BRB Bottomline: It is undeniable that we all suffer from myopia. In the span of a single day, we face a multitude of decisions, and yet, more often than not, we end up making the “wrong” choice. Berkeley students aren’t immune from the short-sightedness of desire, the illusion of mental accounting, or the demand for fairness – human conditions oftentimes shelved under the blanket of “ceteris paribus” in classical economics. Perhaps, before buying another Boba, turning off your alarm in the morning, or taking that Uber, reflect on the reasons behind the decisions you make – whether they are guided by rational thought or driven by irrational impulse.
You wake up. It is 7am in the morning and sunlight sifts in mercilessly from the window. Squinting and groaning, the desire to smack the alarm and go back to sleep overcomes you. Then you realise: you can do exactly that! After all, the you from yesterday predicted this exact predicament, and had set six other alarms expecting this moment. You smugly succumb to slumber, repeat the process 5 more times, until you grudgingly accept that obligation calls—it’s time to get to class.
The Alarming Truth: Why set seven alarms when you can set one?
Deciding when to get up is often the first decision a Berkeley student faces in a day—and for the common night owl, a difficult decision to make. Logically, we understand the importance of attending class, and yet, an undeniable urge to cave into the cocoon of sleep oftentimes manifests itself in the midst of sleep-deprivation. We are often overcome by animal spirits—the capricious, impulsive, myopic thinker that seems to attract us more than the consistent rational, long-term decision maker. Psychologist Daniel Kahneman coined this dichotomy as “System 1” and “System 2,” Adam Smith as “passions” and “the impartial spectator,” and economist Richard Thaler as “the doer” and “the planner”. It is System 1, the passions, and the doer that begs for “five more minutes” of sleep, and System 2, the impartial spectator, and the planner that urges you to finally get up and, for your long-term personal gain, go to class.
Yet, you ask: why does this miniscule, mundane decision hold so much significance? Applied to our macrocosmic decisions, it is the crux of human short-sightedness that affects consumer spending and saving. This is reflected in theories of intertemporal choice, illustrated by the use of Samuelson’s “Discounted Utility (DU) Model”. Despite its simplicity, the DU model is an effective measure of intertemporal choice because of its mathematical applicability. It outlines how rational consumers make choices based on preferences that take into account time and benefit when weighing decisions; decisions that display delayed returns are often anticipated and “discounted.”
George Loewenstein, however, notes that the assumption of “time consistency” in DU models where long-term choices are heavily discounted via an exponential model could be false. In fact, research shows that a more humanly accurate DU model follows a hyperbolic model, whereby discounting has an inverse relationship to delay. Following this model, short-term delays are heavily discounted, while longer-term delays become proportionally less discounted as time goes on. A ten minute wait for a cake would give a way higher utility than a twenty five minute wait – and yet, as time passes, the amount of utility gained from a 3 month wait holds no difference to a 4 month wait.
In fact, because of our lack of self control, we often exhibit behavior that reflects a time inconsistency of “present-bias”— where the value of the choice in the present moment is higher than making the same decision but in the future. Therefore, despite setting resolutions and plans for the future (e.g. I can only spend $200 on leisure this month), consumers may break them when faced with temptation (e.g. impulse-buying when going shopping with friends and exceeding the $200 limit). System 1 takes over system 2, passions override the impartial spectator, and the doer supersedes the planner.
Nowadays, with the widespread use of the internet and convenience of e-commerce, it is extremely easy for consumers to succumb to short-term spending— and businesses know it. With methods to grapple your attention, companies convince you that you not only need the “Classic Black Leather Futon Couch,” but also “Extra-soft Futon Pads,” and “Luxury Cushions” to go along with it (see: “Share of Mind, Not Market Share”).
Because of this lack of self-control, creating a commitment strategy for yourself can encourage long-term behaviour that aligns with your long-term goals— in the microcosmic waking-up-for-class scenario, this is the setting of multiple alarms. When it comes to consumer spending, governments, banks, and consumers alike are finding methods to encourage long-term thinking. For example, Congress created 401(k) retirement savings plans to encourage workers to set a part of their income aside for the future. The money set aside in these accounts is difficult to withdraw and discrete from their other accounts, helping consumers supercede their System 1 and hold that money for the future.
You’ve finished your 8am lecture and your body is thrumming for some sugar or caffeine— what better choice then to buy yourself a cup of coffee or boba? Your conscience reminds you that this is the fifth boba you’ve had this week, and really it isn’t (controversially) that smart of an investment. Yet, a part of you thinks that four dollars doesn’t seem like much of a problem.
A Mental Note: Why can’t you get over your Boba addiction?
We often perceive money relatively. Imagine buying boba every day for $4. Why does that not sound as bad as simply paying a lump-sum of $120 at the end of a month (see “How to Get Rich (Eventually) and Why They Don’t Want You to Be”)? This is because we perceive prices relatively, rather than to its independent, absolute value. To the homo economicus, a perfectly rational entity, there shouldn’t be a difference in perception between the two choices— yet, perceptions of money are often tainted by human conditions and behaviour.
