Dan Ariely

In today’s economy, consumers and financial institutions alike are constantly on the lookout for new ways to reduce spending. As you read this article, consider these questions: what cost-cutting habits has your organization developed, and are they rational? Do you recognize irrational or habitual spending tendencies in your own customers and members? If so, how can you help them make better decisions that lead to improved savings?

Money is an integral part of modern life. We constantly make decisions about whether we’re willing to pay for different products and, if so, how much we are willing to pay. In fact, we make decisions about money so often that we consider money to be a natural part of our environment.

However, money is a relatively recent invention, and despite its incredible economic usefulness it does come with its own set of problems. In particular, it turns out that decisions about money are often unintuitive and, in fact, quite difficult. Consider the following situation as an example: you are thirsty, tired, and annoyed and just want a cup of coffee. You see two coffee shops across the street from each other. One is a specialty coffee shop that sells handcrafted, designer coffee and the other is Dunkin’ Donuts, which sells standard, decent coffee. The price difference between the two options is $1.75 for your cup-a-joe. Now, how do you decide if the benefit of the handcrafted coffee drink is worth the additional $1.75?

What you should do (if you wanted to be rational about it) is consider all of the things that you could buy with that $1.75, now as well as in the future, and decide to buy the expensive coffee only if the difference between the two coffees is more valuable than all of those other possibilities.

But of course this computation would take hours, it is incredibly complex, and who even knows all the possible options to consider?

Heuristically Speaking

So what do we do when we need to make decisions but making them “correctly” is too time-consuming and difficult? We adopt simplifying rules, which academics call heuristics, and these heuristics provide us with actionable outcomes that might not be ideal but that help us to reach a decision. One of the heuristics we often use is to look at our own past behaviors, and if we find evidence of relevant past decisions, we simply repeat those.

In the case of coffee, for example, you might search your memory for other instances in which you visited regular or fancy coffee shops. Then you might assess which behavior is more frequent, and tell yourself, “If I’ve done Action X more than Action Y in the past, this must mean that I prefer Action X to Action Y” and as a consequence, you make your decision.

The strategy of looking at our past behaviors and repeating them might seem at first glance to be very reasonable. However, it suffers from at least two potential problems. First, it can turn a few mediocre decisions into a long-term habit. For example, after we have gone to a fancy coffee shop three times in a row and paid a premium for the same coffee we could get elsewhere, we might continue with this strategy for a long time without reconsidering how much we are really willing to pay for coffee.

The second downfall is that when market conditions change, we are unlikely to revise our strategy. For example, if the price difference between the regular and fancy coffee used to be $0.25 and over the years has increased to $1.75, we might stay with our original decision even though the conditions that supported it are no longer applicable.

Examine old habits

In light of our current financial situation, many people these days are looking for places to cut financial spending. Once we understand how we use habits as a way to simplify our financial decision making, we can also look more effectively into ways to save money.

If we assume that our past decisions have always been sensible and reasonable then we should not scrutinize our long-term habits. After all, if we’ve done something for five years, it must be a great decision. But if we understand that long-term, repeated behaviors might reflect our habitual decision making in the face of complex financial decisions more than they reflect what is truly best for us, we might first examine our old habits and carefully consider whether they indeed make sense or not. We can examine our subscription to the ESPN Sports Package, our annual subscription to the opera, our yearly Disneyland vacation, or our monthly visit to the hairstylist.

By examining these habits — and quitting them when it makes sense to do so — we might actually discover ways in which we could reduce our spending on a long-term basis.

Yes, money is complex, and it is incredibly difficult for us to carefully examine (and re-examine) every purchasing decision we make. But the advantage of examining our habits is that it might lead us to create better ones that will benefit us for a long time.

May you have a happy and exciting new year,

Dan

This column first appeared at http://www.deluxeknowledgeexchange.com

Here it is again: holiday gift-giving season – the best win-win of the year for some, and a time to regret having so many relatives for others.

Whatever your gift philosophy, you may be thinking that you would be happier if you could just spend the money on yourself – but according to a three-part study by Elizabeth Dunn, Lara Aknin, and Michael Norton, givers can get more happiness than people who spend the money on themselves.

