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.

Change Begets Change
This is how you put a positive spin on the recession.

In a new study, Moore School of Business marketing professor Stacy Wood suggests that it’s in times of upheaval that we’re particularly inclined to leave our comfort zone and try new things.

On first thought, this sounds counter-intuitive. You would think that upon losing our job or girlfriend, we’d be more intent on crawling under the sheets with a favorite book or movie and lying low for a while – not deciding that now’s the time to quit smoking or take up sky-diving.

And yet, these are the very kinds of challenges that we’re likely to take on following a big life change, according to Wood. In her study, she ran five related experiments comparing participants’ consumer choices with the degree of stability in their lives at the time.

In the initial experiment, for instance, she had undergrads take their pick between a pack of tried-and-true Lay’s potato chips and a bag of unfamiliar and odd-flavored British crisps (Camembert and plum, anyone?). Afterwards, she handed out a questionnaire that checked for the number of changes occurring in the participants’ lives. And the result? The students who chose the unusual chips were also more likely to be experiencing lots of change at the moment.

Wood later switched up the order of the questionnaire and consumer choice task in a follow-up experiment, and in another she also expanded the choice test to include a wide range of items – and still, the results were the same. When she asked participants to think about either two big life changes or eight, those who thought of more chose the strange chips more often.

It seems that when we are confronted with one disruption to our daily routine, we become more open to other change. Or, to put it differently, when things break, we enter the right mind-frame for breaking our old habits as well. According to Wood’s rationale, this is because once something pivotal in our routine gets switched around, we’re no longer so attached to all the other habits that formed our daily script.

When it comes to our recessionary times, then, it appears that now is a good time for us to embrace all kinds of change. A tighter budget or shorter hours at work might be that catalyst you need to reevaluate your daily shot of Starbucks espresso or your aversion toward exercise. To paraphrase President Obama, (and for somewhat different reasons) now’s the time to believe in change.

Reflecting back on our recent economic history bring to my mind a two sad surprises.

Even as a behavioral economist who generally believes in the prevalence of irrationality in our every day life, I place some stock in the main mechanism that should have maintained the efficiency of the financial markets: competition. In principle, the drive for competition among individuals, banks, and financial institutions should get the actors in the market to do the right thing for their clients as they fight to outdo their competition. After the Wall Street fiasco, I expected and hoped that in the spirit of competition some financial institutions would change their way given the new information about the risks they were talking and self-impose restrictions on themselves. I did not expect that they would do so because they were benevolent, but because they wanted to get the business of those who have lost trust in the financial institutions.

Surprise one: Sadly, the forces of competition do not seem to have any effect on the functioning of our financial institutions and Wall Street seems to be back to is pre-fiasco structure.

We are now discussing the possibility of health care reform, which arguably is even more messed up than our financial institutions (about 18 percent of GDP, bad incentives, bad intuitions, and the leading cause for bankruptcy before the current housing problem). When I look at the health care debate, it seems to be fueled by ideological beliefs about the importance of competition and freedom of choice on one hand, and the evilness of regulations and limits on the other. As someone who loves data beyond theories, it is surprising to me how little we know about the effectiveness of different versions of health care, and how sure people are in their own beliefs — which makes it an ideological and not a very useful debate (this is just a small surprise).

But what is the most surprising to me is that the tremendously expensive lessons we have experienced about the efficiency of markets and self interest do not seem to carry to the health care debate. As a society, we still seem to be enamored with the ideology of free markets, and have not seemed to update our beliefs in their efficiency despite the evidence. On the bright side, it looks like behavioral economists will have a lot of work for the foreseeable future.

Ever since the financial meltdown, and throughout this recession, people keep asking me if I’m optimistic about our future. I think people are actually asking two questions: Where does one naturally fall on the optimism spectrum? And is there a place for optimism in our present circumstances?

One of the most basic findings in behavioral economics is what’s called the “optimism bias,” also known as the “positivity” illusion.

The basic idea is that when people judge their chances of experiencing a good outcome–getting a great job or having a successful marriage, healthy kids, or financial security–they estimate their odds to be higher than average. But when they contemplate the probability that something bad will befall them (a heart attack, a divorce, a parking ticket), they estimate their odds to be lower than those of other people.

This optimism bias transcends gender, age, education, and nationality–although it seems to be correlated with the absence of depression. Depressed people tend to show a smaller optimism bias. They also have a more accurate take on reality–perceptions more in line with what actuaries figure to be their real chances of divorcing, suffering a heart attack, and so on.

UNDERESTIMATING RISK

It is interesting to ponder the utility of over-optimism. It’s not a simple matter, because it can both hurt and help us. Individuals often suffer because of an overly bright outlook. They wind up dead, or poor, or bankrupt because they underestimated the downside of taking a certain path. But society as a whole often benefits from behavior spurred by upbeat outlooks.

