Tag: Richard Thaler | Vivek Kaul

23 August, 2021

Explained: Why the Govt is Misleading Us on High Fuel Prices and Oil Bonds

The reason why doesn’t matter. The only thing that matters is controlling the narrative – Fabian Nicieza in Suburban Dicks.

Over the last few years, several government ministers have blamed the oil bonds issued during the era of the previous United Progressive Alliance (UPA) government, for the high petrol and diesel prices, which have prevailed for a while now.

The then oil minister Dharmendra Pradhan had tweeted in 2018 that: “The country and our OMCs [oil marketing companies} are also yet to recover from the shock of Oil Bonds worth Rs 1.4 Lakh Crores issued during the UPA regime.”

The finance minister Nirmala Sitharaman rblamed the oil bonds for the high prices of petrol and diesel, in a recent statement. This is not true. I have explained this issue in great detail on earlier occasions. Nevertheless, I will try and offer a broader summary here, before getting on to the new points I want to make.

Oil bonds were largely issued by the previous UPA government. This was done in order to compensate oil marketing companies, like Indian Oil, Bharat Petroleum and Hindustan Petroleum, for selling petrol, diesel, kerosene and domestic cooking gas, at a price which wasn’t monetarily feasible for them.

The argument offered by the National Democratic Alliance (NDA) government is that since interest has to be paid on these bonds and that these bonds have to be repaid, the government needs to charge a high excise duty on petrol and diesel. This leads to high petrol and diesel prices.

In that sense, the NDA government and you and me are paying for the sins of the UPA government. This argument is never made in as clear words as I am making it here. Things are left vague enough for people to fill in the gaps and make their own WhatsApp forwards.

As of March 2014, before the NDA government came to power, the total oil bonds outstanding stood at Rs 1,34,423 crore. By March 2015, this had come down to Rs 1,30,923 crore, which is where it has stayed up until March 2021.

This means that between end March 2015 and end March 2021, no oil bonds matured and hence, the NDA government didn’t need to repay a single rupee of oil bonds. Of course, interest had to be paid on these bonds. An interest of Rs 9,990 crore has to be paid on these bonds every year. This means, over a period of six years, between end March 2015 and end March 2021, the government has paid Rs 59,940 crore as interest on these bonds.

During the same period, it earned Rs 14,60,036 crore as excise duty on petroleum products. As the government told the Lok Sabha in early August this year: “Central excise duty is contributed largely by Petrol and Diesel.” So, excise duty earned on the sale of petrol and diesel makes up for a bulk of the excise duty earned on sale of petroleum products.

In total, during this period, 4.1% of the excise duty collected on petroleum products has gone towards paying interest on oil bonds. In 2020-21, this stood at just 2.7% (Rs 9,990 crore of interest against excise duty of Rs 3,71,726 crore earned on petroleum products).

In fact, if were to look at excise duty collected on just petrol and diesel, between end March 2015 and end March 2021, it amounts to around Rs 13.7 lakh crore. The interest paid on oil bonds amounts to 4.4% of this amount.

In 2021-22, the current financial year, Rs 10,000 crore worth of oil bonds are maturing and hence, need to be repaid. The interest that needs to be paid on the oil bonds during the year should amount to around Rs 9,500 crore. So, during 2020-21, around Rs 19,500 crore will be needed by the government to service these bonds.

In an answer provided to the Lok Sabha recently, the government had said that the total excise duty earned on petrol and diesel, between April and June this year, had stood at Rs 94,181 crore.

Given that, the second Covid wave was on during this period, and that it would have negatively impacted the consumption of petrol and diesel to some extent, it is safe to say that if excise duty on petrol and diesel continue to be where they are, the total collections this year can easily touch Rs 4 lakh crore. Of course, the collections on petroleum products will be even greater.

Rs 19,500 crore works to around 4.9% of Rs 4 lakh crore. So, the government is likely to spend one-twentieth of the excise duty earned on petrol and diesel, in servicing the oil bonds (both repaying maturing bonds and paying interest on the outstanding bonds).

The remaining bonds worth Rs 1,20,923 crore (Rs 1,30,923 crore minus Rs 10,000 crore worth of bonds maturing this year), will mature between November 2023 and March 2026.

