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When Budgeting Backfires

New research shows pinching pennies can actually cost you more

On a frigid spring night on the Arbat, Moscow's famed pedestrian shopping district, Christian Dial ducked out of the cold and into a souvenir shop. As his fingers began to thaw, he found a dazzling array of matryoshki—wooden nesting dolls with intricate depictions of fairy tales, czars, and even American NFL quarterbacks. With as few as three pieces inside or as many as thirty, the dolls varied as greatly in price and quality as they did in subject matter.

When a store clerk approached, Dial, a medical physics researcher at Virginia Commonwealth University, selected a five-piece matryoshka with a traditional matriarchal cast of characters and began to barter. After some back and forth, the price dropped from 1,500 rubles, about $50, to 1,100 rubles, or $37. It was still more than he wanted to pay. Finally, the friendly but aggressive clerk asked, "How much money do you have in your pocket?" Dial answered truthfully: 700 rubles. It was a seller's market now.

In a frenzy, the clerk set off about the store, pulling alternative sets from overcrowded shelves. When she returned, she presented Dial with three new choices, priced at 500, 600, and 700 rubles. The first appeared to have been poorly mass produced. The second featured just one character at multiple sizes, rather than different characters, which he preferred. The third closely resembled his original selection—a quality, hand-painted five-piece set with different characters, but smaller.

Of these options, Dial had no trouble selecting the highest quality matryoshka, priced at 700 rubles, which emptied his pockets. The Russian expression for affordable, after all, is po karmanou, or "by pocket."

Whether souvenir hunting abroad or deal hunting at home, savvy shoppers have long hailed budgets as an effective way to avoid overspending—but does naming your own price really save money? Two marketing professors have studied the effects of such self-imposed price limitations, and their findings, published in the Journal of Marketing Research, have rocked conventional wisdom.

According to Marriott School professor Jeffrey Larson and Ryan Hamilton of Emory University's Goizueta Business School, when consumers set a budget for a particular purchase, their preferences for high-priced, highquality items can actually increase. This, in turn, can have the ironic, unintended effect of leading buyers to spend more than if they had not set a budget at all.

To understand the basic premise, it's helpful to think of every purchase as an equation with two variables: price and quality. When you set a budget for a particular purchase—say $100 for a watch—you essentially fix one variable, price, in order to solve for the second, quality. This partitioning effect, as Larson and Hamilton call it, leads consumers to place more weight on quality during a purchase.

"When you're making a choice," Hamilton says, "you have to make trade-offs between price and quality. What happens when buyers impose a budget on themselves is they turn a single decision into a two-step process. By doing that, they tend to overemphasize quality and underemphasize price."

Like Dial, who turned out his pockets for the best matryoshka he could afford, we all fall victim to overspending, but it might happen more often with a budget than without one.

BUDGETING IN THE LAB

Larson and Hamilton's research, which has been picked up by the The Wall Street Journal and The New York Times, was born out of a mutual desire to understand consumer mindsets—and a shared history.

Both BYU grads, Larson and Hamilton went on to earn PhDs in marketing at the University of Pennsylvania and Northwestern University, respectively. Wonks of the same faith and research interests, they formed an easy friendship during graduate school, rallying at academic conferences. When they published this paper, they arranged their bylines by order of height—a spoof on the sometimes arbitrary rules of authorship in academic journals. For the record, Larson is three inches taller.

A consumer psychologist, Hamilton says he was interested in the contextual drivers of consumer choice, in this case, salient price restraints. The key word, he says, is salient, which he defines as "top of mind, rather than some vague notion deep in the recesses of the mind."

Larson, a statistician, hoped to measure changes in people's value perceptions as they approached their price limits. "We were looking for a kink," he says.

To test their theory, Larson and Hamilton ran six rigorous experiments involving nearly 800 participants.

In the first, paid participants were offered a selection of discounted ballpoint pens, ranging in price from $.99 to $3.99. Before seeing the prices, half of the participants were asked how much they might spend. Some 59 percent of those who imposed a price limit in advance purchased more expensive pens, compared with 39 percent of those who did not.

In other experiments, the researchers used online surveys to gauge real consumer preferences for televisions, computers, and other electronics, as well as household goods such as mattresses, garage doors, and luggage. In every case, the results were the same: when imposing a price limit, consumers preferred higher-priced, higher-quality products.

Larson and Hamilton are careful to point out that the price-quality partition does not apply to aggregate budgets, such as grocery bills. A $3 box of butter, for example, may not yield significant price-quality trade-offs in a $100 budget for groceries. But danger lurks when consumers set a budget for big-ticket purchases, even with the intent of saving money. For many, the single largest purchase they will make is a home.

