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 tastingâ¯it was a cheap bottle of Californian Cabernetâ¯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 machineâ¯the drinks were sipped via a network of plastic tubesâ¯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 agentsâ¯getting the most utility for the lowest possible priceâ¯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.