The New Economics of Consumer Behavior and Why You Need to Know About It

What's Next In Payments®
8:01 PM EST November 16th, 2009

This is the first of three blogs on behavioral economics and why people in the payment card industry should pay attention to it. This entry explains what it is, the next one describes how some of the research in this area is helpful for understanding how to price and market cards, and the last one will explain some of the dangers this new field of economics poses.

At one level behavioral economics is so simple you may wonder what the big deal is. Well for the better part of the last century economists have largely assumed in their research that people have something called a utility function that values the various things they could purchase and that people maximize the amount of utility they can get subject to the money they have. This assumes that people act in certain ways that a mathematician would call rational and that they are pretty good calculators. Further economists started assuming that people could maximize their expected utility over time which involved discounting the future appropriately. Of course no one really believed this. Economists may be dull but not stupid. We made these assumptions because they led to nice mathematical models that yielded a lot of insights. Before economics became such a mathematical discipline, economists had a pretty nuanced view of human behavior and didn’t assume people were brainiac calculators. See Justin Fox’s Myth of the Rational Market for a great discussion of all this.

About thirty years ago psychologists and economists started questioning a lot of the assumptions behind these mathematical models. They found they people acted inconsistently. They also made the same kinds of mistakes time and time again.

One of the major findings that has turned out to be especially important for the financial services industry concerns how people discount future values. We’ve all been taught since high school to discount the future exponentially. And that’s how economists assumed people discounted the future. According to a number of the behavioral economics studies that’s not what people do. Instead they engage in what’s known as “hyperbolic discounting”. They place a lot of value on things they get to have pretty soon and then after that they discount exponentially. Now this is all a fancy way of saying that people are shortsighted but it turns out it has some interesting implications. It means that you can think of people as having current selves and a series of future selves. Your future selves would like your current self to be less impulsive. And if your current self is sophisticated enough to know that you will regret things in the future it might even pay for commitment devices to prevent your current self from harmful your future self. We’ll come back to this because some economists have argued that credit cards are mainly a trick to get shortsighted people to borrow: your future selves would like to ban the damn things.

A cute paper in economics highlights both the problem and how businesses exploit these imperfections. Many health clubs give people the choice of signing up for an annual membership with a cancellation fee, paying for each visit, or paying monthly. For people who actually go to a health club regularly the annual membership is the cheapest. Most people though, sign up for an annual membership but then only go a few times. Moreover even though they could reduce their costs by cancelling they don’t do that either.

Another common example involves a product that readers here all know — the debit card. For most consumers it makes no sense to pay with a debit card rather than paying with a credit card. The credit card gives you free float and probably some rewards. The debit card is sucking money from your checking account right away and probably gives you bubkus (though that’s changing). Yet in the United States most people with room on their credit cards use debit cards. The behavioral economics crowd would point to this as irrational behavior although we’ll have more to say on this latter.

Behavioral economics has become increasingly influential in a bunch of ways. First, there are a bunch of popular books by economists and psychologists on it including several that have made the New York Times’ Best Seller List. These include Dan Ariely’s Predictably Irrational, Richard Thaler and Cass Sunstein’s Nudge, and Akerlof and Schiller’s Animal Spirits among others. Second, it is becoming quite influential in the Beltway. Sunstein, who was a prolific law professor at University of Chicago Law School and more recently Harvard Law School, now heads a major regulatory office in the White House (he’s the regulation czar but, unlike Obama’s other czars, he was actually approved by Congress). Third, it is leading to serious legislative proposals. The Consumer Financial Protection Act is almost entirely based on the writings of law professors who became enamored with behavioral economics. It is also the theory behind fat taxes and other taxes on sin goods.

My next blog is going to be about how the payments industry can learn some tips from the economists who are working on this area.

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