Is wanting less money irrational?

The Standard links to an interesting LA times article on loss aversion. Now loss aversion in itself is a very interesting issue, something Rauparaha may like to write about ;). However, my focus is going to fall on the same result that The Standard was interested in namely that people would rather earn $50k when everyone else earns $25k than earn $100k when everyone else earns $250k. The article calls people ‘irrational’ for doing this – but is this the case?

According to the Austrian economists at www.mises.org, rationality is “the use of the peculiarly human mental processes by which man strives to connect his ideas as consciously, coherently and purposively as possible in order to plan the attainment of ends sought”.

I’m happy with this definition, as it gets the idea across, and also illustrates how well those Austrian economists can write!

Sticking with this, I can see three ways that a ‘rational’ person will make this choice, even if they value ‘goods and services’ positively.

  1. If prices fully adjust, then your claim on goods and services depends on your relative income, not your absolute income,
  2. If prices are not different between the two cases, it is possible that you may value your relative position highly enough to allow the sacrifice in terms of goods and services – there is a trade-off here. Economics (in theory) does not presuppose what people value!
  3. Even if it would be the ex-post ‘best choice’ to pick the $100k, because for some wild reason prices have become unfathomably sticky, you may follow a rule of thumb that states ‘choose the income distribution that offers you the best wealth position’, as the prior probability of being in a position where prices are that sticky is so low.

In all three cases, the individuals choice is rational. I find the first one the most appealing – remember people don’t value ‘money’ they value the goods and services that they can purchase with money.

  • CPW

    I think the question states that 1. is not the case. Of course, I doubt that many people can fully comprehend a world in which they have greater purchasing power but a smaller claim on total goods and services. Would I be closer or further away from buying a Picasso? Would girls be more or less impressed with my greater purchasing power (if less, then are “prices” really the same) 🙂

    Of course, I’d take the larger amount of money, so I guess I’m homo economicus. I always wonder whether these survey results actually have any backing in real world decisions. I think I heard the point somewhere that we don’t actually observe middle-class families moving to poor neighborhoods so they can have the largest house on the street.

    You can always posit that your expenditure has an externality for me. You buy a porsche, I feel worse about my ford falcon. But this could be rational too if we think there is imperfect information about how hard it is to find porsches, your porsche might cause me to update my estimate of the cost of obtaining a porsche.

  • “I think the question states that 1. is not the case”

    Thats what I was wondering, the article states it – but I haven’t seen the survey so I don’t know if that was what they actually asked, or if thats how people interpreted it. Furthermore, would this result depend strongly on the current income of respondents, and the initial values of income.

    If it was clearly stated then we have to rely on the fact that people care more about their relative position given this set of initial conditions – in other words it tells us what people are willing to trade-off

    Of course as you say there could be a reporting bias – people want to sound like they care more about their relative position (as relative position is all about gloating to your friends), but when actually faced with the prospect of a lower absolute standard of living in order to achieve a higher relative standard people may make a different choice (their revealed preference).

    “Of course, I’d take the larger amount of money, so I guess I’m homo economicus.”

    That merely tells me that the value of your relative position in society is not worth as much as the value of goods and services.

    “You can always posit that your expenditure has an externality for me.”

    The old consumption externality – isn’t that what Krugman used to try and justify why we should have increased income equality? I don’t know, jealousy is not the sort of externality I think society should promote.

  • CPW

    I remembered the other rebuttal: those large migrant flows from poor countries to rich countries (but not vice versa) suggests that absolute income is preferential to relative income.

    Matt, I agree with about you the consumption externality (I think Robert Frank is the most famous exponent). But if you don’t believe in it, how do think people get added value out of relative status gains (since you’ve also assumed that prices are unchanged in case 2)?

  • “large migrant flows from poor countries to rich countries (but not vice versa) suggests that absolute income is preferential to relative income’

    More revealed preferences aye.

    “Matt, I agree with about you the consumption externality (I think Robert Frank is the most famous exponent). But if you don’t believe in it, how do think people get added value out of relative status gains”

    Fair question, however the fact that I think it is an inappropriate thing to promote (based on its potential impact on social structure and my own moral posturing) does not mean I don’t think it doesn’t exist. People may well receive a negative externality from someone else’s consumption – implying that their behaviour is still rational.

    Furthermore, I could just stipulate that people receive a positive payoff from seeing themselves above other people.

    If people value being ‘better’ than other people above actual consumption, fine. However, won’t all these externalities cancel out, as someone has to be above and someone has to be below. An externality that solves itself just does not seem relevant for policy.

  • Owen

    Some people are stupid, they make dumb decisions. I think this survey illustrates there are more stupid people than not.