It’s the inverse of “the paradox of thrift,” which holds that saving money (instead of consuming) may be good for an individual but is bad for an economy trying to grow.

Overoptimism works the other way. Imagine a society in which no one would take on the risk of creating startups, developing new medications, or opening new businesses. We know most new enterprises fail in the first few years. Yet they crop up all the time, sometimes jump-starting entirely new sectors. A society in which no one is overly optimistic and no one takes too much risk? Such a culture wouldn’t advance much.

So are there objective reasons for optimism in the current recession? There are. Amid the countless half-empty glasses strewn about at the moment, there are many that could be viewed as half-full. Most important, there are lessons we can absorb–insights that point to ways we can improve things. And what’s more optimistic than believing in the possibility of improvement?

This recession has delivered a huge lesson in how far human folly and irrationality can lead us astray–into conflicts of interest, extrapolating long-term projections from short-term trends, putting too much trust in economic advisers, and so on. I don’t anticipate that the downturn will change human nature. We aren’t better, more thoughtful people now. And we’re unlikely to become phoenixes rising from our fiscal ashes. But I am hopeful that if we take these painful lessons to heart (and mind), we might create lasting changes.

There are signs we are doing so, sometimes because there’s no other choice. From my perch as a professor, I see undergraduates turning to volunteering, startups, and the pursuit of all kinds of dreams. And for the first time in many years, Americans are starting to save money. (This might not quicken the recovery, but it’s good for the economy long term.) Manufacturers are building smaller, more sustainable homes and cars. And some banks (banks!) are thinking about how to help consumers become more financially responsible.

Finally, it looks as if there are advances in banking regulations that will endure–those mandating clearer disclosures of mortgage rules, for instance, and those making banks more accountable. Changes like these are unlikely to prevent all future financial shenanigans. But I’m optimistic about their ability to prevent some of them.

This reflection first appeared in Businessweek

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.

A few days ago Dan wrote about Don Moore’s research on how we accept advice from others. A lab experiment showed that subjects adhered to advice from confident, not necessarily accurate, sources. The findings of another research, led by Prof. Gregory Berns of Emory University, show another aspect of our reaction to advice.

Berns recorded his subjects’ brain activity with an fMRI machine while they made simulated financial decisions. Each round subjects had to choose between receiving a risk-free payment and trying their chances at a lottery. In some rounds they were presented with an advice from an “expert economist” as to which alternative they consider to be better.

The results are surprising. Expert advice attenuated activity in areas of the brain that correlate with valuation and probability weighting. Simply put, the advice made the brain switch off (at least to a great extent) processes required for financial decision-making. This response, supported by subjects’ actual decisions in the task, are troublesome, perhaps even frightening. The expert advice given in the experiment was suboptimal – meaning the subjects could have done better had they weighted their options themselves. But how could they? Their brains were somewhat dormant.

References:
Jan B. Engelmann, C. Monica Capra, Charles Noussair, Gregory S. Berns (2009). Expert Financial Advice Neurobiologically “Offloads” Financial Decision-Making under Risk.

“For the great majority of mankind are satisfied with appearances, as though they were realities, and are more often influenced by the things that ‘seem’ than by those that ‘are.'”
-16th-century Italian politician Niccolo Machiavelli

It’s something we come across regularly: presentation trumps content. Often what matters is not what we know, or what we have done, but rather how we spin it. It’s why cover letters are so important, and why the peripheral route to persuasion – one of advertising’s biggest weapons – works.

Now, Don Moore of Carnegie Mellon University demonstrated yet another way that we are heavily influenced by delivery — We tend to seek advice from experts who exhibit the most confidence – even when we know they haven’t been particularly accurate in the past.

In his experiment, Don had volunteers guess the weight of people in photographs, and paid them for their correct answers. But before each guess, the volunteers were asked to choose one of four advice-givers (also volunteers) from whom to buy advice. Each advice-giver submitted their weight guess in percentage form, with some advisers spreading out their advice over multiple weight ranges. So, one advisor might have said that there was a 70% chance that the person’s weight was 170-179 pounds, a 15% chance that it was 160-169, and a 15% chance that it was 180-189. A more confident advisor, however, would have put all his eggs in one basket and said there was a 100% chance that the weight was within the 170-179 range.

Now here’s the really important part: in each round, before they chose their adviser, volunteers got to see each adviser’s percentage spread, but not the associated weight ranges. (See this really handy chart for more on the set-up.)

What did Moore find? Volunteers were more likely to buy advice from confident advisers (such as the 100% adviser from above) than those who spread out their percentages. What’s more, this tendency led advisors to make their advice more and more precise in subsequent rounds – but not more accurate.

These findings are troublesome. Because though confidence and accuracy sometimes go hand-in-hand, they don’t necessarily do so. And when we want confident advisors, some will exaggerate to give us what we want.  Maybe this is why so many pundits on TV for example exaggerate their certainty?

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.