Week 3: Introduction to Unit 2

Week 3: Introduction to Unit 2

“Introduction to Unit 2 … Mental Accounting … Choice Overload … Self-Control … Spending Uncash … Glossary … Debate … Skills and Knowledge”
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Summaries

  • Unit 2 > 2.0 Introduction to Unit 2 > 2.0.2 Unit 1 Debate Debrief
  • Unit 2 > 2.1 Mental Accounting > 2.1.1 Mental Accounting
  • Unit 2 > 2.1 Mental Accounting > 2.1.3 Decoupling Costs and Benefits
  • University_of_TorontoX: BE101x Behavioural Economics in Action
  • Unit 2 > 2.2 Choice Overload > 2.2.3 Choice Overload: Consequences and Solutions<br /> (06:51)
  • Unit 2 > 2.3 Self-Control > 2.3.1 Ulysses, SS and LL
  • Unit 2 > 2.3 Self-Control > 2.3.3 Self Control Strategies
  • Unit 2 > 2.3 Self-Control > 2.3.5 Self-Control and Choice Over Time: Key Ideas
  • Unit 2 > 2.4 Spending Uncash > 2.4.1 Spending uncash
  • Unit 2 > 2.6 Debate > 2.6.1 Debate 2

  • Then we had three people, Spike Lee who is my colleague here at the University of Toronto, Shankar Vedantam who is the author of The Hidden Brain, and Rory Sutherland from Ogilvy UK and Ogilvy Change who all said no, that irrationality was not damaging to welfare.
  • That’s the gap that a lot of people thought was irrational.
  • The second form, the weak form, the feeling that some of our panelists and some of you had was, who cares? Who cares if in fact people don’t behave according to the laws of economics? And an interesting thought there is if you don’t behave according to the laws of economics, does that make you irrational? I’d make the argument that the irrationality is on the other side.
  • So the expectation that other people are going to use information or behave according to the laws of economics is in itself a form of irrationality.
  • Shankar talked about the fact that when you’re in a plane and there’s turbulence, it is irrational to be worried about it, because these things happen, or it is irrational to be worried about crossing a street because the probability of you getting hit by a car is very low, or it is irrational to worry about traffic accidents and many, many other things that are actually low in probability, but again, irrational from an economic standpoint.
  • You probably will be successful at doing all of that, but at what cost? And that was also the theme that Professor Spike Lee raised in his debate, where he said, what is the metric for actually assessing the outcome? When we talk about welfare, what do we mean? Do we mean people’s bank balances? Do we mean how happy they are? And indeed, if happiness is what we’re trying to pursue, then perhaps the economic definition of rationality doesn’t really matter.
  • When we think about the deviation between what people should be doing and what they actually do, who decides what they should actually be doing? Is it a government? Is it a marketer? Or is it themselves? And as we go through this course, we’ll talk about different forms of discrepancies between what people should be doing and what they actually do.

