Weird Ways People
Think About Money
• People think about money in ways
that make no sense to an economist.
Some of these phenomena were
already covered as motivation for the
introduction of Prospect Theory
(recall the examples of loss
aversion).
• Today we’ll look at a couple of new
quirks - Mental Accounting and
Sunk Costs.
• We’ll try to understand both the
pitfalls and the attractions of these
ways of thinking about money.
Not All Dollars Are
Created Equal
• Imagine that you’ve bought a ticket
to a hit Broadway play.At the theater
you realize you’ve lost your ticket
which cost $100 but you have
enough money in your wallet to
replace it. Do you spend another
$100 to see the performance?
• Now imagine the same scenario,
except you’re planning to buy the
ticket when you arrive. At the box
office, you realize you’ve lost a $100
bill out of your wallet. Still you have
more than enough to buy the ticket.
Do you?
• Many people answer “No” and
“Yes”,respectively, although the
bottom line is the same in each case.
How Mental Accounting
Works
• People who say “No” in the first
instance reason that spending what
amounts to $200 for a play is just too
extravagant.
• They say “Yes” in the second
example because they mentally put
the first $100 in the category of “bad
luck” and the second $100 in the
category of cost of entertainment.
• In each case we would be out $200
at the end of the day - and so in each
case we can either afford to see the
play or we can’t - but our little
mental accounting system sees a
significant difference between the
two.
A Really Bizarre
Example
• On your way home you buy a TV
dinner for $3 using a discount
coupon. As you prepare to cook it,
you get the idea of inviting a friend
over. Your friend says sure.When
you go back to the grocery you have
to pay the regular price of $5 for the
identical dinner. You go home and
cook both dinners but your friend
then cancels. Both dinners are
cooked. You are not hungry enough
to eat both and don’t want to freeze
it. You must eat one and discard the
other. Which one do you eat?
• Out of 89 people in the study, 21
people said they would eat the $5
dinner! (It seems less wasteful!)
Should You Use Your
Savings Account to Pay
Off Your Credit Card?
• An accountant would say, Yes. (Your
savings account is drawing 8%
interest at most; your credit card is
costing you 16% at least.)
• But from a budgeting point of view
it might be disastrous, especially if
you were to then run up your credit
card again!
• Mental accounting can help us
budget but when it gets tied too
strongly to past circumstances it
leads to irrationalities.
What Will You Do With
Your Tax Refund?
• Many people treat a tax refund as an
unexpected bonus or “mad money”
and spend it in ways that they would
never think of spending money in
their savings account.
• (This is also the way people often
treat a jackpot they make at a casino
- it doesn’t feel “real” money and
they put it back in play.)
• So if one were able to decrease the
money withheld for taxes just
enough so that one would get zero
refund and have it put into a savings
account instead, one would
undoubtedly spend that same sum of
money in quite different ways.
Is It Still Grandma’s
Money?
• Other times we label unexpected
money as “sacred”. If Grandma
leaves us money unexpectedly, we
may decide that we should be very
careful with this windfall and keep
it in savings instead of investing it.
• The economist would say we should
think this way: First, we add the
inheritance to our overall financial
picture. Now we forget about the
history of the various dollars that we
own and ask: given my new overall
financial situation, do I need to
invest some money? If so, then I go
balance my portfolio. If I also want
to honor Grandma in some way, then
do so directly. Money is fungible completely interchangeable.
Sunk Cost Trap
• You and your companion have driven half-way to a
resort. Responding to a reduced-rate advertisement,
you have previously made a non-refundable $100
deposit to spend the weekend there. Both you and
your companion feel slightly bad physically and
out of sorts psychologically.
• Your assessment of the situation is that you and
your companion would have a much more
pleasurable weekend at home.
• Your companion says it's "too bad" you have
reserved the room because you both would much
rather spend the time at home, but you can't afford
to waste $100. You agree. Further, you both agree
that given the way you feel now, it is
extraordinarily unlikely you will have a better time
at the resort than you would at home.
• Do you drive on or turn back?
• If you drive on, you are behaving as if you
prefer paying $100 to be where you don't want
to be than to be where you want to be.
Good Money After Bad:
The Sunk Cost Fallacy
• Imagine you’ve been given a
courtside ticket to a Chicago Bulls
game back when Michael Jordan
was playing. Before you leave the
house you learn that Jordan is sick
and won’t be playing, plus a big
snow storm makes the trip
dangerous.Do you go anyway?
