# Money Illusion

Here’s a question:

Consider two individuals, Ann and Barbara, who graudated from the same college a year apart. Upon graduation, both took similar jobs with publishing firms. Ann started with a yearly salary of \$30,000. During her first year on the job there was no inflation, and in her second year Ann recieved a 2% (\$600) raise in salary. Barbara also started with a yearly salary of \$30,000. During her first year on the job, there was 4% inflation, and in her second year Barbara received a 5% (\$1500) raise in salary.

As they entered their second year on the job, who was doing better in economic terms, Ann or Barbara?

As they entered their second year on the job, who do you think was happier?

As they entered their second year on the job, each received a job offer from another firm. Who do you think was more likely to leave her present position for another job?

How did you answer? When Amos Tversky and colleagues asked 150 subjects about Ann and Barbara, they got some fascinating answers. 71% of people correctly realized that Ann was doing better in “economic terms,” since she got a 2% raise without any inflation. (As the psychologists note, the 29% who say Barbara was doing better probably “don’t understand the logic of inflation”.) However, when Tversky, et. al. asked the subjects who was happier, or who would be more satisfied with their job, they overwhelmingly favored Barbara. People also assumed that Barbara would be much more likely to leave her job.

This is known as the money illusion, since people appear more likely to think about money in nominal rather than real values. In other words, we forget that money is subject to inflation, and that a dollar can mean different things at different times. (As Yogi Berra once said, “A nickel ain’t worth a dime anymore.”) What I find most interesting about the money illusion is that even when people realized that Ann was actually making more money – they saw through the money illusion – they still believed that Barbara was happier. Why? Because our emotions don’t know about inflation – they just want the raise.

A new paper by a team of German neuroscientists and economists outlines the cortical anatomy underlying this profound violation of the rational agent model. Here’s the abstract:

We used fMRI to investigate whether the brain’s reward circuitry exhibits money illusion. Subjects received prizes in 2 different experimental conditions that were identical in real economic terms, but differed in nominal terms. Thus, in the absence of money illusion there should be no differences in activation in reward-related brain areas. In contrast, we found that areas of the ventromedial prefrontal cortex (vmPFC), which have been previously associated with the processing of anticipatory and experienced rewards, and the valuation of goods, exhibited money illusion. We also found that the amount of money illusion exhibited by the vmPFC was correlated with the amount of money illusion exhibited in the evaluation of economic transactions.

Not the most shocking result, as the vmPFC has been implicated in many similar emotional biases. So what’s the value of trying to find the substrate of the money illusion in the brain? In this case, I think it demonstrates that this flaw in monetary perception is actually part of a larger failure to properly separate our perceptions of pleasure/happiness/satisfaction from nominal monetary amounts. We latch onto numbers without asking what the numbers actually mean. We shouldn’t care how big our paycheck is – we should only care about how much our paycheck can buy. (Just ask the poor citizens of Zimbabwe.) But the vmPFC, it turns out, is constantly looking for shortcuts – it needs to generate an emotional assessment quickly, and with a minimum of cognitive effort – and so it sometimes relies on misleading figures, even when we “know” that these figures are misleading.

One of the co-authors on this money illusion paper is Antonio Rangel, a neuroscientist at Cal-Tech. He’s previously done some quite interesting work on wine and perceptions of pleasure, which I discuss in my book:

Twenty people sampled five Cabernet Sauvignons that were distinguished solely by their retail price, with bottles ranging from \$5 to \$90. Although the people were told that all five wines were different, the scientists weren’t telling the truth: there were only three different wines. This meant that the same wines would often reappear, but with different price labels. For example, the first wine offered during the tasting⎯it was a cheap bottle of Californian Cabernet⎯was labeled both as a \$5 wine (it’s actual retail price) and as a \$45 dollar wine, a 900 percent markup. All of the red wines were sipped inside an fMRI machine.

Not surprisingly, the subjects consistently reported that the more expensive wines tasted better. They preferred the \$90 bottle to the \$10 bottle, and thought the \$45 Cabernet was far superior to the \$5 plonk. By conducting the wine tasting inside an fMRI machine⎯the drinks were sipped via a network of plastic tubes⎯the scientists could see how the brains of the subjects responded to the different wines. While a variety of brain regions were activated during the experiment, only one brain region seemed to respond to the price of the wine, rather than the wine itself: the vmPFC, in the prefrontal cortex. In general, more expensive wines made this part of the brain more excited. The scientists argue that the activity of this cortical region shifted the preferences of the wine tasters, so that the \$90 Cabernet seemed to taste better than the \$35 Cabernet, even though they were actually the same wine.

Of course, the wine preferences of the subjects were clearly nonsensical. Instead of acting like rational agents⎯getting the most utility for the lowest possible price⎯they were choosing to spend more money for an identical product. When the scientists repeated the experiment with members of the Stanford University wine club, they got the same results. In a blind tasting, these “semi-experts” were also misled by the made-up price tag.

What does this have to do with the money illusion? By looking at these biases from the perspective of the brain, we can see that they involve the same basic mistake. In both instances, people are forgetting that the mere amount of money involved doesn’t actually mean anything. A more expensive Cabernet doesn’t always taste better and a bigger salary doesn’t always mean more money, at least in “real” terms. So why do we fall victim to his illusion, even when we know about inflation and potentially overpriced wines? Because it’s very, very hard to figure out how we should feel – Is this Cabernet delicious? Should I be making more money? – and so we end up using untrustworthy shortcuts. The vmPFC and OFC assume that, in general, more expensive wines taste better, and that people making more money are more satisfied with their job. These heuristics might have been helpful way back when, but they’re not so useful in modern life. Inflation is real. And expensive wines, it turns out, don’t actually taste better.