Unit 2 > 2.1 Mental Accounting > 2.1.1 Mental Accounting

  • Economic theory tells us that money is fungible.
  • Today, I want to spend some time talking about an area of research, mental accounting, which is perhaps the single area in which I have done most of my own research over the past 20 years.
  • The box office tells you that the only way in which you can get to consume the symphony is to buy a second ticket, because there were no seat numbers on the original.
  • Would you buy a second ticket? Here’s a second version of the same story.
  • The question is, would you buy a ticket to the symphony? Now, if you’re an economist, both of these stories are exactly the same story.
  • As Richard Thaler showed us in one of his landmark papers, people in the first story are much more likely to say, no, they would not buy a second ticket than people in the second story.
  • If you lose a ticket, you do not want to buy a second ticket.
  • Why does that happen? Mental accounting explains this story.
  • What is mentally accounting? It is the idea that people tend to label money with certain names.
  • The moment you label money differently, it gets spent differently.
  • If you decide to watch a symphony worth $50, what you might end up doing is to create an account in your head. It’s called the symphony.
  • On the other hand, if you lose cash, that’s OK, because that comes from the general expenses account.
  • People look at their money, and they tend to categorize it into different groups, and, as a result, they spend money differently.
  • A number of years back, I was doing some research in Canada- and previously in India- on different budgeting techniques that people use for their money.
  • That method of budgeting is something called Jar Accounting.
  • Or Viviana Zelizer, who’s a sociologist at Princeton, documents a similar phenomenon that she calls Tin Can Accounting.
  • If there’s money in there, you say, OK. If there isn’t enough money, you say, no.
  • Then you put a label on it- ice cream money and entertainment money.
  • So how do people mentally account? How do they create these different categories? Well, there’s a number of different ways in which they do it.
  • You could mentally account as a function of how you earn the money.
  • If I find money on the streets, I’m going to spend it differently from if I worked really hard to earn it- fun money, laborious money.
  • Money that earn through my salary is typically spent on paying my bills.
  • The other way in which you could account is by time period.
  • Finally you could even create mental accounts for a specific transaction, like the symphony example that we looked at.
  • The metering process looks at counting how much money is actually in the account.
  • Part two is the scope or width of the mental account, defining the category over which that account exists.
  • When I look at the symphony mental account, it’s a narrow mental account.
  • Now, the moment you actually incur or prepay to consume something in the future, it sets up an interesting mental accounting phenomenon that we call the Sunk Cost Effect.
  • In India, when I grew up, there used to be a term that was called “Paisa vasool.” And what “Paisa vasool” stood for is making sure you get your money’s worth.
  • There are people who actually play tennis with a terrible tennis elbow simply because they have prepaid to consume a set of lessons.
  • If people prepay for something, it is very likely that they will want to consume something.
  • That is something that is called the Red and the Black accounting.
  • The moment you prepay, you have a deficit in your account.
  • If you cannot consume, then you have to close your account in the red.
  • People don’t like making losses, and so they are driven to consume that particular product opportunity.
  • So the Sunk Cost Effect turns out to be a huge motivator in nudging people to consume products and services.

Unit 2 > 2.1 Mental Accounting > 2.1.3 Decoupling Costs and Benefits

  • Let’s imagine that you love skiing, and you go to the mountains of Colorado, and you buy a four day ski pass.
  • In the picture in the top, you get one card that you carry with you with your jacket all the time that gives you access to the mountains on all four days.
  • In the second case, in the bottom, you see four separate tickets that are attached to each, and every day you detach one, and give it at the gate.
  • You have three beautiful days of skiing, and on the last day there is warm rain.
  • In other words, would the Sunk Cost Effect of having paid $40 a day make you go to the mountain and ski even in conditions when you shouldn’t? Here’s an interesting story.
  • When you look at the tickets at the bottom left, there is an explicit coupling between each day’s worth of skiing and the expense, which is $40. As a result, that $40 that you’ve prepaid is much more likely to burn the hole in your pocket in the lower case, than if you had a single card, because in the card you can amortize- or allocate- the three equal days of skiing across the $160 that you have spent.
  • What we would expect is people are much more likely to go skiing on a bad day in the condition at the bottom as opposed to the top.
  • We found in an experiment that was run back in 1998 that people are much more likely to ski and fall prey to the Sunk Cost Effect when they have separate tickets each day than if they have just one ticket.
  • We were able to document the payment mechanism that was used, the frequency of payment, as well as the frequency of exercising as a function of how often people paid.
  • On the top left were people who had paid once a year.
  • What’s happened as a result here is that the moment you make people pay on an ongoing basis, they are much more likely to couple the benefits that they get in that given month with the cost.
  • That’s a phenomenon called pennies a day advertising that was first made popular by John Gourville.
  • If you compare it to the cost of a yogurt per day, it suddenly starts becoming more affordable.
  • That’s called a pennies a day strategy, and the idea is simple.
  • You say, I’m spending a few dollars on coffee or yogurt every day.
  • The problem was that the daily expense was so high that people realized that there was nothing else that they did that cost them $19 or $20 a day.
  • So the point is that when people think about a pennies a day strategy, there are two elements of the strategy.
  • Element number one- taking a lump sum expense, and expressing that as a daily expense.
  • Element number two- providing people with a comparison which is a consumption that they occur on an ongoing basis.
  • Comparison with a coffee is great- we all drink coffee once a day.
  • Comparison with something which costs $20, or $30, or $50 a day might backfire because people realize that they’re actually going to spend a lot of money doing that.
  • Here’s a third way in which the coupling between cost and expenses can be weakened, and that is by making the metering process a bit more difficult.
  • You’re on vacation, it’s the last day, you’ve got 400 Thai bahts sitting in your pocket, and you’re back at the airport to go home.
  • What do people really do? They look for ways to spend the remaining $400, because, after all, it is play money at this point in time.
  • We did an experiment in Hong Kong where we took people, endowed them with Hong Kong dollars, or a currency that we call more numerous, Thai bahts, or less numerous, the euro.
  • We found this- what we found was when people were endowed with a more numerous currency, they tended to be more generous with their money.
  • When people were endowed with a less numerous currency, they were much more stingy with their money.
  • The third way is to weaken the metering system whereby people no longer have a good handle on how much they’re actually spending.

