A Dollar Is Rarely Worth a Dollar

October 16, 2017

Author: Dave Gardner

Last week University of Chicago Professor Richard Thaler won the Nobel Prize in Economic Sciences for his work in the growing research area of behavioral economics.  Unlike many Nobel Prize winners, much of Thaler’s work is relatively easy to understand by the layperson and can be widely used to improve our lives.

Much of Thaler’s research touches upon one of the somewhat fragile underpinnings of neoclassic economics namely that we all are rational actors in making decisions about our lives.  This would mean that we all go through life wisely weighing the pros and cons of one option or another and consistently choosing the best course of action.  Thaler in a gentle way chided this idea by writing about homo economicus, the version of humanity that consistently behaves rationally but is rarely found in nature.

So how can we use Thaler’s work to our advantage?  By understanding that there are predictable ways that we act irrationally, we can gain insight to improve our economic decisions going forward.   Below we explore how a dollar is rarely worth a dollar to us, as all of the below examples are equivalent but generally feel as if they have different values.

Credit cards.  If you’re like most, a dollar charged to your credit card is worth less than a dollar out of your wallet.  Merchants pay 2 to 3 percent for most transactions for the privilege of accepting your credit card instead of cash.  They do this because we have a much greater propensity to spend with a credit card.  A study of MIT graduate business school students, whom you would assume are relatively rational, found that they were willing to spend about twice the amount on Celtics tickets if they could use a credit card instead of cash.  Apple Pay and other proxy payments suffer from the same affliction.

Debit cards.   We tend to spend less with debit cards than credit cards.  If you want to reduce your spending but don’t want to carry around large amounts of cash, a debit card is a good alternative.  When using credit cards, you don’t need to think concretely about whether you have the funds right now to pay for the purchase you’re about to make.  Debit cards make you pause because you need to take the time to verify that you have a sufficient balance in your checking account to pay for your purchase and other planned ones that will happen before your next paycheck.

Auto pay.  While arranging for your bills to be paid automatically by your credit card or bank account assures you’re never late with a payment, it also increases spending.  Think of it as a secondary factor – whether you’re paying by credit card or out of checking, auto pay short circuits the thought process of whether a service is worth its cost.

Checks.  I’m not aware of any research that differentiates between debit cards and checks, but my experience is that the process of writing out a check costs more in our mind than using a debit or credit card.  I’m not sure why this is – perhaps it’s consulting a check register to look at your balance or it’s the process of writing out the dollar amount.  While you may not currently even have physical checks, consider using them if you want to curb spending.

Cash.  If you have to pull out your wallet or purse to pay cash for something, you will tend to spend much less than if you use an alternative.  If you’re in a consistent budget crunch and have a hard time building up an emergency fund (let alone saving for long-term goals such as college and retirement), you should consider moving to a cash-based system.

Tax refund.  There’s not much rationality behind our love of tax refunds in the spring.  If you receive one, it’s the return of your interest-free loan from the government.  Plus with our Social Security numbers most likely compromised, cheats could file a tax return on your behalf and collect your refund, subjecting you to a multi-month delay to receive your money.  In spite of the downsides of having a tax refund, most of us love them to a degree that exceeds their value in mere cash.  Imagine – someone gives you $500 in cash or you receive it from the IRS, which one would you prefer?

Knowing that depending on the method of payment that a dollar doesn’t always mean the same thing to you can be the first step toward moving toward financial independence.  Want to know more about Thaler’s work?  Read the 2008 book Nudge: Improving Decisions About Health, Wealth, and Happiness co-authored by him.

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About Dave Gardner

David Gardner is a certified financial planner with a practice in Boulder County and can be reached at dave@confluencefa.com and at twitter.com/Dave_CFP.