1. #1 mike
April 3, 2009

It’s easy to recognize which individual is doing better, that’s simple math. But there is no equation to determine happiness or the likelihood one would leave a job.
Isn’t it then likely these respondents assumed Barbara would suffer the effect of money illusion and be happy with her raise (especially if our two publishers were aware of each other’s situation).

I’m not sure if I’m being clear, or maybe I’m not understanding it. As a respondent I would recognize that Ann is doing better, but I would think that Barbara would think she is doing better as inflation is an abstract concept especially when compared to the reality of a paycheck. So if I were to answer these questions I would say Barbara is probably happier and Ann is more likely to take another job (both answers based soley on salary and not taking into account co-workers, boss, commute, etc.)

2. #2 G. Randolph Mayes
April 4, 2009

The other thing that makes it hard to know how to feel in both cases is the fact that the social dimension has been artificially bracketed.

Regarding the money illusion, some research indicates that the main determinant of happiness as a function of income is how one is doing relative to others. Since Barbara has gotten a healthier nominal raise, subjects may be unconsciously assuming that she has received something more akin to a promotion.

In the wine example, plenty of research indicates that our sense of the quality of a product is affected by the judgments of others as well. When we don’t have direct access to this, price is probably our next best indicator.

3. #3 Patrick
April 4, 2009

I’ve saw the same PNAS article and wrote about the money illusion myself here:
http://veryevolved.com/2009/03/the-money-illusion/

The money illusion has been known for some time as an economic phenomenon, this paper is a bit of a milestone because it actually provided the first real physical evidence of it’s existence and mechanism of action. However I believe the implications of the paper are far more significant than may be immediately obvious. It can begin to explain macroeconomic effects like housing bubbles.

For example: It seems like a logical thing that when inflation is low, the monthly nominal interest payments on mortgages are low compared to the rent of a similar property.
So property prices now appear to be cheap. People, for whom the money illusion is a factor, are now likely to buy instead of rent, which produces an upward trend on house prices when inflation declines. But when inflation decreases it also increases the “real” cost of mortgage payments in the future. In any case it’s the discrepancy in the actual value vs. the nominal value of the payments in the future that cause the problem here.

Naturally the money illusion is only one of the factors that contribute to bubbles, housing or otherwise, but clearly the broad economic effects are larger than the level of the individual, where the money effect has been most well studied.

4. #4 Lilian Nattel
April 4, 2009

Before I was able to support myself as a novelist, I was an accountant (long story). I noticed how much people’s emotional life flowed through their use and attitude toward money. What people considered too expensive or worthwhile often had nothing to do with the relative quantities involved. Their attitudes toward spending money on particular items fit into broader attitudes shaped by their life experiences. They fit the uses of money into a framework of values, as well as specific fears and beliefs about a range of things, including their own worth. You’d only find this out by asking questions around money. Otherwise people assumed they were behaving rationally.

5. #5 DK
April 5, 2009

A more expensive Cabernet doesn’t always taste better

In fact, there is some evidence that more expensive wines taste slightly worse.
http://www.wine-economics.org/workingpapers/AAWE_WP16.pdf

6. #6 C Daniels
April 6, 2009

Two pyschologists overanalyze data from a questionaire… which was more wrong! 😉 Seriously, both job happiness, and the emotional “value” of money are subject to so many variables, (probably thousands) that the resulting question is moot. The “money illusion” is really a poor term for an attempt by humans to deal with finite amounts with relative and variable values. Do you also have a “food illusion,” where people mistakenly estimate the value of daily caloric intake when offered a grocery list? I can assure you the applicable value of such research is very, very low!

7. #7 C Daniels
April 6, 2009

I’ll try to make my point more clear. Inflation (and deflation and stagflation) is unpredictable, and even then, price of goods such as gasoline and milk have disproportionate impacts on well-being. Therefore being “rational” about decisions about job satisfaction based only on information about inflation percentage and salary is a laughable premise. You might as well ask for a rational decision about whether Mercury is retrograde while Neptune is ascendant in Pisces. Then say the scientists conclude “The subjects underestimated the influence of Mercury being retrograde!” I’d argue the premise is invalid, so I don’t think the conclusion is very valuable.
Do you think the ruining the world wine markets would really improve the quality of life– or are you just getting a secret thrill from evidence that the vast majority of people are more stupid than yourself, the cheap wine buyer?

8. #8 Phillip
April 6, 2009

Not much to add but great article Jonah. Despite some of the rancor over the words “money” and “illusion”, you’re not exactly saying anything Tversky, Politser, and others haven’t said previously. Just relating it to the newer data that points to a possible biomechanistic explanation. Cheers. More blogs on the specific neural circuitry underlying such behaviors! 🙂

9. #9 Anibal
April 7, 2009

The “money illusion” can be trace back to the scottish philosopher David Hume with his “nominal effect” (the cost of living plus the adjustment of the quantity of money): http://www.iep.utm.edu/h/humeessa.htm

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11. #11 scienceblogs.com
June 3, 2011

Money_illusion.. Outstanding 🙂

12. #12 Kylie
October 1, 2011

Fantastic information as usual, but this seems way beyond me. I am definitely a newbie. Thought I was just figuring it out….