  • “Some people are stupid, they make dumb decisions’

    That is a popular point of view, but one I don’t subscribe too. It is easier for us as individuals to understand our own decisions than the decision of others. As a way of coping with this, we all tend to form this bias where we believe we are of ‘above average’ intelligence, and we assume that other peoples beliefs and/or choices are in some way wrong.

    The truth is that we are stupider than we realise, but the people around us are smarter than we believe.

    I can’t believe that I live in a society of lemmings, I am certain that people make decisions that make sense, even if those decisions don’t make sense to me, and often involve biases.

    In this case, people are obviously stating that they would prefer to be relatively better off than everyone else. I seriously doubt that people would have choosen $50k above $100k is that was the choice – as there is no trade off. The choice they made in the survey mentioned in this post was not stupid, it just happens that they value status above other forms of consumption.

  • MikeE

    As I said on the standard:

    “Would you rather earn $50,000 a year while other people make $25,000, or would you rather earn $100,000 a year while other people get $250,000?”

    It makes sense to want to earn $50k if everyone else earns 25k as you would be earning 2x as much as the average person.

    If you earnt $100k, while everyone else earned $250k you’d only be earning 40% of the average wage. In this case it would suggest that there was a situation where there was rampant inflation and your wages haven’t kept up with everyone else.

    It makes a big difference to your spending power what your wage is compared to everyone else.

    Of course all of this is meaningless unless one knows how much say $50k or $100k would buy in each scenario.

  • “Of course all of this is meaningless unless one knows how much say $50k or $100k would buy in each scenario.”

    The price point is a very important point. It makes more logical sense that you will be able to buy less in the $100k case – which makes peoples response sensible. However, the article seems to suggest they were told that prices were constant (thereby implying that there was over 4x as many resources in the $100k case).

    Once we know how the survey was designed we will be able to figure out what this test group may have meant when they gave these responses.

  • Haris

    Let’s not forget that the question is supposed to state “all things being equal.” Unfortunately, all things are never equal, and the human brain cannot make decisions as if they were. Specifically, we still have an evolutionary drive that causes us to care about rank, meaning that option #2 is probably the explanation. The reason we care about rank, of course, is the many other benefits of being at the top of the pile. Evolutionarily, that would have been the best females for men. Today, it’s the prestige and other ancillary benefits of being the richest man in town, such as political power etc. It’s actually quite rational to care about rank in addition to absolute levels.

  • “Specifically, we still have an evolutionary drive that causes us to care about rank, meaning that option #2 is probably the explanation”

    That is a very good reason. After all, if we have a meme that states ‘care about our relative rank’ because humans have found that prices adjust in such a way that makes relative rank important, then it is likely people are going to support that type of view. And of course as you say their are sufficient social benefits from being top of the pack.

    I think that this reason is more than just like #2, it is also an extension of #3 – I find it convincing and agree that its still rational to do this

  • pete

    It’s not clear what sort of prices remain the same in this scenario.

    If the prices at McDonalds stay the same, and the prices at the fancy restaurant stay the same, but your friends all start eating at the fancy restaurant cos of their $250k salaries, the the price of “dinner with your friends” has increased.

    With $100k, you can do more stuff, but you might be doing it alone. Humans are social creatures, so it makes sense that they have other-regarding preferences.

  • “If the prices at McDonalds stay the same, and the prices at the fancy restaurant stay the same, but your friends all start eating at the fancy restaurant cos of their $250k salaries, the the price of “dinner with your friends” has increased”

    A dinner with friends at a fancy restaurant is a different product to a dinner with friends at McDonalds.

    However, it is a good point that if, everyone else gets a higher income, and you value doing the same things as other people, then your utility is likely to be lower than in the case where everyone else had lower income.

    In economics terms this is when peoples choice of consumption are all strategic complements. In the case where everyone purchases better quality goods (when there income is higher), the relative value of the lower quality stuff falls. As a result, the poorer person either has to buy the same initial physical bundle (which offers a lower level of utility) or buy some more expensive things in order to take advantage of the strategic complementarity. As the person can afford less expensive things, I guess this will also provide him/her a lower level of utility.

    So all in all, a very good point Pete – very interesting.

  • pete

    A dinner with friends at a fancy restaurant is a different product to a dinner with friends at McDonalds.

    And a dinner with friends at McDonalds is a different product to a dinner without friends at McDonalds.

    I think the problem is with asking people to imagine ceteris paribus counterfactuals in cases where ceteris paribus is implausible.

    Researchers have the same problem with the one-shot prisoners’ dilemma — it’s really hard to stop subjects from playing it as though it’s embedded in a larger repeated game.

