Are Poor more rational than we think?
The wife and I have been debating on replacing an expensive mattress that we bought 3 years back. Over the years, we have stopped liking the mattress and it seems to be doing more harm than good. So now we both want to get rid of it. We already have a replacement mattress with us so the replacement cost is zero. The point of debate is – what should be the minimum price at which we should be willing to sell this expensive but useless mattress. In economic terms, what should be the WTA (willingness to accept) price? While I think any price is a good price, my wife is looking for a good deal. When I asked my friends, their responses also varied between 20 – 25% of the original cost.
Is this response rational? As per classic economic theory, only incremental costs should impact decision. All historic costs are irrelevant since they are sunk costs. Considering there is no replacement cost of the mattress, my WTA price should actually be zero. So, why do we value these costs?
The idea of Loss Aversion which is discussed as part of Prospect Theory in Behaviour Economics literature explains this behaviour. We all operate from a reference point and evaluation happens based on the change from that reference point. Further, a negative change feels much larger than a positive change. For example, losing Rs. 1000 is much more painful than gaining the same amount.
The same is applicable when we are replacing or giving up a product. When someone wants to replace a product, they evaluate not only the value of the replacement product (gain) but also the value of the product foregone (loss). If I believe that I have not completely utilised the value of my old product, I feel a sense of loss of giving it up. To cover up that loss, I want to recover at least part of my money. In the case of the mattress which is expected to be utilised for say 10 years, replacing after 3 years means a loss of 7 years of potential use. This paper discusses Product Replacement decisions in detail.
The theory of loss aversion has been used to explain multiple seemingly irrational decisions. In the book Thinking, Fast and Slow, Kahneman has described numerous decisions that people have made which are not in line with decisions predicted by classic economics. But there is also an interesting aberration – in case of poor or people with limited means, loss aversion may lead to rational decisions.
Being poor means living below the minimum level of income needed for adequate living. It means that one is always operating below the reference point that we discussed earlier. So, the individual is evaluating in the domain of losses. In this situation, money given to replace a good will not be interpreted as a gain but as a reduced loss. It will be considered as an aid to move towards the minimum reference point. Not taking money in this case would mean losing out an opportunity. Therefore, a person with limited means operating in the domain of losses is more likely to behave in accordance with the economic theory.
Can I use this learning to convince my wife? My colleague gave me an interesting argument. Instead of arguing based on replacement cost, I should argue based on the cost of not replacing the mattress. This could mean developing back pain and possibly paying for medical costs. In other words, I could use Loss aversion to my advantage. Whether this will be a convincing enough argument remains a matter of debate.