You, Your Brain and Credit Cards

A basic assumption in economics and business finance is that individuals are rational in the sense that they compare the cost and benefits of a decision. Generally, this means comparing the cost of investing or consuming today to the expected benefits in the future. Cost is usually the price of the product or investment; expected benefits are harder to figure. The rule is simple; if the expected benefits are greater than the cost, buy it. If not, don’t.

Even if the cost is spread out into the future – a car paid for with a cash down payment and a car loan – it is relatively easy in theory to discount future costs along with expected benefits back to “present value” (today’s dollars) and do the comparison.

One question that economics and finance doesn’t ask is: Does how you make a purchase or investment affect the buying decision? Does it matter if you pay cash or use a credit card? Theoretically, the answer is no. But recent neuroscience research indicates that the answer is yes. Whether or not you buy something may be influenced by how you pay for it.

Paying with plastic fundamentally changes the way we spend money, altering the calculus of our financial decisions. When you buy something with cash, the purchase involves an actual loss... Credit cards, however, make the transaction abstract, so that you don’t really feel the downside of spending money. Brain-imaging experiments suggest that paying with credit cards actually reduces activity in the insula, a brain region associated with negative feelings. As George Loewenstein, a neuroeconomist at Carnegie Mellon, says, “The nature of credit cards ensures that your brain is anesthetized against the pain of payment.” Spending money doesn’t feel bad, so you spend more money. Jonah Lehrer, How We Decide, p.86.

In another experiment, a group (MIT students) was asked to bid for Boston Celtics tickets. Half the group was told they would pay with cash, the other half with a credit card. The average credit card bid was twice as high as the average cash bid. (Drazen Prelec and Duncan Simester, “Always Leave Home Without It,” Marketing Letters, 12 (2001), 5-12.)

This example is one of many experiments that indicate our brain tends to highly value immediate gain or pleasure and has difficulty computing future cost. The brain is not very good at “discounting” the future or understanding abstract concepts like interest rates on credit balances. The price we pay for impulsive purchases is an interest rate on credit cards that would make a loan shark blush.

This type of behavior is reinforced by other types of “irrational” behavior that leads to bad decision making. The limits to human rationality is a major reason why managers find it difficult to make strategic decision involving future events. (See a summary of the brilliant work on the limits of "rational" decision-making by Nobel Prize-winning Daniel Kahneman, Thinking Fast and Slow.)

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