The other argument that is being made is that the government needs to save money in order to repay these bonds in the years to come. It is worth clarifying here that the government meets the expenditure of a given year from the revenue earned during that year. Hence, bonds maturing in 2023, 2024, 2025 and 2026, will be repaid using taxes earned during that year. This nullifies the argument about the government having to save in order to repay these bonds.

Hence, the entire argument that the oil bonds have led to a situation where the government has had to charge a high excise duty on petrol and diesel, is totally wrong. In fact, as I have explained earlier, the reason for this lies in the fall of corporate tax collections.

In 2018-19, the total corporate tax or the income tax paid by corporates had stood at Rs 6.64 lakh crore. This fell to Rs 5.57 lakh crore in 2019-20. It fell further to Rs 4.57 lakh crore in 2020-21.

This fall was on account of the base rate of corporate tax being cut from 30% to 22% in September 2019. It can also be argued that Covid must have led to lower profits for corporates in 2020-21 and hence, lower corporate tax collections for the government.

Data from the Centre for Monitoring Indian Economy tells us that in 2020-21, the net profit of listed corporates (more than 5,000 companies) increased by 120.3% in comparison to 2019-20. So, Covid didn’t impact profits among the listed corporates. While net profit went up by 120.3%, the corporate tax paid by these companies went up just 13.9%.

Covid has negatively impacted smaller businesses and that must have impacted corporate tax collections to a certain extent. But a bulk of the fall in corporate tax collections seems to have come from a lower rate of tax. This has been compensated through higher excise duty on petrol and diesel.

In 2018-19, excise duty earned on petroleum products by the central government brought in Rs 2.14 lakh crore. This jumped to Rs 3.72 lakh crore in 2020-21, thanks to a higher excise duty on petrol and diesel.

The corporate tax cut was supposed to boost consumption and lead to an increase in corporate investment. But that hasn’t really happened. Expecting consumption to increase thanks to lower corporate taxes was kite-flying at its very best.

Consumption increases when people see the prospect of earning more money, not when corporate taxes go down. Investment, for a whole host of reasons, has been down in the dumps for close to a decade now,. I shall not go into these reasons in detail here, having dealt with this issue on multiple occasions in the past.

This has created a communication problem around high petrol and diesel prices for a government obsessed with managing the narrative.

In their book Nudge—The Final Edition, Richard Thaler and Cass Sunstein talk about the publicity principle, originally elucidated by the philosopher John Rawls. As Thaler and Sunstein write: “If a firm or government adopts a policy that it could not easily defend publicly, it stands to face considerable embarrassment, and perhaps much worse, if the policy and its grounds are disclosed [emphasis added].”

This is precisely the problem with the entire messaging around the issue of high petrol and diesel prices. The only reason for this is the high excise duty on petrol and diesel, in order to compensate for lower corporate tax collections.

The excise duty on petrol has gone up from Rs 9.48 per litre in October 2014 to Rs 32.90 per litre currently, a jump of close to 250%. A bulk of this increase of around Rs 10 per litre has happened in the last one year. A similar story has played out with diesel, with excise duty going up from Rs 3.56 per litre in October 2014 to Rs 31.80 per litre currently, a jump of close to 800%. (I would like to thank Chintan Patel for providing this information by using the central government notifications on excise duty on petrol and diesel).

Of course, this is not something that a narrative obsessed government can admit to. This would mean telling the world at large that the common man is being made to pay for lower corporate taxes. This has led to the entire narrative around oil bonds and they having to be repaid and interest having to be paid on them, and that leading to a higher excise duty on petrol and diesel, and hence, higher pump prices of fuel.

This is a narrative that can be easily sold on WhatsApp, given that most people don’t have the time to check the facts of any argument and buy anything that is sent to them over the world’s newest and the most happening university.

As Thomas Sowell writes in Knowledge and Decisions:

“To exhort the individual citizen to make investments in knowledge comparable to those of lobbyists and political crusaders (both of whom have much lower costs per unit of personal benefit) is to urge him to behaviour that is irrational, if not physically impossible in a twenty-four hour day.”

This is something that the current government is making use of and projecting a narrative that wrongly blames the past government for high fuel prices.

As Thaler and Sunstein write: “Organizations of all forms should respect people, and if they adopt policies that they could not and would not defend in public, they fail to show that respect. Instead, they treat citizens as tools for their own use or manipulation [emphasis added].”