University_of_TorontoX: BE101x Behavioural Economics in Action

  • It turns out that too many choices exist not just in investment options, but in a number of different categories.
  • The average American grocery store had about 25 different varieties of bread. It had about 60 varieties of soft drinks.
  • Over the past 20 years, these numbers have grown exponentially.
  • They’ve grown not just in supermarket categories, and not just in your traditional packaged goods categories, but in services, as well.
  • A number of years back, I was at a local Chinese takeout restaurant.
  • It’s got about 185 different items in this menu.
  • Why does that happen? Now, another example, or another category in which you see a lot of choice, is paints.
  • There were 55 different varieties of beige in that particular store.
  • The growth of choice is becoming a big problem in many different product categories.
  • Assumption number one is that the more choice you give people, the more likely they are to find something that best matches their needs.
  • Assumption number two is people need freedom of choice, that people feel better when they have more choice than less.
  • People report, that they feel too much of a pressure and too much stress when they make decisions in a number of product categories.
  • Psychologically, what happens when you give people a lot of choice? There’s two or three things that jump out.
  • The first thing that jumps out is the idea that when you give people lots of options, they need to make fairly complex calculations.
  • The computations involved, the cognition involved, is fairly elaborate, and people don’t have the ability to perform those calculations.
  • What’s going to happen is you’re in a store.
  • So in choices that can’t be reversed, greater assortment leads to greater regret.
  • You see 15, 20, 25 different types of products in the store.
  • What’s happened here is when you’ve given people a large assortment, certain attributes- in this case, the harmonic distortion- seem to impact decision making to a great degree.
  • Essentially, what’s happening here is that greater assortments creates a greater distance between your choice and what keeps you happy.

Unit 2 > 2.2 Choice Overload > 2.2.3 Choice Overload: Consequences and Solutions (06:51)

  • DILIP SOMAN: We just talked about the fact that having too much choice makes it difficult for people to compute the outcome.
  • What are the effects of choice? We document five different kinds of effects in our research.
  • The first thing that you’ll see here is that when you give people a lot of choice, they end up not choosing at all or they choose to defer their participation.
  • In the domain of retirement savings, the common finding is that the moment you give people lots of ways in which they can actually spend their money, lots of funds they can choose from, they choose to not participate in a fund at all because they have difficulty making a choice.
  • The second thing that you often see happening is people tend to make choices that are conservative, that are safe, because they want to minimize the potential for regret.
  • The bigger the choice set, the more likely are they to go with a conservative option.
  • We compared patrons in restaurants that had a fixed price menu, but in one restaurant, there were six items in which people could choose from.
  • We looked at people that dined as dyads, two people that came together, and we asked the following simple question, what percent of people said I’m going to eat what he’s eating? And it turns out that when you give people a longer menu, the second diner was much more likely to choose exactly what his or her partner choose, again pointing to the fact that as decision making became more complex, people resorted to a simplifying heuristic.
  • The fourth effect is again the reliance on peer choices.
  • What we find is beyond a certain number of options, once you get to seven, eight, nine, or 10, people said, I can’t make up my mind there.
  • What we find is that as the number of options in the middle go up, people tend to gravitate more to what’s the basic or the fully loaded.
  • Now, if in fact it is true that people suffer from over choice and it is true that if you give people too much information they have problems processing it, what can we do to help people make better choices? We identify five different strategies in this regard.
  • Oftentimes, you go to a store and you are asked to make a choice between low-fat and regular options.
  • Within the low-fat options, you might have further choices for the categories, and the moment you try and organize all of your complex alternatives within each of those categories, it becomes easier for a consumer to navigate and drill down towards a particular choice, so now they’re making a sequential set of choices rather than making one out of 160 different options.
  • What was the style of cooking? What meat was used? What’s the level of spiciness? What sort of noodle was used? And what sort of vegetables were added? And if you simply asked people to pick along each of these questions, one out of four, which meat do you want? I could give you chicken, I could give you fish, I could give you lamb or pork.
  • Who are these agents? These agents could be experts, and in fact, people do this a lot.

