate, in our minds we have paid only twenty dollars, and we forget to grab the rebate. We are pleased with ourselves because we account for the money we save, not for the money we spent.” Supermarkets capitalize on this phenomenon by printing more prominently on their cash register receipts the amount shoppers have saved than the amount they have spent, conveying the impression that we are somehow
earning
money in the transaction. “This is motivated reasoning. We want to believe things are a certain way, and so we do,” Ariely said. “We want to believe we got a good deal because it makes us feel richer.”

Rebates come in two varieties, instant and mail-in. Mail-in rebates are by far the more common option, and they are also the more psychologically satisfying for those who use them: Cutting out, filling out, and filing the required paperwork makes us feel that we have earned our reward. For retailers and manufacturers, though, the special beauty of the mail-in rebate is that relatively few of us actually cut out, fill out, and file it. Tracking down reliable rebate redemption rate data is difficult because industry insiders are understandably reluctant to make public this side of their business. But there are hints. As one retailer put it, “Manufacturers love rebates because redemption rates are close to none. They get people into the stores, but when it comes time to collect, few people follow through. And this is just what the manufacturer had in mind.”

This is not always true: Larger rebates for such things as big-screen TVs are more likely than smaller ones to be redeemed. But, as a rule, rebate redemption rates are very low, hovering in the 5 to 10 percent range for many items. Interestingly, some people apparently do not even intend to redeem their rebates when they make a purchase, either because they just don’t care about saving the money or because they consider their time too valuable. This certainly makes sense, but most of us are less rational: We plan to redeem but do not. Marketing scholars refer to this phenomenon as “breakage,” an apt phrase but one that begs the question of precisely what is being broken. Tim Silk, a professor of marketing at the University of British Columbia, is probably better prepared than anyone to answer that question. He has studied rebates for over half a decade and told me that consumer reaction to them is predictable, though counterintuitive.

Manufacturers often affix a deadline to rebates in what they assume is an effort to minimize redemption rates. But Silk’s research gives evidence that the longer we are given to redeem a rebate, the less likely we are to do so, thanks to the normal human inclination to procrastinate in the face of prolonged deadlines. He also found that the more difficult a rebate is to redeem, the more likely it is that it will be redeemed. “There’s a backlash,” he said. “When you cross the threshold of what people believe is a reasonable effort, they get angry and become more determined to get their refund . . . up to a point. Naturally, if you make the process extremely difficult, you’ll probably find fewer takers.”

Rebate breakage plays a critical role in marketing strategy by allowing merchants to have it both ways; they can lure customers with the promise of discounts without having to make them. And as Daniel Ariely explained, while most of us do not redeem our rebates, we
believe
that we will. Hence, in our mental calculus we perceive the slimmed-down rebated price—not the bloated sticker price—as our cost. And we tend to say and even believe we paid the lower price whether or not we redeemed the rebate. This twist of internal accounting is the primary reason that rebates have become so common and so popular.

Our response to rebates is typical of our responses to what psychologists call “intertemporal decisions,” the outcomes of which don’t affect us until well after we make them. Often an action that seems right for now—risking a month’s pay at the races or quaffing three martinis at lunch—will feel terribly wrong tomorrow. As Ariely and others have shown, most of us prefer to grab rewards quickly and delay thinking about the consequences, especially monetary consequences. In the case of a rebate, once we’ve made the purchase and gotten enjoyment from the transaction, an act of will is required to summon the energy and interest to move it forward. The rebate fulfillment industry depends on our not mustering that will since rebate schemes are considered successful only if most purchasers do
not
take advantage of them. Promotions that generate redemption rates greater than 35 percent are considered marginal by manufacturers and retailers; and a 50 percent redemption rate is considered an abject failure. As Tim Silk observed, “From the perspective of the issuing firm, successful rebate programs should increase the number of rebate-dependent purchases (i.e., incremental sales) without encouraging redemptions.”

THE COST OF rebates goes even beyond that incurred by self-delusion. Too often a rebate steers us to make purchases with little forethought, tainting our decision. This is particularly true of items offered with rebates that refund the total price of the purchase. That is, rebates that make things free.

