Taxing Rebate

If people are rational they know how to best spend their money, regardless of how and when they get it. So a recent study by Naomi Feldman (2010) raises some interesting questions.

Feldman examined whether a seemingly unimportant change in US tax law changed savings rates. In 1992 the George H. W. Bush administration changed how income taxes were collected. The amount of the taxes stayed the same, but less was collected each month. This tended to reduce tax rebates at the end of the financial year, but increase monthly net income. It didn't change the amount anyone paid in tax, but changed when they pay it. It meant there was a shift in income. Instead of receiving a sizeable yearly tax rebate, households had a larger net monthly income. Traditional economics would not predict any change in behaviour.

However, Feldman found that people saved significantly less after the change.

The yearly rebate was large enough to be seen as special and so people carefully considered how to spend it, typically saving a high percentage. The small monthly increase in income, however, was just added to household consumption budgets and so typically not saved. This is an example of mental accounting - the process by which people sort income into different budgets and tend not to shift money between budgets.

Thus we have a textbook example of the law of unintended consequences - a minor change in tax law causing huge shifts in behaviour. An argument, if ever there was one, for the use of behavioural economics in policy making!

Heston

You are called Heston. You need to make a bar of chocolate. The process to make this bar of chocolate uses three machines, one after the other. All three need to work for the chocolate bar to be made. Each machine has a success rate of 90%. What is the probability that the whole process is a success and the chocolate bar gets made?

Answer = 73%. (0.9 x 0.9 x 0.9 = 0.73)

People often guess a higher success rate than that. This is an example of the confirmation heuristic, whereby people overestimate the probability of conjunctive events. A 'heuristic' just means a rule of thumb, we use them all the time and mostly that's okay, but sometimes they lead us to make systematic mistakes just like the one above.

Percieved Intentions

This interview with the founder of Wikipedia about the takeover of Tumblr by Yahoo touches on how internet advertising works, and why it is important to get it right.

Jimmy Wales (BBC)

As he says, 'it's a social contract'. That is, things that aren't strictly financial, like intentions, matter. For example, if I think a website is taking advantage of me by throwing too many adverts at me, I might be offended or put off using that website. But if I perceive the website as just using fair means to make ends meet I might put up with the same amount of adverts. In summary, perceived intentions matter. (And as we speak behavioural economists are beavering away to include intentions in standard economic models...)

Coca Cola

I recently noticed an interesting pricing strategy followed by Coca Cola: at my local One Stop grocery store, a 2 litre bottle costs £1.99. But if you buy two bottles, together they cost just £2.50. The second bottle cost 51p - a quarter of the first one!

Needless to say, I bought two. Who wouldn't? 51p for two litres of coke is a great deal! How do we know it's a great deal? Because it would usually cost £1.99!

Very, very clever pricing strategy. (Charging £1.25 per bottle, regardless of quantity, would probably result if far fewer sales.)

They increase sales by anchoring our view of the innate value of a bottle of coke high (£1.99) before smashing it with a 51p deal - of course it's a great deal! (And the great deal feeling will probably increase the likelihood of buying coke again.) Additionally, I knew I only needed one bottle, but I felt that after investing £1.99 I might as well reap the rewards and put in another 51p. (The sunk cost fallacy).