Liz, Lara and Mike approached the study from the perspective that happiness is less dependent on stable circumstances (income) and more on the day-to-day activities in which a person chooses to engage (gift-giving vs. personal purchases).

To that end, they surveyed a representative sample of 632 Americans on their spending choices and happiness levels and found that while the amount of personal spending (bills included) was unrelated to reported happiness, prosocial spending was associated with significantly higher happiness.

Next, they took a longitudinal approach to the topic: they gave out work bonuses to employees at a company and later checked who was happier – those who spent the money on themselves, or those who put it toward gifts or charity. Again they found that prosocial spending was the only significant predictor of happiness.

But because correlation doesn’t imply causation, they next took one more, experimental, look at the topic. Here, they randomly assigned participants to “you must spend the money on other people” and “spend the money on yourself” conditions — and gave them either $5 or $20 to spend by the day’s end. They then had participants rate their happiness levels both before and just after the experiment.

The results here were once more in favor of prosocial spending: though the amount of money  ($5 vs $20) played no significant role on happiness, the type of spending did.

Surprised by the outcome? You’re not the only one: the researchers later asked other participants to predict the results and learned that 63% of them mistakenly thought that personal spending would bring more job than prosocial purchases.

Happy holidays

Dan

Consider some of illusion at the bottom of the demo page (click here to see it).

The two middle color patches look as if they are different, but in fact they are exactly the same. What is gong on here? How can it be that we see wrong? How can it be that eve after we are shown that these two patches are identical we still can’t see them accurately?

It is because our brain is wired in a particular ways and this wiring, while very good for some things, is not perfect — and it makes us susceptible to certain errors and mistakes. Moreover, because these mistakes are a part of us, we are fooled by them in predictable and consistent ways over and over.

Now, vision is our best system. We have lots of practice with it (we see many hours in the day and for many years) and more of our brain is dedicated to vision than to any other activities. So consider this — if we make mistakes in vision, what is the chance that we would not make mistakes in other domains? Particularly in domains which are more complex (dealing with insurance, money, etc.), and ones in which we have less practice? Domains such as decision making and economic reasoning?

Not very high I think — and this is why we have lots of decision illusions. The predictable, repeated mistakes we all make in our financial, medical, and other daily decisions.

Irrationally yours

Dan

Some quick reflections on the ways money is useful and difficult to deal with — and some ways we can fight back.

Money is an integral part of modern life. We constantly make decisions about whether we’re willing to pay for different products and, if so, how much we are willing to pay. In fact, we make decisions about money so often that we consider money to be a natural part of our environment.

However, money is a relatively recent invention, and despite its incredible economic usefulness it does come with its own set of problems. In particular, it turns out that decisions about money are often non-intuitive and, in fact, quite difficult. Consider the following situation as an example: You are thirsty, tired, and annoyed and just want a cup of coffee. You see two coffee shops across the street from each another. One is a specialty coffee shop that sells handcrafted, designer coffee and the other is Dunkin’ Donuts which sells standard, decent coffee. The price difference between the two options is $1.75 for your cup-a-joe. Now, how do you decide if the benefit of the handcrafted coffee drink is worth the additional $1.75?

What you should do (if you wanted to be rational about it) is consider all of the things that you could buy with that $1.75, now as well as in the future, and decide to buy the expensive coffee only if the difference between the two coffees is more valuable than all of those other possibilities. But of course this computation would take hours, it is incredibly complex, and who even knows all the possible options to consider?

So what do we do when we need to make decisions but making them “correctly” is too time consuming and difficult? We adopt simplifying rules, which academics call heuristics, and these heuristics provide us with actionable outcomes that might not be ideal but they help us to reach a decision. In the case of coffee and other, similar decisions, one of the heuristics we often use is to look at our own past behaviors and if we find evidence of relevant past decisions, we simply repeat those. In the case of coffee, for example, you might search your memory for other instances in which you visited regular fancy coffee shops. Assess which one of those two behaviors is more frequent and then you tell yourself “If I’ve done Action X more than Action Y in the past, this must mean that I prefer Action X to action Y” and as a consequence, you make your decision.