This is precisely what is happening.

The interesting thing is that the government has given the more or less the right reason behind high fuel prices in an answer to a question raised in the Lok Sabha. As it said: “The excise duty rates on petroleum products are calibrated from time to time with the objective of generating resources for infrastructure and other developmental items of expenditure, taking into account all relevant factors and keeping in view the prevailing fiscal situation.”

Every government has the right to tax the citizens in different ways. This answer tells us precisely that. Of course, explaining the rationale behind the tax is not always that straightforward.

14 June, 2016

The Sunk Cost of Air India

There are somethings one never expects a minister to say. Hence, the civil aviation minister Ashok Gajapathi Raju’s recent statement on Air India, came in as a pleasant surprise. The minister told the Press Trust of India: “It is a nice airline. I like Air India but I can’t commit taxpayers’ money for eternity. That is not done.”

This is a huge thing for the civil aviation minister to say. If you take Air India out of the civil aviation ministry (by either shutting it down or selling it off) there isn’t much that remains. Having made this statement, Raju hedged it by saying: “Let’s wish and hope that it (Air India) flies high. I am not against the public sector and I am not for only public sector at all costs. Public sector has a role and private sector has a role. Let them work in competition.”

To be honest, I have also liked Air India, on occasions I have travelled in it, as long as it has taken off on time. The leg space is better than the low cost carriers. The seats are more comfortable and the food is hot. Nevertheless, this is no excuse to keep the airline going.

As I have mentioned in the past, between 2010-2011 and 2015-2016, the airline made total losses of Rs 34,689.7 crore. That is quite a lot of money. Further, the airline also has a debt of Rs 51,367 crore, of which Rs 22,574 crore are outstanding aircraft loans. (As the minister of state for civil aviation Mahesh Sharma told the Parliament in March 2016).

A major part of the debt has helped the airline meet its expenditure, given that it doesn’t earn enough to meet its expenditure. Lenders keep lending to a perennially loss making Air India because ultimately they are lending to the government. And there is no safer lending than lending to the government, at least in theory.

Over and above the debt that airline took on, up until March 2016, the government had already poured Rs 22,280 crore into Air India, to keep it going. A further equity infusion of Rs 1,713 crore has been approved for the current financial year. Hence, a lot of public money is being spent to keep the airline going. What these numbers tell us is that the current government and the ones before it, have been basically in favour of public sector at all costs.

The civil aviation minister Raju further said: “Its (Air India) books are so bad. I don’t think that even if it is offered, anybody would come for it.” What the minister was basically saying is that nobody in their right mind will buy Air India in its current state. But is this good enough a reason to keep the airline going? That seems to be the case, given that there has been absolutely no talk of shutting it down.

Behavioural economists have a term for a situation like this—they call it the sunk cost fallacy. As Daniel Kahneman, the Nobel Prize winning psychologist, writes in Thinking, Fast and Slow: “A rational decision maker is interested only in the future consequences of current investments. Justifying earlier mistakes is not among the…concerns. The decision to invest additional resources in a losing account when better investments are available, is known as sunk-cost fallacy, a costly mistake that is observed in decisions large and small.”

Kahneman gives the hypothetical example of a company that has already spent $50 million on a project. As he writes: “The project is now behind schedule and the forecasts of its ultimate returns are less favourable than at the initial planning stage. An additional investment of $60 million is required to give the project a chance. An alternative proposal is to invest the same amount in a new project that currently looks likely to bring higher returns. What will the company do? All too often a company afflicted by sunk costs…[throws] good money after bad rather than accepting the humiliation of closing the account of a costly failure.”

This escalation of commitment is visible in many areas including war as well. As Richard Thaler writes in Misbehaving—The Making of Behavioural Economics: “Many people believe that the United States continued its futile war in Vietnam because we had invested too much to quit…Every thousand lives lost and every billion dollars spent made it more difficult to declare defeat and move on.”

This escalation of commitment is a major reason which has led to the government keeping Air India going over the last few years, despite the mounting losses. No minister or the government for that matter, wants to admit defeat and talk about shutting down the airline.

As Kahneman writes in the context of the example we saw above: “Cancelling the project will leave a permanent stain on the executive’s record, and his personal interests are perhaps best served by gambling further with the organisation’s resources in the hope of recouping the original investment—or at least to postpone the day of reckoning.”

