Thursday, May 30, 2013

Why do we spend irrationaly?

Recently I took this course on Behavioral Economics on Coursera by Dan Ariely. It had some common sensical but good analyses of  the irrationality in our economic behavior. Over next few blogs I would present some of the analyses. See if you can make use of them(at worse, this exercise will at least help me revise ;)

Psychology of money (or rather spending it)

We are bad at considering opportunity costs(especially across time and across categories) when making spending decisions. Instead of considering opportunity costs which would be the right thing to do, we use other things like relativity in prices, discounts, mode of payment etc to justify our decision.
As an example consider the last time you went to buy a Shirt. What did you consider while deciding in favour of the particular shirt you bought? It's price and quality relative to other shirts? Did you consider that, with the same amount you could buy coffee for next 200 days or with the same amount put in bank, you could buy a mobile phone 10 years down the line!

We see our expenses in relative terms when it actually doesn't matter! When we spend 2000, we spend 2000! it doesn't matter whether it was spent relative to an another expense of 20000 or 200.
For example, you would happily go to the other end of city for cheap movie tickets( for saving say Rs 100 ) Would you do the same if a shop is offering 0.5% discount on the Rs.20k mobile phone you want to buy? However, in both cases money saved is 100 Rs! Money doesn't know whether you bought a movie ticket or a phone.

Pain of paying is important- more the pain, lesser we spend. Pain of paying is the most when we pay for something directly in cash and decreases as the mode of payment moves further away from cash.
Ever wondered why expenses tend to increase when you make all payments through card? So, the next time when you want to control your expenses, increase the pain of paying! Some of the ways to do that is to keep less money in your wallet, always pay through cash and keep a record of expenditures.

We believe in being fair to others. Our willingness to pay for a service depends on our perception of the cost we incur to the service provider in terms of time/effort/expense and we want to pay an amount which would adequately compensate the provider( Classical economics says that we should be willing to pay more/less for a service according to the pleasure we derive from the service).
Consider this, scenario one: you call a mechanic who takes a long time to fix things, it vlearly seems from his actions and expressions that he os putting in a lot of effort. Scenario 2: You call a mechanic for the same work; only this time he is very skilled in the work, he does it in minutes and apparently without much effort. Whom would you be willing to pay more? (IT friends, does it ring a bell? My colleague stays late in office without doing any productive work, but gets a better rating...)
Moral of the story: it's important that you work hard but it's also important to show that you work hard!

Other similar posts:
Why do we spend irrationaly?
Who is in control of your decisions?

Follow Dan Ariely at: http://danariely.com