Category: Economics 10e: Ch 04

How to get the most from your money? This is the question posed by the linked article below. It’s a topic we’ve looked at in previous posts, such as Studies show that money can buy happiness (but only if you spend on experiences), Happiness economics and Peak stuff. This article takes the arguments further.

It suggests that, up to a certain level of income, there is a roughly linear relationship between money and life satisfaction. As poor people have more to spend, so they can begin to escape poverty and the negative features of financial insecurity and a lack of basic necessities, such as food and shelter. They also gain a greater freedom to choose what and when to buy. Beyond a certain level, however, the rate of increase in life satisfaction tends to decline, as does the specific pleasure from additional individual purchases. In economists’ language, the marginal utility of income diminishes.

But the article goes further than this. It suggests that satisfaction or happiness is of two broad types. The first is the general sense of well-being that people get from their life. This tends to be relatively stable for any given person, but will tend to increase as people have more money to spend or have more fulfilling jobs. Of course, there may well be a trade-off between income and job satisfaction. Some people may prefer to take a cut in pay for a more fulfilling job.

The second is the satisfaction or happiness you get from specific experiences. This tends to fluctuate on a day-to-day basis, depending on what you are doing. Here, what you purchase and the use you make of the purchases is a key component.

So what lessons are there for earning and spending money wisely? To start with, it is important to get a good work-life balance. It may be worth trading income for job satisfaction. Here the focus should be on long-term fulfilment, rather than on the short-term happiness from more ‘stuff’. Then it is important to spend money wisely. Here the author identifies three lessons:

The first is to consider buying time. Time-saving purchases, such as dishwashers can help. So too can ‘outsourcing’ activities, such as cleaning, laundry, cooking, DIY or child care, if they give you more time to do other more fulfilling things (but not if you love doing them!).

The second is to spend more money on experiences (as we saw in the post Studies show that money can buy happiness (but only if you spend on experiences). A better TV or car may seem like a wiser investment than more dinners out, holidays or going to concerts. But we quickly adapt to new upgraded ‘stuff’, thereby eliminating any additional satisfaction. Experiences, however, tend to linger in the memory. As Tom Gilovich, a psychology professor at Cornell University, is quoted by the article as saying:

Even though, in a material sense, they [experiences] come and go, they live on in the stories we tell, the relationships we cement, and ultimately in the sense of who we are.

Choosing a more fulfilling but less well-paid job is a form of spending money on experiences.

The third is to give some of your money away, whether to charity or to helping friends or relatives. As Gilovich says:

It’s hard to find a more charming finding than that by giving away money, you not only make someone else happier, you make yourself happier.

Article

Questions

  1. What is meant by ‘diminishing marginal utility of income’? Is the concept consistent with the arguments in the article?
  2. In what sense may it be rational to choose a lower-paid job?
  3. Is ‘happiness’ the same as ‘utility’ as the concept is used by economists?
  4. Does the concept of ‘peak stuff’ apply to all physical products? Explain your answer.
  5. If giving money away makes a person happy, is it truly altruistic for that person to do so? Explain.

Economists are often criticised for making inaccurate forecasts and for making false assumptions. Their analysis is frequently dismissed by politicians when it contradicts their own views.

But is this fair? Have economists responded to the realities of the global economy and to the behaviour of people, firms, institutions and government as they respond to economic circumstances? The answer is a qualified yes.

Behavioural economics is increasingly challenging the simple assumption that people are ‘rational’, in the sense that they maximise their self interest by weighing up the marginal costs and benefits of alternatives open to them. And macroeconomic models are evolving to take account of a range of drivers of global growth and the business cycle.

The linked article and podcast below look at the views of 2019 Nobel Prize-winning economist Esther Duflo. She has challenged some of the traditional assumptions of economics about the nature of rationality and what motivates people. But her work is still very much in the tradition of economists. She examines evidence and sees how people respond to incentives and then derives policy implications from the analysis.

Take the case of the mobility of labour. She examines why people who lose their jobs may not always move to a new one if it’s in a different town. Partly this is for financial reasons – moving is costly and housing may be more expensive where the new job is located. Partly, however, it is for reasons of identity. Many people are attached to where they currently live. They may be reluctant to leave family and friends and familiar surroundings and hope that a new job will turn up – even if it means a cut in wages. This is not irrational; it just means that people are driven by more than simply wages.

Duflo is doing what economists typically do – examining behaviour in the light of evidence. In her case, she is revisiting the concept of rationality to take account of evidence on what motivates people and the way they behave.

In the light of workers’ motivation, she considers the implications for the gains from trade. Is free trade policy necessarily desirable if people lose their jobs because of cheap imports from China and other developing countries where labour costs are low?

The answer is not a clear yes or no, as import-competing industries are only part of the story. If protectionist policies are pursued, other countries may retaliate with protectionist policies themselves. In such cases, people working in the export sector may lose their jobs.

