In contrast to what most economists assume, people do not operate rationally when they come to make economic decisions. All of us are vulnerable to cognitive errors that unconsciously influence our decisions, and may cause us to make mistakes.
In a previous column, we considered the excessive fear that consumers and investors have of suffering a loss – a fear that causes people to take irrational risks. This time we will deal with the irrationality that is sometimes involved in the use of money.
Economists tend to assume that the willingness to spend money for a product is a good indicator for comparison of the utility of various goods and services. The basic assumption is that a monetary criterion remains stable. 100 shekels is always 100 shekels, no matter what its source or what it is used for.
On the basis of this assumption, we are quick to conclude that a person who would be happy to purchase a bottle of wine for 100 shekels, but who is not prepared to buy a theater ticket for that price, derives much greater utility from drinking the wine than from watching a theatrical performance.
Easy money will be wasted faster
Rationally speaking, we would expect people totreat every 100 shekels that they take out of their pockets in the same way. But that’s not how the human brain works.
As Richard Thaler and other researchers have shown, people run a complex system of mental accounts in their minds: expenditures are classified and sorted into different conceptual accounts, as is income from different sources.
As a result of this mental accounting, different funds held by the same person do not serve as substitutes for one another. 100 shekels classified in one account may be worth more or less than 100 shekels “deposited” in another account. For example, people tend more easily to use or waste money that they acquire without effort on their part, or which comes to them in unexpectedly – in comparison with money that they earn through their work. Such behavior is not rational.
An item is on sale? It has greater utility
This mental accounting gives importance to other factors apart from the utility inherent in the product itself. Research has shown that economic utility deriving from purchase of a product is accompanied by psychological utility, which derives from the difference between the price at which the product was purchased and the regular price for that item.
These are two separate kinds of utility that operate together. The first is rational, and it derives from the use that a person is likely to make of the item that he purchased. The second utility is irrational; it derives solely from the question of whether the product was bought for a “bargain price,” its regular price, or perhaps for an exorbitant one.
When a product is purchased at a low price, in comparison to its regular price, we perceive it has having greater utility. This can explain why consumers who encounter a product at a bargain price are willing to purchase it, even when the objective utility inherent in the product is low.
For example, when we purchase a garment at a bargain price, the psychological utility arising from buying at a “bargain price” often outweighs the rational insight that it isn’t quite the right size for the us. In hindsight, it is clear to even the most enthusiastic shopper that buying a garment that can’t be used because it is too small is irrational – even if the garment was purchased for a sum much lower than its regular price.
Is it worth going thirsty to teach the seller a lesson?
The same phenomenon also operates in the reverse direction: purchase of a product at a higher than normal price has a negative effect on the utility that we derive from the product. For example, many people are willing to go thirsty throughout a whole theater performance, rather than paying the exorbitant prices charged drinks sold at the theater.
It is understood that the high price for drinks is an economic consequence of limited supply and the seller’s monopolistic status at the event. But, in contrast to what we generally tell ourselves, our not buying an expensive bottle of drink won’t teach anyone a lesson. Were it not for the fact that this pricing strategy leads to the seller maximizing his profits, he would not have adopted it.
Does the small sum that we save as a result of not buying the drink justify the physical discomfort ofgoingthirsty? It seems that the psychological annoyance involved in the purchase of a product at a price higher than normal overcomes any rational consideration, and leaves us with a parched throat.
50 shekels – is it a lot or a little?
In contrast to what we expect, the value of money is not uniform, but varies in line with the circumstances. Let’s assume that a pocket calculator costs 50 shekels at a shop near where you live, but is sold in another shop, at the other end, of the town for 30 shekels. Many people would prefer to make the effort to travel across town to save 20 shekels, particularly when you consider that this is a saving of 40% on the price of the product.
On the other hand, when a food processor is sold at the nearby store for 550 shekels, and across town for 530 shekels, many people would say that the effort of traveling to the other end of town is not justified for a saving of only 3.6% of the product price. In monetary terms, everyone knows that the saving in both cases is the same. If so, why is 20 shekels saved on the purchase of a food processor worth less to us than 20 shekels saved on the purchase of a pocket calculator?
Lost your tickets to the theater? Let’s go home
In a now-classical experiment, Daniel Kahneman and Amos Tversky asked people what they would do if they were to discover, upon arriving at the theater, that the pair of tickets that they had purchased in advance had disappeared from their wallet and been lost. Would they purchase another pair of tickets, in place of the ones they lost? The majority responded in the negative.
But what would they do had they not purchased the tickets in advance, but when they arrived at the theater they discovered that their wallet was missing a sum of money equal to the price of a pair of tickets? Would they still buy tickets to the theater, as they had planned, or would they have skipped the play? Most of those asked responded that they would purchasetickets and see the play.
It’s clear that the economic outcome of the two examples is similar: in both instances, the subjects lost economic value equal to the price of two theater tickets. The difference between the responses derives from the different mental classification of the expense and the loss. In the first example, the mental calculation is that the expense for seeing the play has already been made; its value has been wasted because of the loss of the tickets. On the other hand, in the second example the loss of money is not specifically connected, in our own minds, with seeing the play. Therefore, the loss of the money, unlike the loss of the tickets, does not prevent the respondents from purchasing tickets and seeing the play as they had planned.
Erroneous accounting also harms income
Mental accounting not only influences the way in which we spend our money, but also the way in which we earn it. This conclusion arises, among other things, from research carried out into the work habits of salaried taxi drivers in New York.
If you have tried to catch a taxi on a rainy day in New York, you will be aware that demand for taxis in New York is not fixed. Demand goes up on rainy days or when there are big conventions in town, and goes down on holidays and special occasions. Rationally speaking, we would expect the salaried taxi drivers to work longer hours when the demand for taxis is high, and to go home early when the demand is low. Such a strategy would maximize their earnings per hour worked.
However, the data indicates that the behavior of taxi drivers is exactly the opposite. When there is a high demand for their services, the drivers finish work early. But when the demand for taxis is weak, then they tend to work longer hours.
The reason for this was an error in mental accounting. In their minds, the taxi drivers add up the income for each day separately;every day they tryto earn a certain minimum sum that they set for themselves. Once they reach their daily target, they feel that they are entitled to go home. When demand for taxis is high, the taxi drivers simply reach their daily target earlier, and leave for home earlier. Paradoxically, on days when demand for taxis is high, there will be less taxis operating in the city.
Money is an ancient, easy to use means of exchange. It has no smell, and some people think that it can buy everything. From a rational point of view, every 100 shekels is equivalent to any other 100 shekels. But in practice, the mental accounting going on in our brains changes our attitude to money, depending on the circumstances, and causes us to act irrationally. Apparently, there must be something to the saying that too much money drives people crazy.
Dr. Tal Rotman is a lawyer and lecturer at Tel Aviv University’s Faculty of Law