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January 22, 2008

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I think we are irrational with money because of two competing emotions: fear and greed. I believe it is almost hardwired into humanity to experience these emotions when it comes financial decisions. We all tend to make wrong decisions based on these conflicting feelings. I paid off my mortgage last year because I knew that I have made knucklehead decisions with money in the past. I earned a guaranteed return of the interest on my mortgage.

Regarding your first example, I can think of an instance when earning twice as much as everyone else is better than earning less than half compared with everyone else. If I earned $100,000 while everyone else earned $250,000, then everyone around me would have 2.5 times the spending power I have. This would eventually result in the prices of goods and services becoming what the market can support for a population of people earning $250,000.

On the other hand, if I'm earning $50,000 and everyone else earns $25,000, then I have the upper hand. The cost of goods and services will eventually settle at a level for folks making $25,000. I now have twice their spending power.

Of course, this assumes a lot of things, but it's not a 100% clear cut argument in favor of the higher salary.

Aaron - it was clearly stated the prices of goods and services wouldn't change in the example, so there goes your argument against scenario #2.

Once again, psychology is so interesting, especially when it comes to money.

Aaron, you missed that the scenario required you to assume such a price reset would not occur.

When I was thinking about pursuing a Ph.D. in economics, my focus was going to be the application of cognitive science to economics.

Your examples are great and remind me of some of the experiments I did. For example, I recreated a famous experiment that showed circumstances affected how people viewed the cost of replacing an item. Economists would say the cost is the replacement cost. But if you told people that the reason they needed to replace the item was because they accidentally broke it, wore it out or had given theirs away as a gift, you got all sorts of responses, including that they actually had gained money (the gift example)! Even when you led people to water by hinting at their desire to "replace" the item, that still didn't cure them of sometimes answering with something other than replacement cost.

I helped my thesis advisor with a larger project he was doing on risk aversion and preference parameters. We were able to show that the changing of the scenario from a choice between your current job (A) and a new job (b) to a choice between new job (A) and new job (b) dramatically changed people's willingness to take new job B, even though the lifetime income stream financials of A and B were the same in both scenarios and all that had been changed was the characterization. Now that one isn't irrational. It just points out that there is a status quo bias/preference.

To phrase it differently:

"Would you rather have twice as much as you have now? Or have more than everyone else?"

And most people picked "more than everyone else." I fail to see how this is surprising.

It's not surprising to me that this is the case - I think people more often make money choices based on their feelings, and what feels right - not necessarily on logic. Also, money has a way of influencing behavior in a way that people will use it to feel good, feel powerful, feel secure, etc. So if they can do something that will feel good, even if it makes them less money - they'll do it.

Assume for the moment that prices of goods and services will stay the same.

This doesn't surprise me because this is irrational. It is false to make that assumption. The only rational interpretation of this statement is that the relative prices of goods and services remain the same, in which case you are indeed better off having higher relative spending power. That people won't assume nonsense is a measure of their rationality not irrationality.

The second merely puts a price on regret, which the only the irrational refuse to value.

Some time ago I read a book called "Why Smart People Make Big Money Mistakes". It is full of these type of examples. It explains them very well. Very interesting read.

I think choosing earning twice as everybody else in the example above is the perfect example of "keeping up with the Joneses". Most people care too much about how they are in relation to others. When what I think really matters is how are your financially in absolut terms. We need to learn to be content with what we have and disregards what others have.

I think it is important to know that beyond a certain minimum level which is around 50k, it no longer matters that much how much you earn. The law of diminishing returns apply as
happiness becomes an issue of how you successful, etc. you feel rather than a matter of putting food on the table. In other words, above, say, 25k, income is more a question of keeping score than anything else. Therefore I can easily understand why people would prefer to earn twice as much as everyone else despite a lower absolute income.

I don't find it irrational at all to find that someone's sense of wealth is conditional on how much everyone else has. I'd be willing to bet that the majority of well-fed americans in that study didn't have too many needs that still needed filling (shelter, food, clean water, access to life-saving healthcare). Everything after that is a want and a luxury, and often times the happiness that comes from that is partly due to the actual utility of the product (my iPod is awesome) and partly due to the uniqueness factor that comes with something being too expensive for most people (they look at me when I wear Gucci because they know it's expensive and I must have money and therefore am successful at what i do).

If everyone's got more money than you, you're not going to be able to get those wealth-implying items.

As a person who has a logical mind, can calculate, and believes in numbers, I'd rather earn $100k and make $150.

I don't think the examples you give ARE irrational. Why would I want to make more money if I'm making only half as much as all my friends and peers? I would rather have less money and still be able to afford to interact on the same social level as those around me.

Humans are social animals. The amount of money you make or have is completely irrelevant and matters only in RELATION to other people. Would you rather be a millionaire who is confined to live in a town of billionaires? Or would you rather be a millionaire in a town of those who only have 100,000 on average? OBVIOUSL you'd rather have MORE than those around you - it's human nature.

It's like beauty. I'd rather be "average" looking in a city of ugly women than "good" looking in a city of super-models. What's not rational about that???

Comparing your income / net worth to others is essential only for 'positional' commodities, those that are scarce in nature. Examples would be plots of oceanfront land, tables in an exclusive club etc. To gain access to these you would need to be better off then your fellow countryman and then you may well take a lower pay provided you'd be ahead of your neighbors'. For most other commodities having more wealth for all just means everyone would enjoy a better standard of living and that isn't objectively bad.

There is a good discussion of this in the book "The Paradox of Choice" by B. Schwartz.

-Big Cheese

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