Consumer choices are supposed to be based on rational self-interest. Find out how a new study explains why we often make sub-optimal decisions that barely meet our needs.
As the pandemic winds down, it’s nice to be out browsing around in local shops again. Like most people, I’d gotten into the habit of buying most things online over the past couple of years.
One thing I’ve noticed is the number of deals, discounts and virtual coupons online retailers issue. Just about everything that arrives in the mail from an online vendor comes with some sort of passcode offering a discount on my next purchase.
Economists who study how we respond to these offers call their field behavioral economics. Traditionally, it’s been based on the principle that individuals make rational consumer choices based on logical calculations.
Should Align with Self-Interest and Personal Objectives
Traditional economists assume the spending choices people make align a transaction’s outcome with their self-interest and personal objectives. Adam Smith was probably the first economist to raise this idea as part of his idea of the “invisible hand.”
Smith argued that the invisible hand of self-interest guides individuals to make optimal decisions. Through this rational process, the free market comes to an ideal equilibrium for all concerned.
Yet, we also know that things don’t always work out that way. Everyone loves a deal. However, not everyone understands economics or finance well enough to recognize their self-interest.
Consumers Don’t Always Have the Information They Need
Herbert Simon won the Nobel Prize in Economics for pointing out that we usually don’t have all the information we need to make sensible consumer choices. Another economist named Richard Thaler went on to show that we humans have a peculiar kind of mental accounting.
Every merchandiser knows there’s a lot of psychology involved in the way we make purchasing decisions. Some of it isn’t logical.
An example with which we’re all familiar is the way merchants price items at $3.99 instead of $4.00. That trivial one-penny difference sounds massive to our subconscious minds.
Why People Make Sub-Optimal Consumer Choices
Last week, the Review of Behavioral Economics published a new theory about how we make economic decisions. It attempts to explain why people make sub-optimal decisions that barely meet their needs.
Mina Mahmoudi is a lecturer in the Department of Economics at Rensselaer Polytechnic Institute, America’s first technological research university. She’s also the lead author of the paper.
She explains, “Effectively solving some economic problems requires one to think in terms of differences while others require one to think in terms of ratios.” In other words, we learn to compare prices both in percentages and in dollars and cents.
Compare Prices in Percentages and in Dollars and Cents
So, for instance, we may be offered a discount of $5 on an item. We don’t always make optimal conclusions about that kind of discount. Is a $5 discount on a $25 item better than on a $500 item? Most of us tend to think so.
After all, we’re getting 20% of that $25 item and only 1% off the $500 product. Yet, five bucks is five bucks. We’re saving the same amount of money on either deal.
“Because both types of thinking are necessary, it is reasonable to think people develop and apply both types,” Professor Mahmoudi elaborated. “However, it is also reasonable to expect that people misapply the two types of thinking, especially when less experienced with the context.”
Hardly Seems Worth It to Negotiate $5 off a $500 Item
It hardly seems worth it to go to much trouble or to try to negotiate $5 off that $500 item. It feels like chump change. Yet, we’ll pat ourselves on the back for making a sharp consumer choice if we go out of our way to buy the $25 item on sale or haggle with a street vendor to get that same five bucks.
A smart shopper would make the same effort to earn the same $5 no matter what the base price was. This is a case where we should be thinking about the dollars and cents we’re gaining, not the percentage the vendor’s taking off the price. The team calls this the “ratio-difference theory of choice.”
Traditional economists talk about consumers “maximizing our utility.” However, Professor Mahmoudi points to some flaws in that conventional principle.
“Behaviour that Occurs Because People Cannot Maximize”
“Our model provides an example of a behavior that occurs because people cannot maximize,” she explains. For example, we’ve discovered the weaknesses in the formerly fashionable “just-in-time inventory” strategy with the pandemic’s supply chain disruptions.
Consumers also tend to get caught up in fads or try to “keep up with the Joneses.” Consumer brands often succeed for reasons that don’t have much to do with buyers’ practical needs.
“Many economic behaviors such as imitation occur,” Professor Mahmoudi argues, “and many economic institutions like inventories exist because people cannot maximize or because markets are not in equilibrium.”
All We Need to Do Is Visit a Casino
If we want to see people making consumer choices that fail to maximize their financial self-interest, all we need to do is visit a casino. We see it on a larger scale in financial markets where trendy technology companies often trade at share prices far beyond their objective value.
Humanity needs to get past these ways of thinking to deal with the stark sustainable development choices we’re facing. We need to move away from conventional economic models based on short-term thinking, extraction and exploitation.
Learn to Take Full Cost of Production Into Account
We also need to learn to take the full cost of production into account when we make large-scale economic development decisions. For example, many consumers baulk at the idea of a price on carbon because they think of it in terms of a tax rate instead of a small premium in dollars and cents they’ll get back in a rebate.
Professor Mahmoudi summarized the benefits of her theory saying, “Understanding how the cognitive and motivational characteristics of human beings and the operating procedures of organizations influence the working of economic systems is of critical importance.”
We always have more to learn if we dare to know.
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