Behavioral Economics

Implications for Teaching Personal Finance

• Dr. Allen Cox• Managing Director• Maryland Coalition for Financial Literacy• Towson University• acox@towson.edu

Consumer Behavior

Let’s First Look at Classical Economic Theory

Rational Choice

• When we decide to buy something, economists make some assumptions about us.

First Assumption

• We prefer more to less

Second Assumption

• We have Preferences• If A>B, and B>C, then A>C• Coke Pepsi Sprite

Third Assumption

• We are Rational Utility Maximizers*PS=TB-TC (Personal Satisfaction = Total

Benefits – Total Costs)• We compare the benefits vs the costs and

make a rational decision.

Fourth Assumption

• We have all the information we need to make an informed choice.

Fifth Assumption

• We have the cognitive ability and the time to weigh every choice against every other choice.

Soooooooo…

• Why did you invest the time, energy and money to be here today?

Conclusion?

• Markets are Efficient and Require very little Government Intervention.

• But, only if the assumptions prove accurate in the real world.

Predictably Irrational

• Duke Professor Dan Ariely’s best selling book presents some very interesting ideas about the way we make decisions.

Professor Dan Ariely

• http://www.youtube.com/watch?v=JhjUJTw2i1M

• Decoy Pricing – Steering consumers to a preferred purchase with a pricing strategy.– The Economists ad

Relativity – A financial condition seems good until you realize something else is better.

• CEO salaries being published:• 1976 Average CEO salary was 36 times the avg

worker• By 1993 Avg CEO salary increased to 131 times• In 1993 Fed Securities Regulators required

companies to detail the salaries and perks of their top executives.

• What do you think happened?

Relativity (continued)

• By 2008, when Predictably Irrational was published, the average CEO salary was 369 times greater than the average worker.

• WHY ?????

Arbitrary Coherence – Seemingly unrelated psychological suggestions can affect behavior.

• In one experiment, Ariely asked his students to write down the last two digits of their social security number, then he gave them a list of items and asked them if they would be willing to pay that amount for each item (yes or no).

• Bottles of wine, computer accessories, and chocolate were on the list of items for purchase.

• Would writing down a social security number have any effect on the students’ willingness to pay a higher or lower price?

Behavior Herding – Making judgments based on what the crowd is doing.

• Observed in Investing

Social versus Market Norms and how they affect our behavior.

• “So why don’t we offer to pay $50 to the host/hostess when we go to a friend’s home for dinner?”

Procrastination and Inertia

• Sometimes too many choices or too much complexity causes us to do nothing, even if we know we will benefit from doing something.

• For example, the Opt in versus Opt out policy for organ donors and pension plans.

Two other Ariely ideas to adjust for our irrational behavior:

* Why not charge everyone for health screenings, then refund the money when we show up to get them?

* How about a “self-control” credit card that will not let you spend more than a certain amount on a specific category of purchases (ex. Clothing)

Three Irrational Quirks

1) “We fall in love with what we already have.” It has sentimental value.

Three Irrational Quirks

2) We focus on what we may lose rather than what we may gain.

Three Irrational Quirks

3) We assume other people will see the transaction from the same perspective we do.

Virtual Ownership

• One goal of advertising is to get us to picture ourselves owning whatever is being advertised.

Another Advertising Trick

• Trial Ownership• “Money back guarantees if not satisfied”• “30 day free membership”• “Try it at home with no obligation to buy”

The Effect of Expectations

• Coke vs Pepsi Experiment• Does prior knowledge “just inform us” or does

it also “determine” our preferences?• Does price determine quality?

Ariely’s Website

• http://danariely.com/• This site has buttons that take you to podcasts

of Ariely interviewing researchers who talk about experiments in behavioral economics.