The strategy of looking at our past behaviors and repeating them, might seem at first glance to be very reasonable. However, it also suffers from at least two potential problems. First, it can make a few mediocre decisions into a long-term habit. For example, after we have gone to a fancy coffee shop three times in a row, we might reason that this is a great decision for us and continue with the same strategy for a long time. The second downfall is that when the conditions in the market change, we are unlikely to revise our strategy. For example, if the price difference between the fancy & standard coffee shop used to be 25¢ and over the years has increased to $1.75, we might stay with our original decision even though the conditions that supported it are no longer applicable.

In light of our current financial situation, many people these days are looking for places to cut financial spending. Once we understand how we use habits as a way to simplify our financial decision-making, we can also look more effectively into ways to save money. If we assume that our past decisions have always been sensible and reasonable then we should not scrutinize our long-term habits. After all, if we’ve done something for five years, it must be a great decision. But if we understand that long-term, repeated behaviors might reflect our habitual decision-making in the face of complex financial decisions more than they reflect what is truly best for us, we might first examine our old habits and carefully consider whether they indeed make sense or not. We can examine our subscription to the ESPN Sports Package, our annual subscription to the opera, our yearly Disneyland vacation, or our monthly visit to the hairdresser. By examining these habits, and quitting them when it makes sense to do so, we might actually discover ways in which we could reduce our spending on a long-term basis.

Yes, money is complex, and it is incredibly difficult for us to carefully examine every purchasing decision we make. But the advantage of examining our habits is that it might lead us to create good ones that will benefit us for a long time.

We usually accept without argument the notion that man is at the top of the animal hierarchy. After all, only mammals have a neocortex – the most recently evolved part of the brain and the center of higher mental functions – and ours is the most advanced variation, so it makes sense that we’d be at a higher stage of development.

But is this true? Does the neocortex always make us more rational than other animals?

Most of the time, the answer is yes. For instance, it’s thanks to our neocortex that we are able to plan for the future, something that animals have a hard time doing. (They are even worse at saving than we are!)

Still, this isn’t always the case, as the following chimpanzee experiment suggests. In “Chimpanzees are rational maximizers in an ultimatum game,” researchers Keith Jensen, Josep Call, and Michael Tomasello looked into how chimps fare at one of the classic tests of human rationality, the ultimatum game.

In the human version of this game, a “proposer” is handed some money, say $10, and must suggest a division of the sum for himself and another participant. This other person, the “responder,” can then either accept or reject the offer. If he chooses to accept the division, both participants receive their share; if he opts to reject it, neither gets compensated.

Now, if we were to go by the traditional economic model of man as a self-interested rational maximizer, we would suppose that the proposers would always suggest a division that maximized his self-interest (an $9/$1 division) and that the responders would always accept a nonzero offer ($1 may not be $9, but it’s still better than nothing).

Except, this is not what happens. Research has shown that we human beings not only consider how best to maximize our compensation, but we also factor in such notions as cooperation and fairness when we make our decisions. For example, responders in the ultimatum game will often reject a monetary division that is particularly unfair for them (such as a $8/$2 division) – even when this comes at their own cost (they lose the $2, after all). This behavior is of course wonderfully human — but it is not part of the standard rational model.

Chimpanzees, however, go about the ultimatum game (which involves divisions of raisins in their case) without giving fairness any thought. In this experiment, the researchers found that the chimp responders tended to accept any nonzero offer, however unfair. And conversely, the chimp proposers rarely suggested a fair division, choosing instead to maximize their own share.

In this case, then, animals are more rational than we are. Whereas we’re willing to lose a couple bucks so that the other guy gets punished for his inequitable offer, chimps only act according to what will guarantee them the most raisons.

This curious turning-of-tables suggests that we might want to think differently about the neocortex. Overall, we’re better off having it, as without our sense of right and wrong, we would lack empathy and the ability to reinforce societal rules. Yet, in certain contexts, the neocortex can cause us not to maximize our self-interest. Evolution, then, is a mixed blessing: it makes us better some things, and worse at others.

Motivating people is an extremely difficult and delicate task as anyone who’s ever taught, managed, collaborated with or given birth to someone knows. In business, as opposed to say, child-rearing, the debate is slightly less daunting, though not always much clearer. For instance, offering incentives to employees for improved performance is a fairly common approach to encouraging higher sales —though surprisingly unproven by data.

