Sunday, May 25, 2008

Sometimes, our money illusions are shocking

The following Real World Economics column appeared on page 7D of the Sunday, May 25, 2008 issue of the St. Paul Pioneer Press.

By Ed Lotterman

I don't have a Ph.D., so perhaps that is why I occasionally suffer from "money delusion." But if other average Joes would be shocked by expensive fertilizer, as I recently was, some economic theories are on shaky ground.

"Money illusion" occurs when people make decisions based on nominal prices - the dolar figure printed on the invoice - rather than on "real" prices that are adjusted for inflation.

Money illusion is irrational. Many economists believe people are too samrk to be fooled by inflation in this way. Important theories depend on this belief.

I wasn't rational when I bought fertilizer one day about a week ago. I'm trying to keep alive some spruce planted in soil with a high pH. A forester friend said they might survive better if I acidified the soil around the tree.

One way to do that is with sulfur. The fertilizer-grade sulfer I bought when farming 30 years ago was a dusty powder. So I thought my current applications system - a five-gallon bucket and a tomato can - would work better if I mixed the sulfur with other ordinary fertilizer.

My local co-op mixed 50 pounds of sulfur with 300 pounds of potassium chloride. Now 350 pounds of fertilizer makes a very small pile in a pickup bed, so I was taken aback when the bill was $108.50. It was 27 cents-per-poun potash rather than 55-cent sulfur that tripped me up.

That was irrational. I am an economist. Every year I teach many students to adjust for inflation using price indexes. I make such calculations all the time. Yet I fell into the money illusion trap.

If someone had asked me what I used to pay for potash, I would have said about $90 a ton. How much higher might it be now? Perhaps it tripled, to $270 a ton.

It was exactly twice that, $540 a ton. I might have made a different decision if I had realized the bill would be that high.

Do workers make similar bad decisions about wages they accept? Do consumers ignore inflation when they consider alternate purchases or investments? Many economists, especially the monetarists and rational expectationists who are highly critical of government attempts to manage the economy, think not. Their theoretical models depend on nearly everyone being both well-informed and rational.

Would my naive money illusions change these theorists' minds? Probably not. They could argue that I was confused about a small item in our household spending, a minor hobby. A knitter returning to her craft after a hiatus of a few years similarly might be surprised by the price of yarn. But both of us, they would argue, probably know how our salaries are doing compared to inflation and how the prices of milk, bread and chicken breasts have changed.

Perhaps. Macroeconomic theories based on hyper-rationality were all the craze in the 1980s. More recently, microeconomists examining actual human behavior find that money illusion happens. Psychologist Amos Tversky provided strong evidence of this. If not for his untimely death, he would have shared the 2002 Nobel Prize for Economics with Daniel Kahneman.

This may seem neither here nor there for most people. In the meantime I need to scare up a couple bucks and run to the corner store for a gallon of milk.

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