(Featured image: Roman K/Flicker CC BY-ND 2.0)
What money means in economic terms, and what it means to us, are two – or many more – different things
Imagine you have just spent £70 (€80, $95) on something, only to realize that what you have bought is going to be of no use, and that there is no way you can return it for a refund. It’s the kind of experience that would leave even a seasoned stoic a little upset. But why is this? Is that because of the magnitude of the amount, or is there more to it?
Money has the same value for everyone – a pound is a pound – and you can buy exactly the same thing with any pound. That characteristic essentially endows it with its economic significance: money can fulfil three key roles for us (and for the economy as a whole): it allows us to buy goods and services, to measure their price (a proxy for value), and to store value so we can purchase later what we don’t need right now. From these three perspectives, the meaning of £70 would seem to be invariable, and so the experience of the loss (or the gain) of it should be independent of anything else.
Money in the mind
But that is not quite how we work. We engage in something called mental accounting, a term coined by Richard Thaler in 1985. Daniel Kahneman and Amos Tversky provided a clear example in their 1981 paper The Framing of Decisions and the Psychology of Choice. They conducted an experiment with two similar first-person scenarios about going to see a play, with tickets priced at $10 (cheap, but remember, it is 1981!). In the first version, as you arrive at the theatre, you notice you have lost $10: will you still pay $10 for a ticket? 88% of their participants said they would do so. In the second version, you have bought the ticket in advance, but upon arriving you notice you lost it. In this case, only 46% of their respondents would buy a new ticket.
The actual loss is exactly the same in both cases, yet the reaction is very different. We act as if we have multiple budgets, alongside unallocated cash. In the second case, we already depleted the theatre budget, and so we may not be able to justify buying a second ticket; in the first case, we have lost unallocated cash, so we would still only be buying the one ticket.
And there is another way in which the meaning of money can vary. Let’s return to the £70 purchase that was so upsetting. Imagine that the purchase you made was for unleaded petrol (gas in the US), and that you inadvertently put it in your diesel car. You did not realize your mistake until, 500m down the road, your engine started stuttering. Not only is the fuel now an unusable blend, you are also presented with an eyewatering repair bill of over £6,000 (€7000, $8,500), as the petrol has seriously damaged much of the fuel injection system that relies on the lubricant qualities of diesel fuel. (This recently happened to someone I know very well.)
Suddenly, the wasted £70 doesn’t seem so upsetting anymore. The meaning of money is apparently not only dependent on what mental budget it belongs to, but also on the context in which we view it. Here, the original loss seems truly futile. At the same time, though, if squandering £70 was initially pretty upsetting, then losing £6,000 must be, well, about 86 times worse.
Must be? Or might altering the context also change the meaning of £6,000? It makes sense to allocate that expenditure to a car budget. Assuming that such a mishap will only happen once in our lifetime, we can quite legitimately spread it over all our driving years – say sixty years. That equates to about £100 per year – even if you don’t drive much, in a cheap, reliable and very frugal car, that is just a few % of your annual cost of driving – £2 per week. (This approach is akin to “pennies-a-day”, the disaggregation of a single larger expenditure into a sequence of smaller amounts.) Sure, it’s not nothing, but in the wider scheme of things it is hardly life-changing. And if we want to nuance its meaning even further, we could compare it with other mental budgets (a pound is a pound, remember!) – the value of our house or of our retirement fund: do we even know to the nearest £6,000 what these are worth right now? I don’t think I do.
Spending wisely, and not feeling worse than necessary
Naturally, none of this makes good the actual loss. In absolute terms, the amount isn’t any easier to swallow, and my unfortunate friend has to take the hit. He now needs to decide whether to have his car repaired, or scrap it (it is worth almost nothing in this state) and buy another car. In this choice too, the meaning of money can clarify the options.
Our intuition tends to be that if the repair cost approaches the book value of a car, it’s scrapped. This is what insurance companies generally decide, but as my (I mean his!) insurance policy doesn’t cover this mishap, it is his choice to make, and it’s worth thinking a bit more deeply about the two options. What is the meaning of £6,000 in both cases?
Spending it to get the car fixed means two things: it increases the value of the car back to its book value, and it restores the remaining life of the car as both were before the incident. The former is important in case we intend to sell or part exchange the car in the future: it means that we will recover part of the repair cost. The latter is important if we intend to keep using the car (my friend was planning to replace the car in around three years). The repair cost is then in essence an investment, so it can easily be compared with the alternative option. Putting the £6,000 towards the purchase of a new car means seeing it depreciate over the next three years. Even for a modestly priced used car, a depreciation of the order of £6,000 over three years is, if anything, a bit on the low side. According to this reasoning, getting the car fixed makes financial sense.
So, when we are must make a cool, business-like decision, figuring out the meaning of the money we’re spending in the different options can help us better appreciate the differences. If we look beyond the headline possibilities (repair the old car, or scrap it and buy a newer car) to what each one really means, we get a better idea of the significance.
But it is when we are confronted with the emotional effect of money that exploring the meaning can have the greatest effect. One perspective on a loss may make us (my friend, that is) would make us miserable for days, compel us to relive the faithful moment when we made the fatal mistake, and consider endless “what if?” scenarios. Another one may, at worst, make us shrug and then get on with our lives.
And that perspective, that is ours to choose. It is up to us to choose it wisely.