Question

Traditional economists also assume human beings have complete self-control. But, for instance, people will buy cigarettes by the pack instead of the carton even though the carton saves them money, to keep usage down. They purchase locks for their refrigerators and overpay on taxes to force themselves to save. In other words, we protect ourselves from our worst temptations but pay a price to do so. One way behavioral economists are responding to this is by setting up ways for people to keep themselves free of these temptations. This includes what are called "nudges" toward more rational behavior rather than mandatory regulations from government. For example, up to 20 percent of new employees do not enroll in retirement savings plans immediately, because of procrastination or feeling overwhelmed by the different choices. Some companies are now moving to a new system, where employees are automatically enrolled unless they "opt out." Almost no-one opts out in this program and employees begin saving at the early years, which are most critical for retirement.

Another area that seems illogical is the idea of mental accounting, or putting dollars in different mental categories where they take different values. Economists typically consider dollars to be fungible, or having equal value to the individual, regardless of the situation.

You might, for instance, think of the $25 you found in the street differently from the $25 you earned from three hours working in a fast food restaurant. The street money might well be treated as "mad money" with little rational regard to getting the best value. This is in one sense strange, since it is still equivalent to three hours of hard work in the restaurant. Yet the "easy come-easy go" mentality replaces the rational economizer because of the situation, or context, in which the money was attained.

In another example of mental accounting that seems inconsistent to a traditional economist, a person could carry a credit card debt of $1,000 that has a 15% yearly interest cost, and simultaneously have a $2,000 savings account that pays only 2% per year. That means she pays $150 a year to the credit card company, while collecting only $40 annually in bank interest, so she loses $130 a year. That doesn't seem wise.

The "rational" decision would be to pay off the debt, since a $1,000 savings account with $0 in debt is the equivalent net worth, and she would now net $20 per year. But curiously, it is not uncommon for people to ignore this advice, since they will treat a loss to their savings account as higher than the benefit of paying off their credit card. The dollars are not being treated as fungible so it looks irrational to traditional economists.

Which view is right, the behavioral economists' or the traditional view? Both have their advantages, but behavioral economists have at least shed a light on trying to describe and explain behavior that has historically been dismissed as irrational. If most of us are engaged in some "irrational behavior," perhaps there are deeper underlying reasons for this behavior in the first place.

• Please state where you stand and why using at least 2 supporting examples from the reading assignments or examples you may have experienced or observed of others.

Answer 1

The traditional view is too rigid and doesn't take into account how an individual values different sources of money. I would be more inclined to accept the behavioural economist's views.

Example 1: This can be seen in the actions of a person receiving gifts for a birthday or a life event. A teenager who does odd jobs like baby sitting or book keeping for someone to earn pocket money values money more than physical gifts like books or jewellery. The value of both maybe same in money terms. It can be a choice between a $20 note or a $20 book set. But the teenager would prefer the money to spend it as they want and not accept something that a distant aunt of a family friend thinks he/she needs.

Example 2: A behavioural trait is also seen when a person spends a certain windfall gain. Extra income in the form of gifts, unexpected bonus, inheritance, or even a $5 bill found in an old jacket is treated differently than the actual income. The actual income is divided into various uses, savings and investments. However, this extra money which could be invested or saved is most likely used to buy unnecessary goods or things that we consider luxury. It may be spent on a lavish dinner, refurbishing houses, buying expensive accessories etc. that are never included in the monthly paycheck.