We often keep track of money through mental accounting – “a set of cognitive operations used by individuals and households to organise, evaluate, and keep track of financial activities.” Articulated by Thaler, the way we track our money violates a basic economic assumption that money is fungible: all forms of money are perfect substitutes for one another. We discriminate the cost of a good or service based on how we’re paying, what we are buying, and for what reasons. For example, oftentimes, we make transactions through the use of credit cards, an incredibly accessible and convenient tool for buying coffee or boba. Yet, management scientists Simester and Prelec discuss how credit-card use increases consumers’ willingness-to-pay, in comparison to cash. In their paper “Always Leave Home Without It,” they explore how certain consumers are willing to pay a mean 113% more with a credit card, than with cash— this difference in willingness to pay deemed as the “credit card premium.”
Multiple theories have been explored as to why this is the case. An article by Forbes mentions a compelling phenomenon: the “coupling” of emotion and payment. With cash, the act of buying the boba requires you to acknowledge the cost of the product, and how much that deducts from your total money at hand can be painful. However, if you pay with credit, the time period between the purchase and payment increases, which diminishes the mental perception of the cost. Consumers are often likely to underestimate or forget the payment, and the cost is decoupled from emotion. Other reasons we use to justify spending includes, but is not limited to: having a “bad day,” having spent less money than usual and spending as a reward, buying for your friends, I’ll splurge “just for today,” etc. It is crucial we keep track of our spendings, especially at an age where credit dominates the landscape of transaction; it is too easy to overspend and fall prey to our short-term desires (see “The Importance of Financial Literacy”).
Rejuvenated, you finish your beverage and finally head home until you realise it’s raining horribly. Feeling slightly spoilt by the Berkeley sun, you go to the nearest convenience store, until you realise an umbrella costs an immoral $45. You pull out your phone to call an Uber— $16 for a five minute ride! How unfair!
A Fair Fare: Why are you unwilling to pay $45 for an umbrella?
Having to decide between a $45 umbrella and a $16 Uber ride is considered simple blasphemy. But, after cooling down, you conclude that the market isn’t really out to get you. From Adam Smith’s butcher, brewer or baker that “regard to their own interest,” to Machiavelli’s “men will always deceive you”— we are often perceived to be agents that act for our own personal desires. People and businesses act rationally, and rational behavior is to price goods and services based on such self-interest. If supply and demand dictates $45 umbrellas and $16 Uber rides, so be it.
However, let’s posit an exclusively profit-maximizing enterprise that sets umbrella prices at as high a price as the market will allow. Will that price be $100, $1,000, $10,000,000? Not only will the firm face outrage from consumers but it also won’t sell any umbrellas. The price doesn’t seem fair. And yet this concept, while irrational to expect, underlies the rationality of consumers, firms, and other market actors. Why is it that we seem to be encouraging a sort of “market failure” by taking into account fairness?
This topic is explored heavily by Ernst Fehr and Klaus Schmidt. By conducting multiple fairness games, Fehr and Schmidt observed that the self-interest hypothesis is refuted in certain scenarios. In the example of the “Dictator Game,” an agent could allocate tokens between themself and another agent. For the homo economicus, to take all the money and allocate none to another would be the rational, utility maximising choice. Yet, 30% of the agents chose to equally divide the sum between themselves and the other agent, which many of us would consider “fair”. Fehr and Schmidt hypothesized two categories of agents, “selfish” and “fair,” and found that, on average, “60% of the population are selfish and 40% are fair”.
Turns out, we are not always Smith’s butcher, brewer, or baker. Nor are we considered to be one of Machiavelli’s “men”. After all, the profiteer, who purposely sets unreasonably-high prices, is condemned by our society, and laws have been set to prevent such “unconscionable” business practices. This is reflected in Honolulu, where a price surge cap had been introduced on ride-hailing applications such as Uber and Lyft —penalties on “predatory pricing” deemed “unfair” by society. In this matter, perhaps being socially motivated creatures is a boon rather than a handicap. Emotion can be a positive motivator of our decisions. We are less likely to pursue surplus maximization, and more likely to pursue that which benefits our peers as well as ourselves.
Take Home Points
It is crucial we reflect on our everyday decisions— a small, seemingly insignificant choice can lead to a butterfly effect of diverting routes in the future. To look back in retrospect and realise the amount of coffee you’ve consumed might be worth a new car or regret that you accidentally slept through an irreplaceable final exam – we are too easily susceptible to such human follies. Yet, though a bit short-sighted by our animal spirits, and blinded by the glare of inconsistent mental accounting— perhaps there is a certain relief in finding that we are slightly more altruistic than economics give us credit for. After all, economist and philosopher Amartya Sen once said, “the purely economic man is indeed close to being a social moron”. You, a homo sapien, are no match to the homo economicus— but perhaps you do not need to be.