As we said, thinking about money in the right way is a difficult thing to do so we
find tricks to think about it in a wrong way.
And one of those tricks is thinking about money in relative rather than absolute
terms. So let me first give you some examples to
how to, how to think about it. A very classic and standard example is the
following. Imagine you're going to buy a pen, and you
find a pen that you like and that pen is $15.
And as you're about to check it at the cashier, the cashier tells you, you know
what? You have such a lovely face.
You have such a lovely smile. I don't want to abuse you, so I'll tell
you what, our competitor sells the exact same pen instead of for $15 for $7.
It's three blocks down the street, it's up to you if you want to buy the pen here or
go to this other place and now you can think to yourself.
Would you walk three blocks down the street, to save $8 on this pen?
And most people when given this decision, say yes, I will do that.
Now imagine a slightly different case. You're coming and you're buying a camera,
it's an expensive camera, its cost: $1,015.
And as you're about to check out, the salesperson says you know what, you have
such a lovely face, you have such a lovely smile.
I'll tell you what. Our competitor is selling the same exact
camera, three blocks down the street for $8 dollars less, instead of $1,015, for
$1,007.00 dollars. Would you now take the trip down to the
other store to buy the camera? And most people now say, absolutely not.
Now the reality is that your checking account doesn't care where the $8 came
from, they came from a pen, or they came from a camera, or they came from a small
amount of purchase, or a big amount of purchase.
But we care, $8 from 15 looks like a really big amount, more than half, $8 from
1,015 looks like a tiny amount, doesn't seem to be worth it.
Or think about the following example. Imagine you buying a car, you're going to
buy a car, the car is $40,000 and the sales person tells you that for $2,000
more you could get leather seats. Now I'm not really sure what the benefit
of leather seats are, but let's say that there are benefits for the leather seats,
and the question is, is it worth $2,000 when you buy a $40,000 car.
Or imagine the second case, you going to buy a chair for your office and the sales,
the sales person tells you that for $2,000 more, the chair costs $500, and for $2,000
more you could get the leather seat. Would you do it?
Now for most people they would say the first one is an easy decision the second
one seem offensive. Spend $2,000 more on a $500 chair, just to
get leather. Now presumably, you sit more in your
office chair then in the car and whatever the benefits are from leather would be
higher in the office then in the car, but that's not how we think about it.
You spend $40,000, $2,000 seems very small, you spend $500, $2,000 looks
incredibly large. And here's another example.
If you're like me, a couple of times, we've renovated, our house.
And when you renovate your house, the contractors come and give you an initial
price and then there's all kinds of options for upgrades and changes and so
on. And what I found myself doing, and I think
it's universal, is making very, very quick decisions on big sums of money.
Why? Because the renovation is incredibly
expensive, so all of a sudden spending only, you know, x extra thousands of
dollars on, you know, better tile or French something or another or Italian or
counter tops or granite, all of a sudden seems like a good, a good deal.
But at the same day, that they spend this huge amount of money in a quick decision,
I can go to the supermarket and look very carefully, do I want the more expensive
tomatoes then the cheaper tomatoes. Which one makes more sense?
Now my whole life of making decisions about tomatoes could not sum up to that
snap decision I made a few hours ago with the contractor.
But because the amount of money we start with, with the contractor is so large,
it's incredibly easy to make snap quick decisions.
And by the way all of this also should tell you that there are probably ways to
think about how to fight this. That what we don't want to do, is we don't
want to make a decision based on something relative that we're spending, we want to
think about them as independent. And the question is how can we do that?
And now this, these decisions are not just about how we feel about spending money,
they're also about happiness. So ask yourself for example, what would
you prefer to be, to be a person that makes $90,000 a year, which is a very
good, salary in a company where everyone makes between 90 and 100.
So you're making 90, but you're the lowest paid employee, versus to work in a company
that pays less, between 60 and 85,000 and you're the highest paid employee, you get
85,000. So in an absolute way, you would get paid
less in the second company, but in a relative way you would be at the top at
you game, while in the first company you would be at the bottom.
Now the interesting thing is when you ask people these choices next to each other,
most people say I'll take the first one, I prefer to get more money and be the lowest
paid employee. When you ask people where they would be
happier with, most people recognize, they'll be probably happy in the second.
Okay, So'll be the highest paid employee even if they get paid less for it.
Now, this is an interesting question of yes, we do understand the issue of
relativity and we do understand the influence of happiness, but are we willing
to pay a premium for this increased happiness?
And the answer is not so much. Now if you think about all these examples,
of relativity, they all come about the fact that we have diminishing returns.
We have this function in which our happiness starts very high, and then we
have diminishing returns. And another way to think about it is that
we think in terms of percentages, so ratio increases.
So think about the following graph. What we have on the x-axis is the amount
of money, the physical amount of money, how much is actually involved.
And what we have on the y-axis is the psychological intensity of that.
Now because this curve has a diminishing return shape function to it, what does it
mean? It means that if we take an amount of
money, on the x-axis, in the left side of the lower end of the scale.
And we take an amount that is exactly the same in terms of the amount of money on
the, far right, they project very different psychologically.
So this is why, 7, 8 dollars out of 15, which is represented by the left two
columns, look like it has a huge psychological effect between thirty and
forty something on that scale. Where $8 on the right side of the scale,
even though it has the same $8 effect, psychologically it has a much, much
smaller effect. And this is basically the way that
relativity works, and how diminishing returns work.
And why the same physical amount in terms of money has very different psychological
implications.