This logic applies to the civil aviation minister as well as the government (and not just the current one). No government wants to admit defeat and shutdown the airline. This, in a situation, when the government isn’t exactly flush with money and there are other important sectors, like education, health as well as physical infrastructure, that need more money.

Further, the airline continues to lose money and in a scenario where the Indian Railways is in a mess and needs a lot of money to be revived. If there is only so much money going around, shouldn’t that money be going to the Railways, instead of an airline?

I guess that is a no-brainer. But then no-brainers aren’t always so easy to process.

The column originally appeared in the Vivek Kaul Diary on Equitymaster on June 14, 2016

30 July, 2015

The “confirmation bias” of a real estate investor

Vivek Kaul

I have been writing quite a lot on real estate recently. Given that, I had thought that I will take a break from writing on real estate for some time. But that I guess is not going to happen. So here is one more column on real estate.

As I have pointed out in the past, every time I write a column on real estate, people write to me with reasons as to why real estate prices in India, can never fall. The reasons usually offered are population growth, not enough land, inflation and black money. I have debunked these theories at various points of time, so I won’t get into these reasons all over again.

But I would like to point out that real estate prices in India did crash between the mid 1990s and early 2000s. As an August 1997 newsreport in the India Today magazine points out: “Be it Mumbai’s ‘golden mile’, Nariman Point – the most expensive stretch of real estate in the world – or Somajiguda in Hyderabad; Delhi’s commercial hub Connaught Place or Koregaon Park in Pune; Bangalore’s pulsing heart M.G. Road or the sedate T. Nagar in Chennai. Each of these upmarket addresses, the most sought – after in their respective cities, are now dotted with unoccupied apartment blocks, unwanted commercial complexes and office space purchased at rates too hot to handle today.”

And this led to a huge real estate crash. “For the country’s over Rs 1,00,000 crore real estate business-one-twelfth the size of the GDP – it has been a crash without precedent. Between mid-1995, when the real estate boom peaked, and mid-1997, prices have fallen a bruising 40 per cent,” the India Today report newsreport further pointed out.”

The irony is that all the reasons that are offered now in favour of real estate prices not crashing, were as valid then, as they are now. But real estate prices did fall. So, real estate prices do fall, it’s just most people don’t remember about it, given that they haven’t fallen for a while now.

One of the newer reasons that has been offered in the recent past is that the government won’t allow the price of real estate to fall. This is because politicians have their ill-gotten wealth invested in real estate. Another corollary to this was offered to me by a friend yesterday who citing a discussion he had on a WhatsApp group said that the government will not allow the price of real estate to fall by more than 20%. If the government allows the real estate prices to fall more than 20%, the banks will end up with a huge amount of bad loans.

The problem with this argument is the assumption that the government can control these things. If it could, the banks would not be sitting on the massive amount of bad loans that they already are.

Let’s take the case of the Chinese stock market. On July 27, 2015, the Shanghai Composite Index fell by 8.5% during the course of a single day. It would have fallen more. But that did not happen given that the rules in China prevent share prices from moving freely once they have risen or fallen by 10% during the course of a single day.

This despite the Chinese government doing everything within its power to ensure that the stock market did not fall. It banned short selling. It banned initial public offerings, so that people buy shares already listed in the market. It banned investors with more than 5% of shares in any company, from selling those shares over the next six months.

Over and above this, the government got stock brokerages to buy shares. As Wei Yao of Societe Generale points out in a recent research note: “ The Ministry of Finance, one of the big shareholders of listed financial institutions, promised not to sell its holding and several central government SOEs[state owned enterprises]…started to buyback shares.” Despite all these measures the Chinese market fell by 8.5% in a single day, its biggest fall since 2007.

The Chinese government has way more control over the Chinese economy than the Indian government will ever have over the Indian economy. And if the Chinese government hasn’t been able to prevent the stock market from falling, what are the chances that the Indian government will be able to prevent the real estate market from falling?

The Shanghai Composite Index has fallen by close to 27% between June 12 and July 29, 2015. This, despite the government taking multiple measures to arrest the fall. The moral of the story is that the governments cannot prevent big market falls.

Another point that I want to make here is regarding the people who are going around saying that real estate prices will not fall and that real estate prices never fall. These are essentially individuals who make money through real estate. Either they own multiple homes and are sitting in the hope of prices continuing to go up or they work for the real estate industry.

