PBS is poised to run a NOVA special tonight at 8PM ET/PT titled Mind Over Money. The show seeks to explore the differences between conventional economics and behavioral economics. They try to understand how emotions play a role in economics and show various experiments that were conducted to “prove” emotions influence your decisions. This emotional influence contrasts to conventional economics which says that people will always perform rationally when dealing with money. The theory is that you will work out exactly what something is worth to you and don’t allow your emotions to influence your decision.
Now I am not an actual economist so I can’t refute any of these theories on economics, it makes sense to me though that people will be influenced by their emotions. The show uses bubbles as an example of people acting irrationally. We convince ourselves that the value of something is considerably higher than it really is and start jumping on the bandwagon, right up until it pops like an overinflated balloon.
One of the “experiments” they used as an example of people acting irrationally was the auctioning of a $20 bill to a group of students. One student ended up paying$28 for a $20 bill. This is supposedly an irrational measure. What they don’t explain well enough is that the second place bidder also has to pay their bid and gets nothing. The bidding goes up above $20 in an effort to win and cut your losses, the person who lost the bidding war still had to pay $27 while the winner was only out $8. Of course had they stopped at the $20 mark the second place bidder would have been out $19 which is more than the $8 extra he paid for the $20. They artificially forced the price above $20 by instituting a penalty for the second place bidder. To me it would have been rational to continue to bid if I was sitting in second place.
Experiments aside I think you would be hard pressed to say people are always going to act rationally when it comes to money. The rational method of reducing debt would be to pay off your highest interest debt first to cut down the amount of money your debt is costing you. Dave Ramsey has made his career by encouraging you to act emotionally not rationally when it comes to debt reduction. This process makes sense and it works. You get the little wins up front which encourage you to continue to reduce debt by building on your snowball. This isn’t rational but it makes sense. Looking back at the housing boom can we think that the epic rise in house prices was the result of rational thinking or irrational actions.
NOVA quotes Robert Schiller, author of Irrational Exuberance as an example of someone who believed the markets were overvalued and didn’t support the prices being seen at the time. Other economists were shown discounting his claims. Shiller’s theory was that while the booming markets were initially based on solid reasoning it converted to emotional excitement and envy which further fed the building bubble until it burst. Emotions are a big part of how we handle money, whether or not that proves conventional economics is wrong is up to you.
If you are interested in learning more check out the NOVA special tonight on PBS at 8pm ET/PT and/or visit their site at http://www.pbs.org/nova/money for more information.