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It’s the Consumer, Stupid

By Priya Raghubir, Professor of Marketing & Mary C. Jacoby Faculty Fellow

priya raghubir opinion article 1

consumers do not behave as economics models predict

Whether the discussion is about the consumer sentiment index, the stock market, labor and unemployment numbers, mortgage rates, home buying activity, or retailer numbers … center stage of the economy is occupied by the consumer. Yet how, how much, when, on what, and why consumers spend do not appear to be questions the government is especially curious about.

The government, including all its agencies, has good representation from respected economists and a smattering of finance academics. But where are the consumer psychologists?

Why would one need a consumer psychologist to inform public policy and consumer welfare? Because consumers do not behave as economics models predict.

For the last half-century or more, a growing body of evidence debunks the idea of “human rationality.” Understanding the systematic violations of rationality for consumer spending and savings is the purview of consumer psychologists, who have studied specific individual violations of many of the tenets of economic theory—such as the fungibility of money.

A basic concept of economics is that money is fungible—that money in another currency, form, or denomination is spent or saved in the same way as an equivalent amount of money in another currency, form, or denomination. However, this is not the case.

Joydeep Srivastava of the University of Maryland, and I have shown repeated violations of the principle of fungibility in consumers’ behavior. Consumers typically spend more using credit cards, debit cards, and gift certificates compared to cash, as paying with cash is painful; they are more likely to spend smaller denominations (e.g., four $5 bills) compared to a larger denomination ($20 bill); and they under-spend in a foreign currency where the face value is a multiple of their home currency (e.g., Americans in Mexico) and over-spend when the foreign currency’s face value is a fraction (e.g., Americans in the UK). Further, the source of money can also affect the manner in which it is saved or spent and what it is saved or spent on, as consumers keep different mental accounts for different types of expenditures.

How are these insights relevant to government policy? Take tax rebates. An understanding of how the form of money affects people’s save/spend decisions could certainly have helped achieve the government’s goal of encouraging consumer spending through tax rebates.

Rebates credited directly into a taxpayer’s bank account would most likely have been maximally assimilated into the bank account and had greater impact on encouraging saving rather than spending. Sending tax rebates to the taxpayer as checks may have been more effective.

But the most effective strategy for inducing consumers to spend their tax rebate checks might have been rebate checks in the form of easily cashable and spendable “gift certificates” (like traveler’s checks accepted at retail stores, but issued by the government)—especially if they looked like Monopoly money.

Small, seemingly trivial, manipulations in the way consumers receive their tax credits could add up to a substantial impact on the economy.

Another issue preoccupying everybody for the last three years is the housing market—mortgage rates and home prices. The Federal Reserve reduces rates in a bid to encourage homeowners to purchase or upgrade homes, which they may have been putting off for a while. However, the strategy does not appear to have worked to get the market out of its slump. Why not?

Again, consumer psychologists may have the answer. We would point out that consumers are risk-averse and make decisions based on their predictions of how the market may look in the future—and that forecast is still cloudy. Simple lessons learned about how consumers avidly buy on sales promotions—versus when prices are simply lowered—might have been valuable to the Fed when deciding on the amount, timing, and information it would provide about interest rates.

Then there is the personal debt crisis—consumers are clearly not saving what they need for their retirement, especially given the aging US population.

One area of potential consumer savings is the consumer’s own home—for many, their largest investment. Public service messages could inform mortgage holders that adding a minimal amount to their monthly payments reduces the life of the mortgage by an eye-opening amount.

For example, a mortgage of $200,000 at 5 percent fixed for 30 years starting July 2011 has a monthly payment of $1,073.64 that continues until July, 2041. Merely rounding up the amount to $1,100--by adding $26.36 per month--reduces the period of the loan by 18 months to December 2039! Adding another $100 monthly reduces the loan period by over five years.

These are huge differences for people struggling to save and pay off their homes, but I speculate that most are unaware that such small additional payments wield such powerful leverage.

Insights from consumer psychology can assist with developing these public service messages, whether the goal is to encourage consumer spending or saving, or reduce consumer debt.

So, where are the consumer psychologists?