• Same scenario except this time you
paid a small fortune for the ticket
and can’t resell it. Do you go?
• Note that in each case, going will
“cost” you the unpleasant trip out to
a not very exciting game. Why
should you be more willing to do
this in the case where you’ve already
spent a lot? Why should the history
of how you got the ticket affect you
decisions about the future?
What’s Wrong With
Including Sunk Costs?
• Both the above are examples of what
economists call the "sunk-cost
fallacy"--the human tendency to
judge options according to the size
of previous investments rather than
the size of the expected return.
• Truly rational choices would be
made looking only at future costs
and benefits.
• Many proverbs remind us of this.
– What’s done is done.
– Don’t throw good money after bad.
– No use crying over spilt milk.
• So where does this human tendency
come from? Does it have any
function?
Re-Thinking Some of
the Cases
• Let’s go back to the couple going to
the resort. Are there any good
reasons for driving on?
• Well, they might perk up when they
got there. (But of course that would
be true if they hadn’t already made
the reservation.)
• Perhaps neither wants to appear
fickle - the kind of person who can’t
follow through on plans and hence
may be unreliable. But this worry is
really about the future and we are no
longer dealing with a sunk cost,
strictly speaking.
• Similarly, taking responsibility for
one’s own past decisions may
contribute to future satisfaction.
The Cost of Not
Admitting Past Mistakes
• The judgments of professional
basketball coaches are also
blighted by sunk costs. They
should play and keep their most
productive players, but Barry
Staw and Ha Hoang at Berkeley
found that players’ salaries
significantly affected both these
decisions.
• The most expensive players
were given more time on court
and kept on the team longer
than cheaper players, even after
adjusting for variables such as
performance, injuries and the
positions they played.
The Cost of Pride
• Sometimes countries are
reluctant to end wars without
total victory because they don’t
want people saying that the
early casualties“died in vain”.
• Governments and businesses
frequently keep spending new
money on expensive projects
even as it becomes clearer and
clearer that the project will lose
even more money.
• Some have called sunk costs
the “Concorde effect”.
Trying to Play Catch-Up
• In one of the earliest studies of the
fallacy, Staw asked business school
students to play the role of corporate
executives who had to allocate
research and development funds to
divisions of their own companies.
The students received feedback on
their initial decisions and were then
asked to make a second investment.
• They put significantly more money
into failing investments than
successful ones, and they invested
even more money if they themselves
were responsible for the earlier
decision rather than another
(unidentified) executive.
Do Animals Respond to
Sunk Costs?
• Dawkins was surprised to discover
what looked like Concorde fallacy
behaviour in female digger wasps.
These wasps paralyse katydids--a
sort of grasshopper--with a sting,
and drag the bodies to their burrows.
Once they have collected four or five
katydids, they lay a single egg that
hatches and feeds on the paralysed
but still living katydids. Sometimes
there's a mix-up and two wasps end
up putting katydids in the same
burrow. When they eventually bump
into one another, they fight for the
right to lay their egg in the burrow.
Fights end when the loser gives up
and retreats.
Yes - It First Appeared
• According to observations made
by Jane Brockmann of the
University of Florida in
Gainesville, how long the losing
wasp keeps fighting depends on
how many katydids she has
already placed in the burrow-that is, the investment to date-rather than the total number of
katydids in the burrow.
• The second option would be the
rational basis for such a
decision because it alone
dictates how much future effort
the wasp must make to fully
stock its larder.
Maybe Not After All
• When Dawkins and Brockmann put
their heads together, they came up
with another explanation for the
wasps' apparently irrational
behaviour. Plainly each wasp knows
how many katydids she placed in her
burrow because that dictates how
long she fights. (She probably
doesn't actually count the number of
katydids, but assesses it indirectly,
perhaps by sensing how much time
she spent flying back and forth from
the burrow.) She is, however, unable
to tell whether another wasp is
stashing katydids in her burrow until
she meets her rival, so it's probably
safe to say that she has trouble
counting the total number of
katydids that are there.
Projecting to the Future
• As the wasp cannot be said to be
ignoring information she does not
have access to, she can hardly be
held to be committing a fallacy. The
two researchers concluded that the
number of katydids each wasp puts
in its burrow is simply the best
estimate of the burrow's future
worth. In that case, it makes sense
for a wasp to fight longer the more
katydids it has put in.
• So this is not a case of making a
decision on the basis of a sunk cost
per se. Rather the sunk cost provides
a basis for predicting the future
value. So this is not a case like the
Concorde.