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Lecture 35 Payment Decoupling & Budgeting

Payment Decoupling

  • Prepayment separates or decouples the purchase from the consumption (reduces perceived cost)
  • Prepayment is not the only way…
    • Pricing policy of luxury club resorts… fixed-fee for a vacation (meals, lodging and recreation included)
    • Advantages:
      1. Extra cost of meals and recreation will look relatively small compared to other costs in the vacation
      2. Under the alternate plan… each small transactions look large (negative transaction utility comparing prices at most resorts)
    • Disadvantage of piece-rate pricing policy
      • Links payment and specific consumption act…
      • The opposite is desirable (e.g. Unsavory prospect… very high price \(\implies\) very small quantity of food)

Another application, urban car owners would be better off financially by selling their car and using a combo of taxis and car rentals. But doing so will lead to linking the small taxi fare with the small consumption act, which would raise the price of groceries and movies. (Monthly car payments do not make you feel so)

  • 'Flat rate basis in Telecom (even though paying by the call would cost them less)
  • Even if bill with or without the basis would be the same
  • Health club charge on a per-month/year basis rather than a per-use basis

IDEA: Decouple usage from pees… Make the marginal cost of a visit = 0

Usage-based pricing
- Incompatible with the desire of encouragement

  • Decoupling device… credit card facilitate spending… stores pay 2% of their revenue to card companies
  • How?
    1. Postpone payment by weeks. Two effects created
      • Payment is later than the purchase (attractive to impatient or liquidity constrained) But consumers prefer paying before… so unlikely to be the main appeal
      • Payment is separated from the purchase. This makes the payment less salient.
      • Vividness or salience, you won't remember how much you paid for.
    2. Purchase is mixed in with many others.
      • Compare paying $50 in cash vs adding $50 to an $843 bill
      • Psychophysics \(\to\) $50 is larger by itself than in context in a much larger bill, each one loses salience
      • Effect is stronger if not paid immediately

Budgeting

  • Categorization/Labeling
  • Three labels for money
    1. Expenditure \(\to\) Budgets (food, housing)
    2. Wealth \(\to\) Accounts (pension, rainy day)
    3. Income \(\to\) Category (regular/windfall)
  • Standard Econ assumes that they are perfectly fungible (substitutable)

Consumption Categories

  • Why divide spending into budget? two purposes
    1. Facilitate making rational trade-offs
    2. Acts as a self-control device (limits)
  • Tighter the budget, more explicit the budget
  • Wealthy families, budgets are both less biding and less well defined.
  • Expenses need to be tracked (2-step) (in brackets are parallels in IRL)
    1. Notice the expense (booking or recording in financial accounting) \(\to\) Depends on attention & memory
    2. Assign to their proper account (post in financial recording) \(\to\) Depends on similarity judgements & categorization

  • Small, routine expense are not booked (= org practice, assign to a 'petty cash' fund)

    • can explain an apparent contradiction in hedonic framing

  • 'pennies a day' strategy \(\to\) Goal: don't let it be booked so that making the purchase doesn't affect the consumer

    • $100 membership = 'mere 27 cents a day'
    • 27 cents is a petty cash category
  • Opposite direction: quit smoking, $2 a day. Save $730 for a vacation in an year…

Implications of Violations of Fungibility

  • If budgets not fungible, it is possible that…
    • one budget is spent to its limit
    • Others unspent funds remaining
    • Can create extreme distortions
  • A typical study…
    • Are you willing to buy a ticket to a play?
    • Group 1: Basketball game (same budget)
    • Group 2: Parking ticket (different budget)
    • Both cost $50 but budget categories are different.

Money & time should be fungible. A rational person should 'equate at the margin' (allocate optimally).
- The marginal value of an extra minute devoted to any activity should be equal
- But "Jacket and Calculator problem" contradicts!
- Another situation, "How much will you pay, to avoid ticket line for 45 minutes"
- People are willing to pay twice as much to avoid wait for a $45 than a $15 purchase
- Implicit value of time depends on financial context

Self-Control

  • Another violation of fungibility… intentionally set low budgets to help deal with self-control problems.

Self-control & Gifting

  • MA analysis suggests that…
  • Best gifts are somewhat more luxurious than the recipient wouldn't buy for themselves.
  • Luxurious gifts can be better than cash
  • Buy a smaller quantity (price premium paid) so that consumption is contained.