Imagine that you purchased a ticket to a concert given by your favorite musical group. On the evening of the concert, a blizzard makes travel extremely hazardous. Would you go? Now imagine that you had been given this same ticket. Would you be more or less likely to travel to the concert in this case than in the previous case?
Or, suppose that you were given $200 and these two options: A) a sure gain of $50 or B) a 25% chance of winning $200 and a 75% chance of winning nothing. Which would you choose? Now, suppose that you were given $400 and these two options: C) a sure loss of $150 or D) a 3/4 chance of losing $200 and a 1/4 chance of losing nothing. Which would you choose?1
If you are like most people, you would be less likely to go to the concert if the ticket were given to you. However, this response is, according to the logic of economics, irrational. If you are like most people, you will choose A over B and D over C in the second example. Again, this is an irrational response. Examples such as these suggest that we should be cautious in assuming that people are rational calculating machines. There are cases in which people deviate from the behavior that the simple calculus of utility maximization says they should follow, and these deviations are predictable. Richard Thaler said that this behavior was "quasi-rational," a clever term that others sometimes use. More often, the study of these situations, and more generally the attempt to incorporate insights from psychology into economics, is called behavioral economics.
When given the concert example, many people find it difficult to believe that it should make no difference how one obtains the ticket.2 The easiest way to see the logic of economics is to ask what determines the value of the ticket. Is it the cost of the ticket or is it the value of the concert? If it is the value of the concert (the economist's answer), it should be obvious that you should be equally likely to go in either case. If you want to say it is the cost, what is the value of a forged ticket that you bought? Does it have value because you spent money on it, even if it will not get you admitted to the concert?
If you analyze the second case above, you will see that situation A and C are identical, as are B and D. In A or C, one is offered a sure gain of $250; and in B or D, one is offered a 25% chance of $400 and a 75% chance of $200. Yet the way of framing the question seems to trick the human mind into seeing these options in very different ways.
The economists and psychologists studying these anomalies have suggested that our mental abilities cannot process the economic information in our lives as the abstract logic of consumer choice says we should, and in order to deal with it, we develop mental accounting systems. Sometimes, these systems are more than mental, as when families have separate savings accounts for various items. They will often borrow money rather than dip into one of these special accounts, though a calculating-machine mind would never do that.
One feature of most mental accounting systems is that they start from a fixed point, usually the status quo. Changes coded as losses seem to have a greater emotional impact than changes coded as gains. As a result, if a situation is seen as an actual loss rather than as a gain not taken, it has a greater impact on people than if it is seen in the other way. However, economic theory says an actual loss and a gain not taken are equivalent.3 This asymmetry in dealing with losses and gains is called "loss aversion."
If we can be fooled by the way situations are framed, people selling things to us should be smart enough to take advantage of this computational defect. There are a number of situations in which this seems to happen.
We are more pleased with many small gains than one big gain of equal magnitudewe would rather get our Christmas presents in lots of boxes rather than one big one. There are innumerable sales pitches that promise something free if and only if we buy a product. If we think about this, we realize that nothing is freewe are paying for the complete package. Yet, the popularity of this type of sales pitch suggests that it works.
Alternatively, we are less affected by one big loss than a number of small ones of equal value. One of the appeals of credit cards is that they give us the bad news as one number. Also, sellers know that when we make a large purchase, they have an opportunity to sell us even more. If we are paying $100,000 for a house, an extra $1000 does not seem to be much to add on some conveniences. However, if we see the extra $1000 as a completely separate transaction, we may react in a very different way.
Although the free trial with money-back guarantee is a way to signal quality, it also takes advantage of our mental accounting. Once we have an item at home and in use, it becomes part of the status quo. Giving it up is coded as an actual loss rather than a gain not taken and affects us more.
If you are still dubious about people relying on mental accounting rules, ask yourself why so many prices are in nines: $9.95, $19.95, $999.99, etc. Why not simply round them up to an even number? The author has been immersed in economics for almost 30 years and finds it amusing that he has mental accounting techniques that violate the logic of economic choice and that they are so deeply ingrained he cannot get rid of them. If you start examining how you view the world, you will probably find that you too often make decisions in ways that violate the logic of choice.
Having seen that one can harbor reservations about the traditional theory of choice, we next return to that theory to see why economists prefer cash to in-kind transfers.
1 This example is from Slovic and Lichtenstein, "Preference Reversals," American Economic Review, Sept. 1983, p. 601. Much of the rest of the material is based on Richard H. Thaler's Quasi Rational Economics (New York: Russell Sage Foundation, 1991).
2"The lure of the sunk cost is so strong in this problem that, when it is presented to subjects untrained in economics, substantial explanations must be given to convince subjects that the economic analysis is sensible." Thaler, p. 148.
3The fact that people consider losses as different from foregone gains seems to have been understood by Aristotle. "It is easier not to take than to give because we are more inclined to be too stingy with our own goods than to take another's." See his Nicomachean Ethics, Book IV.
Copyright Robert Schenk