She also looks at how people may respond to a rise or cut in tax rates. Again the answer is not clear cut and an examination of empirical evidence is necessary to devise appropriate policy. Not only is there an income and substitution effect from tax changes, but people are motivated to work by factors other than take-home pay. Likewise, firms are encouraged to invest by factors other than the simple post-tax profitability of investment.

Podcast

Article

Questions

  1. In traditional ‘neoclassical’ economics, what is meant by ‘rationality’ in terms of (a) consumer behaviour; (b) producer behaviour?
  2. How might the concept of rationality be expanded to take into account a whole range of factors other than the direct costs and benefits of a decision?
  3. What is meant by bounded rationality?
  4. What would be the effect on workers’ willingness to work more or fewer hours as a result of a cut in the marginal income tax rate if (a) the income effect was greater than the substitution effect; (b) the substitution effect was greater than the income effect? Would your answers to (a) and (b) be the opposite in the case of a rise in the marginal income tax rate?
  5. Give some arguments that you consider to be legitimate for imposing controls on imports in (a) the short run; (b) the long run. How might you counter these arguments from a free-trade perspective?

Coffee cupCoffee chain Starbucks announced last week that it is trialling the introduction a 5p charge for takeaway cups. The proceeds will be donated to environmental charity Hubbub. Starbucks is the first UK coffee chain to make such a move and it hopes that the charge will reduce the use of disposable cups.

Perhaps unwittingly, Starbucks appears to have based its trial on important insights from behavioural economics and this may significantly increase the likelihood that it is successful.

Behavioural economics was thrown into the spotlight last year when one of its leading advocates, Richard Thaler, was awarded the Nobel prize in Economics. However, two of Thaler’s mentors, Amos Tversky and Daniel Kahneman, sowed the seeds for the field of behavioural economics. Most notably, in one of the most cited papers in economics, in 1979 they published a ground breaking alternative to the standard model of consumer choice.

One of the key insights from their model, known as prospect theory, is that rather than simply being concerned with their overall level of wealth, individuals care about gains and losses in wealth relative to a reference point. Furthermore, individuals are loss averse – a loss hurts about twice as much as an equivalent gain makes them feel good.

So how does this help to predict how consumers will react to Starbucks’ trial? Well, crucially, Starbucks is increasing the price of coffee in a takeaway cup. Prospect theory predicts that consumers will see this as a loss relative to the pre-trial price, which serves as a reference point. Since this hurts them a lot, they will be likely to take measures to avoid the levy. In support of this, research undertaken by Starbucks shows that 48% of consumers asked said that they would definitely carry a reusable cup to avoid paying the extra 5p.

As the company’s vice-president of communications, Simon Redfern, made clear, this would be in stark contrast to Starbucks’ previous attempts to reduce waste:

We’ve offered a reusable cup discount for 20 years, with only 1.8% of customers currently taking up this offer.

Furthermore, in 2016 they even experimented with increasing the discount from 25p to 50p. However, the impact on consumer behaviour remained low. Again, this evidence is entirely consistent with prospect theory. If consumers view the discounted price as a gain relative to their reference point, while they would feel some benefit from saving money, this would be felt much less than the equivalent loss would be.

Therefore, it seems likely that introducing a charge for takeaway cups will prove a much better way to reduce waste. More generally, this example demonstrates that the significant insights which prospect and other behavioural theories provide should be taken into account when trying to intervene to influence consumer behaviour in markets.

Articles

Questions

  1. How do you think rivals might respond to Starbuck’s strategy?
  2. Are there any other strategies Starbuck’s might pursue to help reduce the use of disposable cups?
  3. Can you think of any other situations in which individuals exhibit loss aversion?

Each year for the past 60 years, the ONS has published ‘Family Spending’, which ‘gives an insight into the spending habits of UK households, broken down by household characteristics and types of spending’. The latest issue, covering the financial year ending 2017, has just been released.

To mark the 60th anniversary, the ONS has also published a blog, Celebrating 60 years of Family Spending, which compares spending patterns in 2017 with those in 1957. The blog looks at the percentage of the family budget spent on various categories, such as food, clothing, housing, tobacco and alcohol. Some of the percentages have changed dramatically over the years; others have hardly changed at all.

Before you read on, of the six categories mentioned above, which do you think have increased, which fallen and which stayed the same? What is your reasoning?

Differences in patterns of consumption partly reflect incomes. In 1957, real household income was £381 in today’s prices; today it’s £544 (43% more). You would expect, therefore, that a greater proportion of household incomes today would be spent on more luxurious goods, with a higher income elasticity of demand.

Other changes in consumption patterns reflect changes in tastes and attitudes. Thus there has been a huge fall in the proportion of household income spent on tobacco – down from 6% in 1957 to 1% in 2017.