Such individuals suffer from a confirmation bias. As John Allen Paulos writes in A Mathematician Plays the Stock Market: ““Confirmation bias” refers to the way we check a hypothesis by observing instances that confirm it and ignoring those that don’t. We notice more readily and even diligently search for whatever might confirm our beliefs, and we don’t notice as readily and certainly don’t look hard for what disconfirms them.”

Given that their incomes depend on real estate prices continuing to go up they refuse to look at even the most basic evidence. Real estate prices have gone way beyond from what most people can afford. At prices homes are currently selling at, even the Ritchie-Rich are having a difficult time buying. As a research report brought out by real estate consultant Knight-Frank points out: “On the other hand, for end users, high property prices and low income growth continue to be the top concerns.”

And this explains why real estate builders have been unable to sell homes. The Knight Frank report talks about the sad state of affairs in the Mumbai Metropolitan Region (MMR): “The MMR residential market contracted further in H1 2015 (January to June 2015). In comparison to the preceding half yearly period of H2 2014 (July to December 2014), absorption and new launches shrunk by 22% and 30%, respectively. Housing sales of 28,446 units and new launches of 18,887 units made H1 2015 the worst half-yearly period in the post global financial crisis era.”

So here is a real estate consultant telling us that the overall Mumbai real estate scene is in a mess. It’s never been so bad since 2008. And Mumbai is not even the worst performing real estate market in the country. That title goes to Delhi.

Despite all this, those whose incomes depend on real estate continuing to do well, are still telling us that prices won’t come down. I really don’t know what they are smoking but as the American journalist Upton Sinclair once said: “It is difficult to get a man to understand something, when his salary depends on his not understanding it.”

A few years back I had a similar experience when those associated with the insurance industry kept telling us that unit linked insurance plans (Ulips) are the best mode of investing. We all knew what happened to those who invested in Ulips.

The column originally appeared on The Daily Reckoning on July 30, 2015

8 July, 2015

Uber’s surge pricing shouldn’t just be about ‘good’ economics

Vivek Kaul

The two most basic laws in economics are the law of demand and the law of supply. The law of demand basically states that all other factors being equal the price and the quantity demanded of any good or service are inversely proportional to each other. The law of supply states that an increase in price results in the increase of the quantity of the good or service supplied.

These two laws are the heart of the business model of Uber. The price of the taxi-service goes up when the demand is higher i.e. more people want to use Uber cabs in an area than the number of cabs available at that point of time. The company calls this “surge pricing”.

On the face of it this pricing practice sounds normal. It is often compared to airline ticket prices where the prices during weekends, summers, festivals and end/beginning of the year tend to be higher because the demand is higher. Along similar lines Uber prices go up when the demand is higher. Nevertheless, the comparison is not so straightforward.

When the demand is high, the price charged by Uber starts to go up. There have been cases when the price has gone up many times the normal price charged by the company. A December 2014 article in the Time magazine puts the highest multiple ever recorded at 50 times the normal price. This happened in Stockholm, Sweden.

When terrorists took over a café in Sydney in December 2014, the price went up four times its normal rate. A similar thing happened in Toronto, last month, during a massive subway disruption in the city.

The company has a standard explanation for this—the law of supply is at work. Travis Kalanick, the CEO of Uber explained it on his Facebook page once: “We do not own cars nor do we employ drivers…Higher prices are required in order to get cars on the road and keep them on the road during the busiest times. This maximizes the number of trips and minimizes the number of people stranded.”

How good is this argument? As Richard Thaler writes in Mishbehaving: The Making of Behavioural Economics: “You can’t just decide on the spur of the moment to become an Uber driver, and even existing drivers who are either at home relaxing or at work on another job have limited ability to jump in their cars and drive when a temporary surge is announced.”

Further, “one indication of the limits on the extent to which supply of drivers can respond quickly is the very fact that we have seen multiples as high as ten”, writes Thaler. If drivers were actually responding to surge pricing quickly that wouldn’t have been the case.

Research carried out by Nicholas Diakopoulos of the University of Maryland (which was published in the Washington Post) suggested that: “surge pricing doesn’t seem to bring more drivers out on the roads”. What it does instead is that pushes drivers already on the road towards areas with higher surge pricing.