Unit 2 > 2.3 Self-Control > 2.3.1 Ulysses, SS and LL

  • DILIP SOMAN: I want to start off by telling you a story from Greek mythology, and this is the story of Ulysses.
  • In particular, I want to focus on The Odyssey, which is the story of Ulysses returning home after the Trojan War- was a voyage that took 10 years.
  • Perhaps the most interesting part of the story of Ulysses is the story of Ulysses and the sirens.
  • Now of course, Ulysses had heard about this, and what he wanted to do was he wanted to make sure that he would not be a target of these kinds of shipwrecks.
  • Ulysses could hear the singing, but he couldn’t do anything about, as a result, the crew was able to continue rowing and Ulysses was able to continue steering.
  • As an economist, that’s OK, because it simply reflects a large discount rate that you place on the future.
  • Suppose I add an extra year to both options, and now the question is, would you rather take $10 in 52 weeks or $12 in 53 weeks? And when you’re asked that question, everybody is willing to wait one week for the extra two bucks.
  • In sum, guess what’s happening? When people are making a choice between waiting an extra week for an extra $2, they will make it if both choices are in the future but not if both are in the present.
  • What you see is if I’m looking at the future today, I can see that SS is shorter than LL. I’m going to choose LL. I’m going to be patient.
  • As I keep getting closer and closer, I get to a point that’s called the indifference point in an area of time that’s marked on that plot as the lapse zone.
  • You could think about SS and LL as two buildings, and when you look at those two buildings from a distance, you can tell which one is shorter than the other one.
  • Now, the notion that these two lines coming out of SS and LL cross each other is a phenomenon that is called by behavioral economists as hyperbolic discounting.
  • Discounting is the idea that people value things differently in the present as opposed to the future.
  • Hyperbolic refers to the specific equation, the specific functional form which lets those two lines cross each other.
  • SS could be getting the tasty chocolate cake now, LL could be having a healthier life in the future.
  • SS could be working hard at a given point in time and then goofing off, LL could be keeping working hard and making sure you have a secure future.
  • So there are many points in time when we look at options that are in the future, we can see that LL is better than SS, but as soon as we get closer to SS, the tempting option, we choose it.
  • The same option can be framed as you’ve got a good thing coming a week from now, how much do you want to pay to speed it up, versus, I can give you something today, how much of a premium would you accept to delay that same thing.
  • So as a result of these three factors, we end up with the notion of intertemporal choice with the notion that while people know from a distance that LL is bigger than SS, they end up choosing SS as they get close to it.

