I try to be frugal. But my instincts as a consumer are mistaken. Behavioral economics suggests that I’m often frugal in the wrong way and that you may be, too.
Consider this situation: You’re shopping for headphones. An electronics store has the model you want for $50, a reasonable price. But a sales clerk says: “You know our other branch has this item on sale for $40.” Going to that store will take 30 minutes, and you can’t buy the headphones for that price online. Do you go to the other branch?
Before you answer, consider a slightly modified version of the same situation: Instead of headphones, you are buying speakers. You go to the same store and find the model you want for $400. Again, the price seems reasonable but the sales clerk says it’s on sale at the other branch for $385. What do you do now?
The psychologists whose work helped spawn behavioral economics, suggests that people are more likely to make the trip for the $40 headphones than for the $385 speakers.
At first glance, this makes sense. By taking the trouble to go to the other store, you can save 20 percent on the headphones and only 3.75 percent on the speakers. The bigger percentage in savings is more appealing.
Though intuitive, this way of looking at the choices is mistaken. In each case it will take 30 minutes to save some money. But with the headphones, you save $10; with the speakers, you save $15.
It’s as if you had two identical job offers, but one paid $20 an hour and the other $30. Yet you consistently chose the lower-paying job.
We tend to focus on the percentage rather than the amount we save, and fall prey to a mental illusion. After all, when your shopping is done, it is dollars — not percentages — that will be in your bank account.
This error is pernicious because it leads to a great deal of misdirected frugality. Ofer H. Azar, an economist at Ben-Gurion University in Israel, asked consumers in the United States how much they needed to save to justify spending an extra 20 minutes. The same pattern emerged. When shopping for a $10 pen, they required only a $3.75 savings, on average. For a $30,000 car, though, they needed $277.83 for that 20 minutes.
This kind of foolish frugality is common. Consider how easy it is to fritter away time surfing the web for, say, a great deal on a $50 pair of jeans. Yet many of us spend no time at all on our investments. The result is that we barely glance at the fees charged by mutual funds: Without thinking much about it, we will choose a fund that charges an extra 0.25 percentage point rather than spend the time to find a cheaper one. That’s reasonable on the face of it. What’s a quarter of a percent? But that seemingly tiny percentage difference can easily amount to thousands of dollars of lost money. We brag to our friends about how much we saved on the jeans — “30 percent off!” — never mentioning (or even registering) the money we threw away on our investments.
Another of Professor’s Azar’s papers summarizes the problem perfectly: “Do Consumers Make Too Much Effort to Save on Cheap Items and Too Little to Save on Expensive Items?” The answer is, resoundingly, “Yes.” ( The investments is a costly & serious affair).
Complicating matters is the fact that marketers understand this all too well. When you go to buy a new car, at the very end of the transaction, the dealer may suggest some add-ons. And you may be tempted to bite. Once you’re paying tens of thousands of dollars, what’s an extra $200 for a better sound system? It’s not just a problem with car sales. When you’re buying a $1,000 computer, why quibble over a little extra for a bigger hard drive? Or when you’re choosing a large flat-screen TV, why not pay a little more for one that is a few inches bigger?
This is a slippery slope. Once you have gotten started, substantial sums can feel small. If you have remodeled your home recently, this may be painfully familiar.
What all of this amounts to is a tendency to think in relative rather than absolute terms. In some ways, what we experience as consumers is like what we experience when we listen to music or lift a heavy object. For example, we are more likely to notice that a drumbeat is loud if we have been listening to, say, a gentle violin. And we will notice that we are lifting extra pounds if they are added to a lightly packed suitcase. The same additional weight is barely noticeable in a heavy one. Vision, heat perception, smell and taste all obey a similar law: Perception is largely a relative mechanism.
Recent work in neuroeconomics suggests this link between dollars and senses is not just metaphorical. The economists Antonio Rangel of the California Institute of Technology and John A. Clithero of Pomona College say similar factors are at play in both cases.
This neurological connection is fascinating, a reminder that even higher order cognition has humble origins. But these kinds of errors aren’t inevitable. We may not be able to control how our senses manage stimuli, but we can control how we manage our money.
Not everyone falls prey to this effect, as Anuj K. Shah, a professor of behavioral science at the University of Chicago, has demonstrated in research done with Eldar Shafir, a psychology professor at Princeton, and me.
For one thing, lower-income people behave more consistently as consumers than more affluent ones. Poorer people tend to value a dollar more consistently, irrespective of the context. It is not simply that those with less money pinch more pennies; it is that they are compelled to value those pennies in absolute rather than relative terms.
Whereas the well-off may dabble in frugality, necessity makes the poor experts in it. To them, a dollar has real tangible value. A dollar saved is a dollar to be spent elsewhere, not merely a piece of token accounting.
The insight here is simple: When it comes to money, stop looking at relative values and start looking at absolutes. Dollars, not percentages, matter. In this case, the well-off can learn something about money management from the poor. ( See the total return on the investment portfolio and not scheme wise or even %age wise!!
This is an article written by SENDHIL MULLAINATHAN on Feb 16,2016 Published by The Times Of India.