Also, in most cities which have taxi-cabs people are used to paying a fixed rate. Uber is trying to challenge that notion. The trouble is that while it is doing that it ends up with a lot of bad PR, during tough situations(like terrorists entering a city, weather disasters, transport strikes/disruptions) when the surge pricing tends to kick in. While “surge pricing” follows economic theory, what the company needs to realise is that they are charging the consumer more, when he or she is in a spot of bother anyway.

So what should they do? Thaler has the answer: “This insensitivity to the norms of fairness could be particularly costly to the company…Why create enemies in order to increase profits a few days in a year?…I would suggest that they simply cap surges to something like a multiple of three times the usual fare.”
Now that sounds like a sensible thing to do.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column appeared in the Bangalore Mirror on July 8, 2015

12 November, 2012

Gambler’s fallacy: The lesson I learnt last Diwali

Kyon daren zindagi main kya hoga, kuch na hoga to tajurba hoga’ – Javed Akhtar (tajubra = experience)
Experience is a great teacher, but the trouble is it only comes with time, and by then the mistakes have already been made.
Last Diwali I played teen patti for the first time with friends and family. I started cautiously with a hundred rupees bet. But with the beginners luck at work I easily won the next few rounds and half an hour later I had won Rs 5,000 and was now worth Rs 5,100 in total, which included the Rs 100 I had started with as well.
Then egged on by sister I bet the entire Rs 5,100 blind, on the tenth round that we were playing. And against the luck of the draw, I lost.
I turned around wanting to look at my sister, but before I could say anything i.e. call her names she said “Don’t worry bhaiyya you just lost a hundred rupees.”
Now did I? Was that really the case? Or was something else at work?
Following the time tested method of when in doubt then Google, I came to realise that I had just become a victim of what behavioural economists (a section of economists who link human psychology to economics) call “mental accounting”.
Richard Thaler, a pioneer in the field of Behavioural Economics and who coined the term mental accounting, defines it as “the inclination to categorise and treat money differently depending on where it comes from, where it is kept and how it is spent.”
This leads to what is referred to as the gambler’s fallacy, the tendency of gamblers who lose their winnings, feeling that they haven’t lost anything at all. Precisely, like what my sister said.
Thaler along with Cass Sunstein explains this in his book Nudge — Improving Decisions About Health, Wealth and Happiness. “You can also see mental accounting in action at the casino. Watch a gambler who is lucky enough to win some money early in the evening. You might see him take the money he has won and put it into one pocket and put the money he brought with him to gamble that evening (yet another mental account) into a different pocket,” write the authors.
The gamblers call their winnings ‘house money’. As the authors write “The money that has recently been won is called ‘house money’ because in the gambling parlance the casino is referred to as the house. Betting some of the money that you have just won is referred to as ‘gambling with the house’s money’; as if it was, somehow, different from some other kind of money. Experimental evidence reveals that people are more willing gamble with money that they consider house money.”
The house money effect is even seen at work when stock markets are on an upside. Thaler and Sunstein, give the example of the late 1990s when the world was seeing the dotcom bubble. “Mental accounting contributed to the large increase in stock prices in the 1990s, as many people took on more and more risk with the justification that they were playing only with their gains from the last few years,” they write.
It isn’t only while gambling and investing in stock markets that human beings categorise money in different ways. As John Allen Paulos writes in A Mathematician Plays the Stock Market “People who lose a $100 ticket on the way to a concert, for example, are less likely to buy a new one than are people who lose $100 in cash on their way to buy the ticket. Even though amounts are the same in the two scenarios, people in the former one tend to think $200 is too large an expenditure from their entertainment account and so don’t buy a new ticket, while people in the latter tend of assign $100 to their entertainment account and $100 to their “unfortunate loss” account and buy the ticket.”
Or sample this situation. Let’s say you are at an electronics shop looking to buy a laptop. You finally decide to buy a model which costs around Rs 36,300. Just as you are paying for it a friend calls and tells you about a better deal on a website which is offering the same model for Rs 36,000? Will stop the purchase and go back home and order the laptop from the website? The chances are no.
But consider another situation where you are out looking to buy a DVD player. You finally zero down on a model that costs Rs 3000. At that point of time a friend calls and tells you that the same thing is available on a website for Rs 2700. Will you stop the purchase and go back home and order the DVD player from the website? The answer is yes.
