Stories | February 3, 2016

The longer I use it, the better I get: “practice makes perfect” for managing money

Did you know that studies suggest the longer people use a credit card, the smarter they typically get at using it?

It’s one example university professors are using to help explain behavioural economics to students.

In a 2015 paper in the American Economic Review, Harvard’s David Laibson and John List, of the University of Chicago, give ideas on how to teach six principles of behavioural economics. The paper’s goal is to show behavioural economics is an integrated part of economics, not a freak show that is isolated from “the standard ingredients” in the rest of the economics course. Many examples relate to managing money. The pair explain common financial problems, such as why people say they want to save for retirement but struggle to actually do it. We’ve picked out the highlights.

Experience pays
People try to make an optimal choice but it doesn’t always work out that way, write Laibson and List. Experience is one reason why and they cite the fact that credit card users pay fewer and fewer fees – such as late payment fees – the more experience they have with their card. Likewise, research suggests people switch to better telephone plans as they gain experience.

Relative to my weekly pay...
A reference point might be someone’s weekly earnings or the price they paid on an investment. Many decisions are made relative to these reference points. And the natural tendency to want to avoid losses adds to it. The pair cite a study that shows people won’t take an even odds gamble unless the upside has twice the reward as the downside (Kahneman and Tversky 1979).

I intended this to go differently
In traditional economics, there is no gap between a person’s good intentions and their actions. By contrast, the behavioural economics model of present bias says that people have good intentions but often renege at the last minute. So while they plan to work hard (or save for retirement, or stop borrowing on their credit card or take other helpful steps), the plans often fall through. The pair suggest that there are steps that can be taken to help, such as locking savings away when good intentions are strong to prevent the last minute change.

They suggest steps that can be taken to help, such as locking savings away when good intentions are strong.

Fairness matters
Mostly people care about their own situation but they also care about the actions, intentions, and payoffs of other people. An example of these “social preferences” is reciprocity – the impulse to return a favour. A favourite of behavioural economists is the ultimatum game, which tests fairness by requiring person “A” to split an amount of money they have been given with person “B”, who can reject the offer if they think it unfair. The authors write that almost no “Bs” reject an offer 20%. Perhaps people agree that 20% feels “about right”.

Give me a little bit of choice
Too many choices can be baffling but forcing people into a position by not offering choice is also unpopular. The pair write that nudges are a popular alternative. A nudge encourages certain decisions without removing the freedom to choose. They cite automatic enrolment in retirement plans as a leading example and write that nudges are liked because they are scalable, inexpensive, successful in changing behaviour and also freedom-preserving.

eZonomics team
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