Decisions by consumers often seem to defy logic

April 20, 2008|By Gregory Karp | Gregory Karp,THE MORNING CALL IN ALLENTOWN, PA.

Who wins your money-spending battles, your inner Mr. Spock or Homer Simpson?

For a long time, economists assumed consumers made calculated and logical spending decisions that are in their best interests; that they would act like the always cool and calm Mr. Spock from Star Trek.

Problem is, in the real world we often behave like the dopey Homer Simpson of the The Simpsons. Like Homer, we repeatedly get into trouble because of poor and impulsive decisions.

You need only look at the rising levels of debt, bankruptcy and mortgage foreclosures, coupled with low savings rates and closets full of ridiculous and never-used junk, to see that somewhere consumers have gone awry with money decisions.

Consumers are not only sometimes irrational but "predictably irrational," according to a new book of that name by Dan Ariely, a professor at Massachusetts Institute of Technology.

In fact, consumers need help in making the right decisions, say Richard H. Thaler and Cass R. Sunstein in their new book, Nudge: Improving Decisions about Health, Wealth and Happiness.

Thaler and Sunstein use the Spock-Homer Simpson analogy.

Both books address a relatively new field of study called behavioral economics. It goes beyond looking at the money decisions people make, to search for why they make them. The books have implications for how you could be spending your money smarter.

Are you irrational?

If you don't think you're irrational with money, answer these questions: Would you mow your own lawn to save $10? Many people say, "Of course." Would you mow your neighbor's lawn to earn $10? Many people respond, "No way."

Interesting, considering that from a money standpoint the questions are the same.

The list is full of examples demonstrating people's irrationality with money. But take heart. No one with rationality short of Mr. Spock's is immune.

Behaving badly.

Behavioral economists place fancy names on a variety of human behaviors that promote irrational decision-making, but here is a layman's rundown of some common ones.

We hate losses about twice as much as we enjoy gains. We hate anything that limits our choices, even though too many choices can lead to bad decisions. We have a need to follow the crowd.

Three ways to win.

So if you accept that you make irrational decisions, there are three primary ways to make fewer bad decisions and more good ones, Ariely said. One is to learn about the miscues humans make and keep them in mind during your decision-making.

Consider the concept of free! Marketers typically punctuate the word with an exclamation point. It seems we consumers are inordinately attracted to choices that include something for free, even if it is the wrong choice. Lowering the price, even to a penny, does not have the effect on us that free does.

The second way is to avoid situations in which you know you will lose the battle.

"An example of this is if you have ever gone hungry to the supermarket and, as a consequence, buy too much food," Ariely said.

The third way is to build in a mechanism to save you from your inner Homer Simpson. An example is the 401(k) retirement plan and other payroll deductions. "We make a decision once, and we create a mechanism carried out for us multiple times without us having to think about it," Ariely said. "That's actually very effective."

Gregory Karp is a personal finance writer for The Morning Call in Allentown, Pa.

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