14  Payments

A fundamental choice when making a payment is whether to pay in cash or via a more abstract method. Besides cash, we can pay via cheque, bank transfers, BPay, credit card, “tap and go”, PayPal and so on.

In 2007, almost three-quarters of in-person payments in Australia involved cash. As larger transactions were more likely to be via other means, a bit less than half of these transactions by value were cash. By 2019 cash had reduced to 32% of transactions by number and 19% by value (Delaney et al. (2020)). The use of cash has plunged further during the pandemic.

This change has consequences not just for the practicality of how we purchase goods and services. It also changes how we think about those purchases.

In this chapter we will look at a series of facts about individual or household financial payment behaviour, examine where that behaviour is inconsistent with traditional economic explanations, and examine possible explanations that can account for the observed behaviour.

14.1 Abstract payments

Prelec and Simester (2001) ran an experiment in which they sought bids from college students for tickets to see the Boston Celtics and Boston Red Sox. Some students were told that they had to pay in cash. Others were told they had to pay by credit card. In both cases, payment was to be made the next day. Those who bid by credit card bid around twice as much as those who were asked to pay by cash.

Knutson et al. (2007) suggested phenomena such as this may be because excessive prices trigger a pain-like response. The abstract nature of a non-cash method of paying (together with the delay that may occur with credit) might “anaesthetize” consumers against the pain of paying.

14.2 Rewards

Many of our financial transactions don’t just involve an exchange of money for a good or service. Often our choice of transaction method can involve other costs, such as fees, or benefits, such as rewards points.

Rewards points increase the proportion of transactions that occur via the reward-attracting purchase method. However, we are often poor at assessing the value of rewards.

A reward point in itself is essentially valueless. The reward point only has value in that it can be exchanged for something else of value. As a result, when someone is considering whether they want to use a particular payment method that accrues rewards, they should ask what is the cost of the method relative to other options, and what is the value of the goods or services they could obtain through the reward points. The particular “number” of the reward points is irrelevant.

Despite this, people do not just try to maximise the value of what they can receive by earning reward points. They also seek to maximise the reward points themselves. Hsee et al. (2003) call this “medium maximisation”.

Medium maximisation implies that people can be induced to take a more costly action through an offer of more of the medium, even if that additional medium can be used to obtain the same ultimate good or service. For instance, double rewards points for each purchase will attract more purchases through that method even when the value of those reward points, in terms of the goods and services they can be exchanged for, is halved.

14.3 The pain of paying

Under the standard economic approach, the utility cost of a purchase is felt through the reduction in other consumption due to that purchase. If I pay $10,000 for a car, there is no loss in utility due to the payment of $10,000 itself, but instead a loss of utility from other consumption I could have possibly bought with that $10,000. If my next best alternative to a car was a holiday, the utility cost of buying the car comes in the form of no holiday. There is no pain from the payment itself.

Prelec and Loewenstein (1998) argued that this does match our experience. Rather, we experience an immediate “pain of paying” that can undermine the pleasure of consumption. They give an example of a ticking taxi meter reducing the pleasure from the ride.

To capture this phenomena, they proposed a “double entry” mental accounting model that captures how the pleasure of consumption and the pain of paying interact. The model has the following features:

  • “Prospective accounting”: Consumption that has already been paid for can be enjoyed as though it is free. The pain of a payment that is made before consumption is mitigated by the thought of the benefits that the payment will bring.
  • “Coupling”: Coupling is the degree to which the payment or consumption brings to mind the other. Cash payments lead to tight coupling. Credit card payments have weaker coupling.

The theory leads to a prediction of “debt aversion”, whereby people prefer to pay before consumption. This allows people to reduce the pain of paying as they can think about the future consumption. They can then enjoy the consumption without having to think about paying for it. For example, people will tend to prefer flat-rate pay-in-advance pricing schemes to pay-as-you-go.

The presence of debt aversion provides a countervailing force to time discounting. Prepayment may be attractive to increase the experiential benefits of future consumption, whereas time discounting can lead to a preference to delay the payments. Which dominates would depend on factors such as the discount rate and the difference in consumption utility if they pay in advance or not.

One prediction of the theory is that the pain of paying is not constant across different types of consumption. For a brief, high-utility experience (e.g. a vacation), the use of credit will result in a painful payment when one no longer has the vacation to look forward to. The purchaser will have a large mental debt. For a durable (e.g. a washer-dryer), the use of credit will not be as painful as at the time of payment there will still be future utility to come from its use. The contrast between the experience and durable would lead to a further prediction that people would be more likely to prepay or clear debt for experiences. There is a desire to keep the mental account “in the black”.

Quispe-Torreblanca et al. (2019) examined this prediction using credit card transaction data. They found that repayment of debt for non-durable goods was 10% percentage points more likely that for debt incurred purchasing durables.