For the most part, the effectiveness of incentives is supported by intuition and some anecdotal evidence. Wouldn’t everyone work at least a little harder for a $100 bill on top of their usual paycheck? Certainly it can’t hurt. But one important open question is whether monetary or tangible (spa retreat, ipod, dinner for two, etc) rewards more efficacious motivators?

Those who advocate for monetary incentives claim they have the greatest appeal given that the winners can do anything with them; what if someone needs an ipod like they need another hole in their head? On the other side, those in favor of tangible incentives argued that money lacks the emotional appeal of, say, a weekend for two at a romantic country inn or swank hotel. But either way, there was nothing to back up either camp.

Thankfully, there is some data on this debate.  A few years ago Goodyear Tire & Rubber Company decided to test which method was more successful in an effort to improve sales of a new line of Aquatred tires. Their plan was simple and elegant: first they ranked their 60 retail districts according to previous sales, then divided them into two groups of equal performance and assigned one group to receive monetary incentives and the other to receive tangible incentives of equal value to the first group.

The results were very interesting; it turned out that the tangible-reward group increased sales by 46% more than the monetary-reward group. They also improved in terms of the mix of products sold by 37%. One explanation, and it seems to me a fairly good one, is that we can visualize tangible rewards (imagine yourself on a Hawaiian beach), which creates an emotional response. Money, on the other hand, is not accompanied by images as often (aside from maybe Scrooge McDuck swimming in piles of it), and lacks the emotional pull that tangible rewards have, so they’re less effective in motivating employees. I guess it’s called “cold, hard cash” rather than “future beach vacation cash” for a reason.

Our prehistoric ancestors spent much of their waking hours foraging for and consuming food, an instinct that obviously paid off. Today this instinct is no less powerful, but for billions of us it’s satisfied in the minutes it takes to swing by the store and pop a meal in the microwave. With our physical needs sated and time on our hands, increasingly we’re finding psychological outlets for this drive, by seeking out and consuming concepts.

Conceptual consumption strongly influences physical consumption. Keeping up with the Joneses is an obvious example. The SUV in the driveway is only partly about the need for transport; the concept consumed is status. Dozens of studies tease out the many ways in which concepts  influence people’s consumption, independent of the physical thing being consumed. Here are just three of the classes of conceptual consumption that we and others have identified.

Consuming expectations. People’s expectation about the value of what they’re consuming profoundly affects their experience. We know that people have favorite beverage brands, for instance, but in blind taste tests they frequently can’t tell one from another: The value that marketers attach to the brand, rather than the drink’s flavor, is often what truly adds to the taste experience. Recent brain imaging studies show that when people believe they’re drinking expensive wine, their reward circuitry is more active than when they think they’re drinking cheap wine – even when the wines are identical. Similarly, when people believe they’re taking cheap painkillers, they experience less relief than when they take the same but higher-priced pills.

Consuming goals. Pursuing a goal can be a powerful trigger for consumption. At a convenience store where the average purchase was $4, researchers gave some customers coupons that offered $1 off any purchase of $6, and others coupons that offered $1 off any purchase of at least $2. Customers who received the coupon that required a $6 purchase increased their spending in an effort to receive their dollar off; more interestingly, those customers who received the coupon that required only a $2 purchase to receive the dollar off actually decreased their spending from their typical $4, though of course they would have received their dollar off had they spent $4. Consuming the specific goal implied by the coupon – receiving a savings on a purchase of a designated amount — trumped people’s initial inclinations. Customers who received the $2 coupon left the store with fewer items than they had intended to buy.

Consuming memories. One study of how memories influence consumption explored the phenomenon whereby people who have truly enjoyed an experience, such as a special evening out, sometimes prefer not to repeat it. We might expect that they would want to experience the physical consumption of such an evening again; but by forgoing repeat visits, they are preserving their ability to consume the pure memory – the concept – of that evening forever, without the risk of polluting it with a less-special evening.

