Why We Spend Expenses Wrongly

August 14, 2014

My company, like many others, provides a fixed daily amount to recompense travellers for their daily expenses. On most occasions this ends up being a little more than your expenses naturally sum to. Now, in theory, this means that once you know the duration of that trip (and assuming you trust payroll) you are sure to receive a fixed amount of money. However, people do not quite react accordingly. In particular, there is a tendency to fixate on the daily amount to guide decision-making. When I have been with my colleagues to dinner, we tend to spend more when expenses are being paid than when they are not. People want to spend the allowance - and when they spend the allowance, they stop spending.

According to rational economic theory, this makes no sense at all. The daily allowance has no relevance to your spending - you should spend as you normally would for dinner. Simply, you just buy according to your preferences. However, prospect theory comes in to play to explain this behaviour, as follows.
There is in fact a difference between the way losses and gains are valued. Specifically, it is experienced as being more bad to lose £10 than it is good to gain £10. Intuitively this makes sense - this is the experience that we have, and this fact in turn explains what’s going on here. We know there is a certain amount of money set aside for our expenses, and we may feel happy to reallocate that towards dinner. This is not initially experienced as a loss because the money has not been received. When this allocation is spent, the extra is experienced as a loss, which is aversive. Otherwise, if we had received the money in advance, spending like this would also be experienced as a loss and so it would become less attractive to spend money on dinner.

So far, so good. This is a straightforward example of the psychology of loss aversion - and we use prospect theory which tells us that we must identify a person’s reference point to be able to know what is seen as a loss and what is a gain. What I find more unusual is the evolution of attitudes towards this. On some of my first business trips, I travelled with an older colleague. He took the view that I have described as rational here (although I may have referred to it at the time as “stingy” or something along those lines). He described something like this story to myself and another colleague - that your expenses should be treated like your own money - and although we disagreed with the sentiment, we did not disagree with the logic. But despite agreeing with his logic, this did not affect the way we actually made our decisions.

Now, there might have been some rational reasons for a discrepancy. We might have had a more strong preference for spending on food, or spending time with amicable colleagues, than he. The novelty of the trip may have made us want to try and make the most of it. But there is still something fundamentally irrational about the choices that I and my younger colleague made - in the places we went to there was nothing special to eat (compared to in London..!) and there is no reason why we shouldn’t economize whilst also being sociable. Like people normally tend to do. The choices we made were not bad, but they were certainly not optimal. And, as we now see, they were flawed in a predictable way.

The thing is, over time this tendency has tended to decrease - people who have been travelling longer tend to act more rationally. That is, they tend to make decisions with expenses that are more consistent to decisions they make when spending their own money (although there is still some gap). It is not clear what is driving this shift but it seems quite plausible that it is related to how valuations are made instinctively (by accumulation of positive activity of the Ventral Striatum and negative activity of the Amgydala) vs how decisions are controlled by concious thought-processes. Similarly to when we try and form new habits, it takes some time for our valuations to change. When starting a new habit, for some time we have to consciously remind ourselves and encourage ourselves before - after a few weeks - we might start to instinctively look forward to the new habit routine.

One last thought from a different angle - due to the generally unpredictable and sporadic way that we generally come to receive expenses (as and when travel is required) those receipts might be more highly valued by travellers than they should be. Research into the psychology of gambling has shown that randomly dispensed rewards are more highly than when rewards which are predictable. The reason seems to be that when the unexpected event occurs, the reward centre in the brain activates as a learning mechanism. It is this mechanism that drives the brain to look for patterns in the occurrence of events. In this case, it relies on the expenses being thought of as separate from the travel in order to view them as a reward - generally the disutility of travel tends to be greater than the utility of expenses(depending on the travel destination!) and so this prediction wouldn’t be valid.