Three of the biggest changes over the 60 years have been in housing costs, food and clothing. Housing costs (rent, mortgage interest, council tax, maintenance and home repairs) have doubled from around 9% to around 18% (although they were around 20% before the huge fall in interest rates following the financial crisis of 2007–8). Expenditure on food, by contrast, has fallen – from around 33% to around 16%. Expenditure on clothing has also fallen, from around 10% to around 5%.

Expenditure on alcohol, on the other hand, having risen somewhat in the 1970s and 80s, is roughly the same today as it was 60 years ago, at around 3% of household expenditure.

Some of the explanations for these changing patterns can be found on the supply side – changing costs of production, new technologies and competition; others can be found on the demand side – changes in tastes and changes in incomes. Some goods and services which we use today, such as computers, mobile phones, many other electrical goods, high-tech gyms and social media were simply not available 60 years ago.

Articles

Celebrating 60 years of Family Spending ONS blog, Joanna Bulman (18/1/18)
How did households budget in 1957? BBC News, Simon Gompertz (18/1/18)
Rising burden of housing costs shown by 60-year UK spending survey Financial Times, Gemma Tetlow (18/1/18)

Data

Family spending in the UK: financial year ending 2017 ONS Statistical Bulletin (18/1/18)
All data related to Family spending in the UK: financial year ending 2017 ONS datasets (18/1/18)

Questions

  1. Why has expenditure on housing increased so much as a proportion of household expenditure? What underlying factors help to explain this?
  2. Why has expenditure on food fallen as a proportion of household expenditure? Are the explanations on both the demand and supply sides?
  3. What has happened to the proportion of expenditure going on leisure goods and services? Explain.
  4. What factors affect the proportion of expenditure going on motoring?
  5. Of the broad categories of expenditure considered in this blog, which would you expect to increase, which to decrease and which to stay roughly the same over the coming 10 years? Why?
  6. If expenditure on a particualar good falls as a percentage of total expenditure as income rises, does this make it an inferior good? Explain.

We are coming into the big spending season, with Black Friday, Cyber Monday, the run-up to Christmas and then the winter sales. So will we all be rational maximisers and weigh up the utility we expect to receive from items against the price we pay (plus any other cost, such as time spent searching/shopping)? Or will we use a set of heuristics which make life easier and that we have found to be useful in helping us choose – heuristics such as buying things we’ve liked before, or going for things on special offer?

The answer is that we do probably use a set of heuristics, at least for many items. And don’t the retailers and the marketing firms they employ know this!

They will use all sorts of tricks of the trade to persuade us to part with our money. These tricks are designed to nudge us (or push us), without us feeling manipulated or conned – at least until we’ve bought their product.

And the tricks are getting more sophisticated. They include special offers which are not as good as they seem, time-limited offers which stimulate us to buy quickly without carefully thinking about what we’re doing, cunning positioning of products in shops to encourage us to buy things we had not planned to buy, adverts which play to our idealised perceptions or the ‘good life’ or what we would like to achieve, and packaging or display which make the product seem better than it is.

Also we are increasingly faced with targeted advertising where our smart devices capture information about our spending habits and tastes through our previous online spending or our search behaviour. This is then fed to advertisers to tailor adverts specifically to us on our mobiles, tablets, laptops and even, soon, on our smart TVs.

We may have a general desire to maximise utility from our spending, but market failures, such as consumers having imperfect information about products and a present bias (see also) in decision making, make us easy targets for the advertising and marketing industry. They understand the heuristics we use and try to take maximum advantage of them.

Happy shopping!

Articles

How shops use tricks to get you spending The Conversation, Cathrine Jansson-Boyd (16/11/17)
ColourPop looks to Qubit for next-gen personalization guidance Retail Dive, Dan O’Shea (13/6/17)
Channel 4 to offer 100% ad targeting across All 4 platform, seeking partners for linear equivalent The Drum, Jessica Goodfellow (14/11/17)
How Google aims to bring TV advertising into the 21st century The Drum, Ronan Shields (19/10/17)
How to Use Heuristics to Your Marketing Advantage MarketingProfs, Cam Secore (12/11/15)

Questions

  1. Does the use of heuristics contradict the assumption that consumers behave rationally?
  2. Give some examples of heuristics that you yourself use.
  3. Other than those identified above and in the first article, what ‘tricks’ might companies play on you to persuade you to buy their products?
  4. Is advertising personally targeted to individual consumers desirable for them?
  5. Give some examples of present bias in people’s behaviour.
  6. What factors should a retailer take into account when deciding whether to make pre-Christmas discounts?
  7. Explain what is meant by ‘affect heuristic’ and how the advertising industry uses the concept in setting the background to or scenario of an advertisement.
  8. Have you ever been persuaded into buying something you didn’t want? Why were you persuaded?