Unit 2 > 2.3 Self-Control > 2.3.3 Self Control Strategies

  • So the idea behind self control devices is can we think about ways in which the planner can trick the doer, and make sure that they don’t fall prey into a lapse zone? And that’s essentially the heart of self control devices.
  • So when we ask people about whether they want to work hard or not, when they look into the future, the answer is yes.
  • So a simple strategy for getting people to do what is good for them is to get them to pre-commit to doing something for the future, and then figuring out a locking mechanism to make sure that they follow through on that.
  • You commit to saving more tomorrow, and if you do not meet those savings targets, you pay an economic penalty.
  • The site is going to help you find a judge- this is somebody who’s going to monitor your progress- and you can also set up your own cheering groups.
  • So you’re going to say to yourself, I want to lose five pounds, and if I don’t lose five pounds, I’m willing to give up $400. You commit.
  • What happens if you do not meet your target group? There’s two things- one, stickk.com could donate the money that you just gave them to a charity, not of your choice, but a charity that they believe is going to be something that you hate.
  • So people are motivated to actually not lose that money to a cause that they don’t trust.
  • The other locking mechanism that can be used is designing a product, or designing a service, where people almost forget that they are in a contract.
  • By the virtue of the fact that it was a separate mental account, people never saw that extra money being aside.
  • A lot of people actually forgot that they were in the program.
  • When their salaries went up, what they noticed was the separate account where the savings kept going up, but they just did not keep track of the fact that they were in the program.
  • A number of interesting examples of product categories that could involve- in the savings domain, for example- piggy banks, or savings boxes, that can only be opened by two keys.
  • If I have to dip into my savings, the only way I can get to that savings is to ask you to provide your key.
  • So these are just some example of how you can lock people into a behavior that they have committed to doing in the future.
  • Here’s another interesting example of an invention of an intervention that is designed to exert self control.
  • So what you can do is you can impose a lock on your self.
  • What Google will then do is, if you try and send an email in that window, it’s going to make you solve a bunch of math problems- like this one, here.
  • So again what’s happening here is you’ve got a planner who knows that you might end up sending risky emails at a given point in time, and the planner imposes a cost- a lock- on the door, a classic example of self control.
  • So when we think about the notion of self control, you can think about it as a conflict between willpower and desire.
  • How do I reduce desire? Avoidance- people take long walks just to avoid the cake shop on the way to work.
  • If you don’t see it, you’re not going to fall in the lapse zone.
  • A lot of people will chew gum every time they feel like smoking a cigarette.
  • You could tell yourself, I’m only going to spend $200 on a given product in a given month.
  • If there’s no money in there, then you’ve blown your budget, and that acts as a wonderful self control device.

Unit 2 > 2.3 Self-Control > 2.3.5 Self-Control and Choice Over Time: Key Ideas

  • DILIP SOMAN: In this segment, we will review the key ideas from Self-control and Choice Over Time.
  • Future outcomes are valued differently from present outcomes.
  • How much do you need now to make you indifferent? Let’s say that 30 days prior to the outcome, you would require $700 to be indifferent.
  • The line connecting these points is called the discounting function.
  • In this particular discounting function, there is steep discounting close to the outcome, and gradual discounting further away in time.
  • Hyperbolic functions help us understand reversals in preferences as a function of time.
  • In this chart, SS represents a smaller, sooner outcome- say, $10- and LL, a larger, later one- say, $12. When I am here, the discounted value of LL is larger than the discounted value of SS, so I pick LL. But as one gets closer in time to SS, the functions crossover here, and now at this point SS starts looking larger than LL, resulting in an impulsive choice.
  • The doer ends up deviating from plans made by the planner, creating the intention-action gap that we talked about earlier in this course.
  • These smart planners are called sophisticates- people who have self-control problems, they know they have self-control problems, and they want to address those self-control problems.
  • We could now model self-control as a battle between the planner and the doer, or a battle between will power and desire.
  • If you find yourself in this region where you expect that desire will dominate willpower, there are a number of strategies to both reduce desire and to increase willpower.
  • Avoiding the tempting stimulus is an easy desire-reduction strategy, as is the imposition of cooling off periods, a mandatory period of time between making a decision and actually making a purchase.
  • To the extent that you can put a lock on your own behavior at the time that you make an intention to do something good, that lock will help to close the gap between your intentions and actual actions.