While concepts can influence people to consume more physical stuff, they can also encourage them to consume less. Offering people a chance to trade undesirable physical consumption for conceptual consumption is one way to help them make wiser choices. In Sacramento, for example, if people use less energy than their neighbors, they get a smiley face on their utility bill (or two if they’re really good) – a tactic that has reduced energy use in the district and is now being employed in Chicago, Seattle, and eight other cities. In this case, people forgo energy consumption in order to consume the concept of being greener than their neighbors.

We suggest that examining people’s motivations through the lens of conceptual consumption can help policy makers, marketers, and managers craft incentives to drive desired behavior – for better or for worse.

by Dan Ariely and Michael I. Norton

The full paper on which this article is based is available here.

They say money can’t buy happiness. That might be true, but a new study suggests money holds more benefits in store than just the obvious ones. A clever set of experiments by Xinyue Zhou, Kathleen D. Vohs and Roy F. Baumeister suggest that simply handling money can dull physical and emotional pain.

Previous research has shown that social exclusion and physical pain share common underlying mechanisms. This is due to the way we evolved as social animals. In fact, a 2003 study (Eisenberger et al.) showed that the brain produces similar responses to social rejection as to physical pain. Other work (Vohs et al., 2006) revealed that thoughts of money convey feelings of self-sufficiency, thus soothing the uneasiness of social exclusion. Putting these findings together, Zhou et al. propose that money and physical pain are linked to one another, and they set out to examine this connection as well as the connection money has to social distress.

Three pairs of experiments were carried out on university students, looking to see if:

a. social exclusion and physical pain increase the desire for money
b. money can appease this pain, both physical and emotional
c. losing money intensifies these sensations. As it turns out from the study, the answer to all of these hypotheses is yes.

Since I liked the design of the study I’ll describe it succinctly as I introduce the findings. The impatient reader can skip the part in blue.

The first pair of experiments explored if the desire for money increases with social rejection and physical pain. Researchers let groups of four get acquainted with each other, and then split them to individual rooms. The subjects were then told that they were not picked by any of the others as partners for a dyad task, to stem feelings of social rejection (subjects in the control group were told everyone chose them). After this semi-cruel manipulation, the subjects’ desire for money was measured in three different measures (e.g. the sum they were willing to donate to an orphanage) and in all three the participants in the rejected condition expressed higher desire for money, compared to their ‘popular’ counterparts.

In the second experiment, half the subjects were primed to the idea of physical pain with word-completion tasks, while the other half was exposed to neutral concepts. Simply priming the notion of pain also increased the desire for money.

The next pair of experiments investigated if money can sooth pain. Subjects in the one condition were asked to count eighty $100 bills, in order to invoke the feeling of obtaining money, while the other subjects counted 80 pieces of paper (all this under the pretence of a finger-dexterity task). Then, one experiment had subject play ‘Cyberball’ – a computerized ball-tossing game with other players. The participants were lead to believe the players were human but in fact were a simple computer program. Subjects in the exclusion condition weren’t passed the ball and were effectively left out of the game by the other ‘players’. How tragic it must have been for some of them – it’s the grade school playground all over again. After the game ended participants were questioned about their experience, and – as you might have guessed it – those who counted money beforehand felt less social distress over being left out of the game, and maintained higher self-esteem than those who counted paper.

The other experiment of the pair is possibly the most interesting in the bunch. After that same money/paper counting exercise, the poor participants had to undergo a pain-sensitivity task (and all they got in return was partial course credit!). Zhou et al. used another approach – they put subjects’ hands in an immobilizing contraption and then poured hot water on their fingers. After this ‘pleasantness’, subjects rated how painful was this experience. The results indicate that simply counting money significantly reduced feelings of pain in the high-pain condition, and that it made participants feel stronger than those who counted paper.

The last pair of experiments used similar measures to show that thinking about losing money actually intensifies the sting of social rejection (Cyberball) and exacerbate physical pain (hot water again). Subjects in the money-losing condition indeed reported higher vulnerability in both cases.

To sum up, these experiments suggest that having financial resources diminishes pain, both physical pain and emotional pain caused by social rejection. Possibly the most interesting thing to pinpoint is that the method these findings were obtained indicates a general perception of money as a mean to alleviate pain and suffering. This is because money by itself had no value in the experiments as it could not “buy” any passes of the ball nor a release out of the hand constraints. It is also interesting to notice that merely thinking about having or losing money, without any actual change in resources, had the described effects since the experimenters didn’t award (or take) the subjects any money (neither as a part of the experiments nor for their participation).