Free is a category unto itself. It can rob us of our reason. Razor blade maker King Camp Gillette took full advantage of this temporary insanity. Gillette grew rich handing out free safety razors to generate demand for his pricy disposable blades. A hundred or so years later a similar business model informs the workings of entire product segments: computer printers and cell phones, to name but two. Rebate the full price of a printer and gain a buyer for your overpriced printer cartridges. Rebate the full price of a cell phone and freeze the customer for two years into your service plan. Most of us respond to free offers by assuming that they are better than other options; it is very difficult to pass up a free printer for one that costs real money. But at the same time most of us know instinctively that freebies must come with a catch. For this reason we have developed some unconscious but fairly consistent internal rules for free.

Consider the free sample in the local supermarket, perhaps a selection of tempting cheddar cheese bits impaled on toothpicks. Studies show that most of us will take only one, perhaps because taking more would appear discourteous or greedy. But when we are charged a penny for each nibble of cheese, more of us take more than one, perhaps because the penny payment psychologically liberates us from the guilt of freeloading. Daniel Ariely has tested this phenomenon using candy as a lure. He found that when offered a Starburst for a penny, the average subject bought four, but when offered free Starbursts, the average subject took only one. Free, he said, elicits a response like no other: It is the point on the mental money meter at which reaching the lowest possible price (zero) both increases and reduces demand. Free is unique among price points because it jettisons market-based values and the question of whether the object or service is worth the cost, in favor of social-based values and the question of whether we are worthy of the object or service. It also softens us up for the sell: Research shows that samplers are much more likely than nonsamplers to buy the product.

Ariely was so intrigued by the paradoxical power of zero to both stimulate and stifle demand that he conducted another empirical study to test it. He offered sixty subjects three choices: a Hershey’s Kiss for one cent, a Ferrero Rocher hazelnut chocolate for twenty-six cents, or nothing at all for zero cents. Twenty percent of subjects chose nothing at all, 40 percent chose the Kiss, and 40 percent went for the more luxurious Ferrero Rocher candy. Ariely then offered the same subjects the same choice on different terms: nothing for no money, twenty-five cents for the Ferrero Rocher, or a chocolate Kiss for free. This time every subject took something, but only 10 percent took the Ferrero Rocher and 90 percent went for the Hershey’s Kiss. “When something is free, it has no down side and becomes elevated in our minds,” Ariely said. Those who chose the free chocolate forfeited the opportunity to get a more valuable chocolate at a much reduced price, but as merchandisers well know, the average shopper does not worry much about such “opportunity loss.”

One of the mysteries of free is why we so often pursue it when it is against our interests to do so. I once attended a street fair in Cambridge, Massachusetts, and noticed an extremely long line of people snaking toward an open serving window of a Ben & Jerry’s ice cream truck. On closer inspection it became clear that the ice cream was free. “Free ice cream,” it occurred to me, was not the same thing as ice cream. “Ice cream” did not explain why at least two-dozen teenagers—iPod’s firmly in place—were waiting with uncharacteristic patience. “Free ice cream” explained this perfectly. But “free” did not entirely account for the twenty or so middle-aged patrons shuffling slowly toward their single scoop. From the well-dressed look of them, most of these boomers earned something more than minimum wage. An ice cream cone costs about $3 and is worth maybe ten minutes of their time, but certainly not the thirty-plus minutes it was taking them to get served. At least some of these people were bound to be highly paid professionals who were effectively shelling out $50 or even $100 in billables for a scoop of Chunky Monkey. But was Chunky Monkey even available? As it turned out, it was not. Only chocolate, vanilla, and chocolate chip cookie dough were on board the truck that afternoon. Ben & Jerry’s Cambridge Scoop Shop, just four blocks away, had many, many more choices, and when I strolled over to take a look, had no line at all. The people waiting in line were willing to invest their time—and forgo their freedom of choice—for free. Very low prices—especially zero—tend to make us overvalue the deal itself in relation to the object of the deal. This is a boon for merchants who know that as their price approaches zero, consumers tend to lower their expectations and become more willing to endure significant costs, generally the highest cost being their time.