Unit 2 > 2.4 Spending Uncash > 2.4.1 Spending uncash

  • DILIP SOMAN: If you google the keywords “How to do laundry,” you will come across hundreds of articles.
  • How many people actually do that? It turns out that the answer depends on how you pay for your laundry.
  • In a study done in a laundromat in 1999, 44% of people who paid with quarters separate their clothes.
  • Today, it’s becoming increasingly easy and convenient to make payments.
  • What happens when the payment form changes and evolves away from cash? The biggest effect of changing away from cash is the fact that metering, in a mental accounting sense, becomes difficult.
  • Think about a simple world in which you could either pay by cash or by credit card.
  • You have a very good idea of how much you’ve paid because the process is very salient.
  • Today it is becoming increasingly more difficult to keep track of how much people have paid.
  • We are going to talk about a concept we call the transparency of the payment mechanism.
  • Cash is easily the most transparent of payment mechanisms simply because you have a very good visual idea of how much you’re paying.
  • If you look at the transparency spectrum, as you start moving away from cash into checks, or plastic, debit cards, credit cards, electronic payments, and, finally autopay- autopay is a system where you authorize your bank account to automatically make bill payments at the end of every month.
  • What starts happening is that consumers lose track of how much they have spent.
  • As you go from the spectrum from left to right, not only does the physical similarity of the payment mechanism to cash change, but also the salience of the payment experience itself reduces over time.
  • We found in our research, a number of years back, then when you look at people that have made payments by cash, those payments are much more memorable, and people are much more accurate recalling how much they had spent by cash.
  • In particular, in our research, we looked at the effect of credit limits on people’s beliefs on how wealthy they were.
  • We found out that people actually tend to use the credit limit as a signal for how prosperous they are.
  • They tend to lose memory for their payments, and they tend to spend faster than people who actually use cash.
  • If you want to control how much you spend, cash is still the king.

Unit 2 > 2.6 Debate > 2.6.1 Debate 2

  • AVI GOLDFARB: Consumer credit is good for a bunch of reasons.
  • If you want to buy a whole bunch of things in one month, say, December, and then have your Christmas presents but then pay it off over the rest of the year, you can do that with consumer credit.
  • Consumer credit cards offer consumers access to unsecured credit that’s accepted around the world by literally millions of retailers.
  • The primary role of credit cards is to offer consumers with interest-free debt.
  • The period of time in which consumer credit card debt is interest-free from the date of purchase until when it has to be paid is up to seven weeks long.
  • Now, of course, at the same time, credit cards offer consumers the opportunity to accumulate debt on which they do have to pay interest.
  • There are a lot of misconceptions about Canadian credit card debt.
  • One reason is that Canadian credit card debt is a little different from US credit card debt.
  • So 70% of Canadian households pay off their credit card bills in full every month.
  • Credit cards account for just 5% of total household debt.
  • They’re using credit cards for short-term debt.
  • There’s a common misconception that the large majority of Canadian credit card debt is carried by very low-income households.
  • Actually, the proportion of low-income, middle-income, and high-income households who carry credit card debt is almost exactly the same.
  • Actually, in Canada, credit card delinquency rates are quite low.
  • They’re half of what they are in the US. There’s also a misconception that Canadians who carry credit card debt do so at high interest rates.
  • Actually, in Canada, there are 70 low interest rate credit cards; 40 of them have interest rates of less than 12%. A significant proportion of credit card debt is carried at 0%, and those 0% introductory rates are available for up to two years.
  • Credit card debt offers Canadians an opportunity to carry debt for short periods of time at reasonable interest rates.
  • MIN ZHAO: I definitely think consumer credit is a curse.
  • So when consumers get an increase of credit line or get the credit line, most of them will automatically think about getting this as free money.
  • Nowadays where we have this generation of people who are impulsive, providing them with credit lines or an increase of credit lines will only encourage their impulsive spending.
  • There’s a good chance, there’s a reasonable chance that people might get into credit card debt.
  • What is interchange fee? Interchange fee is, in short, basically a fee that the merchants have to pay to the credit card system in order to settle the payments.
  • So what happens is, every $100 that you pay, if you pay by credit card, the merchant may only get $97 or $95 back depending on which credit card you are using.

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