This study springs several implications to mind. As for me, I wonder if there will ever come a day that a dentist appointment will kick off with a brief game of monopoly (one where the patient always accumulates great wealth) prior to the actual treatment. It just might alleviate the pain.

Reference: Zhou, X., Vohs, K., & Baumeister, R. (2009). The Symbolic Power of Money: Reminders of Money Alter Social Distress and Physical Pain Psychological Science.

Before the financial crisis of 2008, it was rather difficult to convince people that we all might have irrational tendencies.

For example, after I gave a presentation at a conference, a fellow I’ll call Mr. Logic (a composite of many people I have debated with over the years) buttonholed me. “I enjoy hearing about all the different kinds of small-scale irrationalities that you demonstrate in your experiments,” he told me, handing me his card. “They’re quite interesting-great stories for cocktail parties.” He paused. “But you don’t understand how things work in the real world. Clearly, when it comes to making important decisions, all of these irrationalities disappear, because when it truly matters, people think carefully about their options before they act. And certainly when it comes to the stock market, where the decisions are critically important, all these irrationalities go away and rationality prevails.”

Given these kinds of responses, I was often left scratching my head, wondering why so many smart people are convinced that irrationality disappears when it comes to important decisions about money. Why do they assume that institutions, competition, and market mechanisms can inoculate us against mistakes? If competition was sufficient to overcome irrationality, wouldn’t that eliminate brawls in sporting competitions, or the irrational self-destructive behaviors of professional athletes? What is it about circumstances involving money and competition that might make people more rational? Do the defenders of rationality believe that we have different brain mechanisms for making small versus large decisions and yet another yet another for dealing with the stock market? Or do they simply have a bone-deep belief that the invisible hand and the wisdom of the markets guarantee optimal behavior under all conditions?

As a social scientist, I’m not sure which model describing human behavior in markets-rational economics, behavioral economics, or something else-is best, and I wish we could set up a series of experiments to figure this out. Unfortunately, since it is basically impossible to do any real experiments with the stock market, I’ve been left befuddled by the deep conviction in the rationality of the market. And I’ve wondered if we really want to build our financial institutions, our legal system, and our policies on such a foundation.

As I was asking myself these questions, something very big happened. Soon after Predictably Irrational was published, in early 2008, the financial world blew to smithereens, like something in a science fiction movie. Alan Greenspan, the formerly much-worshipped chairman of the Federal Reserve, told Congress in October 2008 that he was “shocked” (shocked!) that the markets did not work as anticipated, or automatically self-correct as they were supposed to. He said he made a mistake in assuming that the self-interest of organizations, specifically banks and others, was such that they were capable of protecting their own shareholders. For my part, I was shocked that Greenspan, one of the tireless advocates of deregulation and a true believer in letting market forces have their way, would publicly admit that his assumptions about the rationality of markets were wrong. A few months before this confession, I could never have imagined that Greenspan would utter such a statement. Aside from feeling vindicated, I also felt that Greenspan’s confession was an important step forward. After all, they say that the first step toward recovery is admitting you have a problem.

Still, the terrible loss of homes and jobs has been a very high price to pay for learning that we might not be as rational as Greenspan and other traditional economists had thought. What we’ve learned is that relying on standard economic theory alone as a guiding principle for building markets and institutions might, in fact, be dangerous. It has become tragically clear that the mistakes we all make are not at all random, but part and parcel of the human condition. Worse, our mistakes of judgment can aggregate in the market, sparking a scenario in which, much like an earthquake, no one has any idea what is happening. All of a sudden, it looked as if some people were beginning to understand that the study of small-scale mistakes was not just a source for amusing dinner-table anecdotes. I felt both exonerated and relieved.

While this is a very depressing time for the economy as a whole, and for all of us individually, the turnabout on Greenspan’s part has created new opportunities for behavioral economics, and for those willing to learn and alter the way they think and behave. From crisis comes opportunity, and perhaps this tragedy will cause us to finally accommodate new ideas, and-I hope-begin to rebuild.