HOME BUDGETING


In the shadow of the Superstition Mountains, Arizona's sun-drenched Sonoran Desert is home to roadrunners, the saguaro cactus, and one of the nation’s hottest real estate markets. Lured by a high number of foreclosures and home prices that fell nearly 50 percent from 2007 to 2012, house hunters are flooding Phoenix in search of a sizzling good deal.

Realtor Lorin Hatch, who earned an MPA from the Marriott School in 1974, has served the Phoenix metropolitan area for more than twenty-five years. And although he’s seen every kind of buyer, there’s always a common thread.

“Most people are budget conscious,” he says. “They know what they can afford, and price is often the starting point.”

Facing increasingly competitive markets, Hatch’s customers are honing their decision-making skills. Their potential reward is a coveted property in the Valley of the Sun, where homes come with stucco exteriors, rust-colored roof tiles, and the occasional palm tree swaying in the breeze.

One of the implications of Larson and Hamilton’s research is that consumers who place too much emphasis on quality are more likely to be house poor, living in properties they can’t really afford. According to real estate experts, people who are house poor spend a larger proportion of their income on home ownership and therefore have less cash for discretionary items.

“Luxury home buyers are more likely to be house poor, more likely to roll the dice,” Hatch explains.

For many buyers, attractive lending rates have made it easy to overspend. In Arizona, buyers can lock in interest rates of 3.5 percent, compared to rates of 18 percent a quarter century ago when Hatch first entered the market. “The rates are so low that you could go considerably higher than you might otherwise afford. You could easily purchase a $200,000 home instead of a $100,000 home,” he says.

Though financing is primarily the business of the lender, not the realtor, Hatch encourages clients to base their spending limit on what they can afford monthly, including principal, interest, utilities, taxes, fees, maintenance costs, and yard upkeep. From a budgeting perspective, this aggregate figure helps shoppers better identify affordable options.

He also encourages budget-conscientious house hunters to base their searches on features, making honest assessments of needs versus wants, so as not to confuse costly luxuries with necessities during the decision-making process.

Basic criteria beyond price include square footage, number of bedrooms and bathrooms, garage, and school district. Some luxury criteria might include pools, city views, or LEED certification.

“Typically I work with people who are very realistic in their home purchases and do not overspend,” Hatch says.

He tells the story of a Phoenix couple who recently found a house costing just $5,000 more than a suitable alternative. The monthly payment would have been just $15 more per month, but the couple passed on the deal. “They didn’t do it,” Hatch says. “They considered their lifestyle and said, ‘We don’t want to be tied to our house. We want to live simply and have money for eating out and traveling.’”

We all want the best money can buy, but how much we ultimately spend depends largely on our ability to avoid bad budgeting behaviors—no matter what we are shopping for.

“There is hope,” Hamilton says. “This wasn’t one of those cognitive biases that researchers sometimes identify where there’s really nothing we can do to correct it. There are some pretty easy things we can do to make budgeting work to our benefit.”

BUILDING A BETTER BUDGET

1. Set very low price restraints.

“If you’ve got the goal of saving money and want to set a price restraint on yourself, really go after it,” Hamilton says. If you would have settled on a $1,500 TV, for example, set a maximum budget of $1,000. The goal is to create a restraint that is much lower than you would have naturally spent, Hamilton says.

Alternatively, consider products well below your restraint, Larson adds. “If you’ve budgeted $250,000 for a house, you should look at a couple homes in the $150,000 range. That way, you’ll see there’s not a large difference in quality between a top-of-your-budget home and one that costs a few thousand less.”

2. Focus on features.

“Flip the effect on its head,” Larson says. “Instead of saying, ‘I plan to spend about $1,500 on a TV,’ say, ‘I want it to be a 50-inch LeD TV.’ You’re more likely to spend less money because you’re going to buy a reasonably priced 50-inch LeD TV.”

3. Pay attention to prices.

“When people pay just a little bit more attention to price, the effect completely goes away,” Hamilton says. Why? Because they break the partition between price and quality, thereby reemphasizing the importance of price in the decision. “You might say, I really don’t want to spend more than $1,500, but I have to compare prices when I get there or I might be fooled,” Hamilton says. “That might be enough to restore the value of budgeting.”

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Article written by Bremen Leak
Illustrations by Iker Ayestaran

ABOUT THE AUTHOR
Bremen Leak studied journalism at BYU before joining BusinessWeek in 2005. He now lives and works in Washington, D.C. An avid traveler, he wrote this article in Russia while souvenir hunting.