  • “And a dinner with friends at McDonalds is a different product to a dinner without friends at McDonalds.”

    Indeed, that was the point of the strategic complementarity discussion thingy 😉

    “Researchers have the same problem with the one-shot prisoners’ dilemma — it’s really hard to stop subjects from playing it as though it’s embedded in a larger repeated game.”

    Indeed, and it makes sense that people act that way. We have limited cognitive capacity and follow rules of thumb – rules of thumb aren’t always going to be optimal, but they are better than re-analysing every decision. I think thats what researchers are finding when making these specific examples.

    I had the opposite problem when I was doing 3rd year Industrial economics. We would play a repeated prisoners dilemma game and I would always defect straight away :). The reason I did that is because when I was in first year, someone defected on me in a practice prisoners dilemma game, and I had internalised this rule of thumb without even thinking about it 😉

  • CPW

    When I first heard this experiment described, I think the survey group was MBA students and the income parameters related solely to their classmates. This doesn’t rule out misinterpretations, but it makes it less likely that price level was expected to adjust.

    Has anyone actually tracked down the study being referenced?

  • “Has anyone actually tracked down the study being referenced?”

    Tracking down the survey would be a good idea, I’ll think about it when I’ve got some time.

    “When I first heard this experiment described, I think the survey group was MBA students and the income parameters related solely to their classmates’

    That is very different to having the world on a certain income – as prices will not adjust. Very interesting. Then again, I would guess that these people don’t like their class mates (as they are MBA students), so the person is willing to spending 50K to mess up all these other guys.

    If anything that sounds like a consumption decision to me 😉

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  • CPW

    From an economist article:

    In one striking example, students at Harvard University were asked whether they would prefer (a) $50,000 a year while others got half that or (b) $100,000 a year while others got twice as much. A majority chose (a)….

    Although people value their income in relation to that of others, this does not seem to be true of their leisure time. The same Harvard students were also asked to choose between (c) two weeks’ holiday, while others have only one week and (d) four weeks’ holiday while others get eight. This time a clear majority preferred (d). In other words, people’s rivalry over income does not extend to leisure. The result of this, suggests Lord Layard, is that developed societies may tend to work too hard in order to consume more material goods, and so consume too little leisure.

    I think the leisure result would also be consistent with confusion about the price level explaining the income result. Surely the original survey, if well designed, would have asked follow up questions to the students about why they chose a).

  • Thanks CPW, that is very interesting.

    “Surely the original survey, if well designed, would have asked follow up questions to the students about why they chose a).”

    I agree. Experimential economics is a new field, and as a result is often fraught with methodological inconsistencies. Given time I’m sure that survey design will improve.

  • Moz

    Warning: acecdotal “evidence” follows.

    Australia has a movement of “sea changers” and “tree changers” as well-off people semi-retire to live on the coast or in small communities inland. They’ll either telecommute or start a small business that they can run part-time. Selling a million dollar home in Sydney (there are lots of them) and buying something for $200k is quite practical and becoming more common (and house prices in popular areas are rising as a result). To me that’s a clear case of people choosing lower pay and more leisure.

    I’ve chosen a variant of that – for quite a while was working as a contract programmer and earning $50k each year before stopping and doing other things. So I worked 4-8 months and had 4-8 months off. Then I got sucked into a salaried job for lots more money. Some days I’m not sure it was a change for the better…

  • “To me that’s a clear case of people choosing lower pay and more leisure”

    The old labour – leisure tradeoff. I run into a bit of a problem as an economist – both my labour and my leisure is doing economics, and as my wage is not based on hours worked, my optimal hours spent performing labour are undefined!

    I know, I’m a geek 😛

  • Individuals are more likely to choose $50k because individuals think in terms of relative deprivation. While $100k is clearly greater than $50k, choosing $100k means being relatively deprived in comparison to your peer group. If you choose $50k, you are at the top of the peer group and others will aspire to earn as much as you do.

    It is more common for individuals to complain about wages if they are lower in comparison to their peer group. If I was earning $50k in a group of individuals earning $100k, I’d feel relatively deprived. However, if there was an individual earning $30k outside my peer group, I would not feel grateful for earning more than them.

    Everyone lives in a state of mild deprivation, however depressing that is. Few people stop and appreciate that most Americans are better off than those living in third-world countries. Instead, they compare themselves to Americans within their own social strata, or at their workplace, or academic institution. This emphasizes the importance of peer groups..

  • Also, another comment: a dinner at McDonald’s is almost always an inferior good. As income level increases, people are more likely to branch out to upper-end restaurants that fit their social status.

    Though I agree that the price of the dinner at McDonald’s increases if your friends are all going to a higher-end restaurant. There are some interesting social incentives at play.