The funny thing is that in both the cases you would have saved Rs 300. But in one case you decided to go ahead with the transaction and in another case you did not? Why does this happen? At a fundamental level the Rs 300 we save is being categorised into different mental accounts because we are thinking in terms of percentages. Rs 300 expressed as a percentage of Rs 36,300 is very small whereas Rs 300 expressed as a percentage of Rs 3000 is significantly larger.
This tendency to categorise money into different mental accounts leads to several other interesting situations. Money that comes in rather unexpectedly, like a tax refund, a salary arrear, a higher than expected bonus at the end of the year, or a generous cash gift from a visiting relative for that matter, gets spent faster.
As Gary Belsky and Thomas Gilovich point out in their book Why Smart People Make Big Money Mistakes and How to Correct Them “Consider tax refunds, for example. Many people categorise such payments from the government as found money – and spend it accordingly – even though a refund is nothing more than a deferred payment of salary. Forced savings, if you will. If, on the other hand, those same people had taken that money out of their paycheck during the course of the previous year …they would most likely think long and hard before spending it on a new suit or Jacuzzi.”
This also leads to a situation where people have personal loans or huge credit card balances outstanding even though they have money lying in the bank earning nterest in the savings account or in the form of a fixed deposit. This despite the fact that the interest earned on a fixed deposit is much lower than the interest being paid on a personal loan or credit card balance outstanding.
In fact research has been carried out to show precisely this. “David Gross and Nick Souleles (2002) found that the typical household in the sample of Americans had more than $5,000 in liquid assets (typically in savings accounts earning less than 5% per year) and nearly $3,000 in credit card balances, carrying a typical interest rate of 18% or more,” write Thaler and Sunstein. Now wouldn’t it have been much simpler to pay off the credit card debt instead of paying such a high rate of interest on it?
But mental accounting is at work. People put the loan outstanding into the loan mental account whereas money in the bank gets categorised as a savings mental account. And the two do not meet. As the Thaler and Sunstein write, “Many of these households have borrowed up to the limits that their credit cards set. They may realise that if they paid off the credit card debt from the savings account, they would soon run up the cards to their limits once again. (And credit card companies, fully aware of this, are often more than willing to extend more credit to those who reached the limit, as long as they aren’t yet falling behind on interest payments.”
Hence it is important to remember that money is fungible. So there is no point in having money lying in a fixed deposit while you are still paying off your credit card balance or a personal loan for that matter. The interest you earn on your fixed deposit will be always lower than the interest you pay on your credit card debt or on a personal loan. Given this it makes more sense to first and foremost pay off your debts instead of saving money while categorising it into a “mental account”.
If all this wasn’t enough, have you ever wondered why shops and malls actually accept payments made through credit and debit cards, even though they do not get the full price on those transactions? Well the answer again comes back to mental accounting.
As Belsky and Gilovich point out, “In fact, credit cards…are almost by definition mental accounts, and dangerous ones at that. Credit card dollars are cheapened because there is seemingly no loss at the moment at the purchase, at least on a visceral level. Think of it this way: If you have $100 cash in your pocket and you pay $50 for a toaster, you experience the purchase as cutting your pocket money in half. If you charge that toaster though, you don’t experience the same loss of buying power that your wallet of $50 brings.”
Given this, while shopping most individuals end up paying more when they use their credit cards. And that explains why shops accept credit cards happily even though they get paid only around 98% of the price of what is purchased. But they benefit because the size of the purchase goes up.
If you still haven’t understood what mental accounting is all about here is a brilliant example that Thaler and Sunstein talk about. “The concept is beautifully illustrated by an exchange between Gene Hackman and Dustin Hoffman. Hackman and Hoffman were friends back in their starving artist days, and Hackman tells the story of visiting Hoffman’s apartment and having his host ask him for a loan. Hackman agreed to the loan, but then they went into Hoffman’s kitchen, where several mason jars were lined up on the counter each containing money. One jar was labelled ‘rent,’ another ‘utilities,’ and so forth. Hackman asked why, if Hoffman had so much money in jars, he could possibly need a loan, whereupon Hoffman pointed to the food jar, which was empty.”
The article originally appeared on www.firstpost.com on November 12, 2012.
Vivek Kaul is a writer. He can be reached at [email protected]