The science of penny wise and pound foolishness

Stefano Virgilli –
stefano@virgilli.com –

An old saying warns about not being “penny wise pound foolish”. It refers to the habit of bargaining on little amounts, while taking rushed decisions on more important expenses or financial commitments. There are stories and examples, that narrate perfectly what goes through our brain when we take a purchase decision, and explain why we are all (to a certain extent) “penny wise pound foolish”. Here is one of the stories:
Abdullah and Ibrahim are close friends. Whenever Abdullah is about to buy something, he calls his buddy Ibrahim to sound his opinion.

WATCH
One day, Abdullah was in shopping mall A and considered buying a casual wrist watch. In the shop it was available for RO 30. As usual, Abdullah took a picture of the wrist watch and sent it over to Ibrahim. Ibrahim commented: “Very nice! How much?”. Abdullah replied: “30 rial”. Immediately Ibrahim commented the message by informing Abdullah that, in shopping mall B, the same exact wrist watch was for sale at RO 19!So Abdullah decided not to buy the watch in shopping mall A, but he rather drove 30 minutes to shopping mall B, to eventually purchase the same wrist watch for RO 19.

PHONE
Another day, Abdullah was again in shopping mall A, this time looking for a new phone. He found the model that he was looking for, at RO 299. As usual he took a picture and sent it over to Ibrahim, informing that the phone was priced at RO 299. Ibrahim replied that in shopping mall B, the same exact phone was for sale at RO 288. Abdullah thought: “It’s almost the same, and I don’t feel like driving 30 minutes… I might as well get it from here.” So he did.

PROPERTY
Lastly, Abdullah drove his car by a plot of land in a nice residential area and noticed the “For Sale” sign. He stopped the car and called the agent’s number.
The agent said that the plot was for sale for RO 90,000. Again Abdullah double checked with his friend Ibrahim, whether it was a good deal or not.
Ibrahim told Abdullah that the plot of land next to the one that Abdullah had enquired about, was sold a week earlier for RO 89,000.
So Abdullah went ahead and bought the plot at RO 90,000.
CONCLUSIONS
In the first example, Abdullah saved RO 11 by driving 30 minutes to another mall to buy the same exact watch.
In the second example, Abdullah decide NOT to drive 30 minutes to the other mall, hence he failed to save RO 11.
In the last example, Abdullah spent RO 1,000 more than a comparable transaction. Of course in this last case is more difficult to compare apples with apples, but the substance is approximately the same.
One of the main criteria involved when we make a purchase decision happen to be the relative exposure. Being a relative perception, it is only comparable to the individual case. That is why for RO 11 in the first case it felt as if it was worth driving 30 minutes away, while for the second case, the same RO 11 was no longer a contributing factor to the decision.
By bringing this logic to the extreme, a can of soft drink can be bought for a few baizas in a supermarket, while for RO 1 we can buy it a restaurant and for as high as RO 4, we can buy a can of soda in a 5 stars hotel.
Of course when we think of a can of soda priced RO 4, we feel a certain degree of discomfort, because we all know what is the price of it in any supermarket. So the fact that we are paying several hundreds per cent higher than the best price we know, makes us wondering if it is really worth buying.
That is because our brain works in percentage (relative price). We fail to realise that the absolute price discrepancy is slightly more than RO 3, which is an amount of money that most of us is ready to lose without any financial implication.
However, when it comes to large expenditures or investments, that relative price in percentage becomes smaller and we think of it as negligible, whereas in absolute terms, it could be thousands of rial, or as costly as several thousands cans of soda.