Hot wiring the brain to pay off more debt
This report for Radio 4’s Money Box programme is a superb example of behavioural economics in action and in particular the anchoring effect. Researchers have found that by putting a small minimum required payment at the bottom of credit card statements, people’s brains are wired to pay less back than if no such minimum was posted. The result is that debt takes many years more to repay and the accumulated interest to the lender is naturally much higher. Offering low minimum repayments each month seems seems intuitively to benefit the borrower - making the servicing of debt appear more manageable on a month-by-month basis. But the anchoring effect in fact lifts the profits of finance houses.
Anchoring describes the human tendency to rely to heavily or ANCHOR on a trait or piece of information in particular. Natural human nature is to rely to heavily on certain pieces of information and then adjust to that piece of information to account for other elements of the circumstance.
When a price anchor is established for a product, it serves as a reference price for all similar products and substitutes. For example, when bread-makers were first introduced to consumers in the USA at a retail price of $275, consumers were not prepared to buy them. However, when a similar product was priced at $400, consumers flocked to buy the $275 bread-maker because they perceived it to be available at a bargain price. This was because their price anchor had shifted from $275 per bread-maker to $400. Anchoring a price for a good or service at a higher level helps to attract consumers to products priced below the level of the anchor.
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Questions in Behavioural Economics - Saving More for Tomorrow
Joe Murdy writes on this question - Why do so many people fail to save for their future?
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The most powerful law in the world?
We are studying information failure this week and at one point during the lesson today I was tempted to spurt out that the biggest information failure of all was the failure of people to understand the law of compound interest. That was going to be in the context of discussing why people often leave it so late to start saving money when a small pot earning interest on a compound basis over a large time period can grow very quickly if it invested for long enough. Just small changes in the annual return - say from 2.5% pa to 3.0% pa can have an enormous effect on the final value of a pension fund. MindYourFinances has a good example to use by way of illustration.
I will leave that discussion until the next lesson ... but tonight I picked up a piece by John Kay which will appear in the FT tomorrow on the wealth of Warren Buffett newly crowned as the world’s richest man. Kay reinforces the power of compound interest in shaping the value of the Buffett Foundation.
“Albert Einstein supposedly observed that the most powerful force in the universe is compound interest, and Mr Buffett’s frugality has enabled compound interest to work its magic. During Mr Buffett’s tenure at Berkshire Hathaway, the S&P 500 index has produced an average total return of 10 per cent. That return reinvested over 42 years will multiply your stake 67 times. But if your investments yield twice as much as that – as Mr Buffett’s have done – your wealth increases not by twice 67, but 67 squared, a factor of 4,500. That arithmetic makes Mr Buffett the richest man in the world.”
Read the rest of John’s piece here
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