Warren Buffett said:
"Price is what you pay, value is what you get."
Mr. Buffett is considered one of the greatest investors in history. He is also one of the wealthiest people in the world.
This quote gets to the heart of a surprisingly difficult human challenge - this is a challenge Mr. Buffett has successfully overcome in his investing career. We struggle to assess the value of the things we acquire in our lives, more so than determining the price of those things. This article explores the challenges of determining utility and provides a solution to help make the best decisions by clearly defining your utility.
About the author: Jeff Hulett is a behavioral economist and a decision scientist. Jeff is a personal finance professor at James Madison University. Jeff is an executive with the Definitive Companies. Definitive helps people and organizations make the best decisions using time-tested and patented technology. Our solutions are developed from the research-informed behavioral sciences and decision sciences. Jeff holds advanced degrees in finance, mathematics, and economics. Jeff previously held leadership positions with KPMG, IBM, Citibank, and Wells Fargo.
Related to Mr. Buffet's comment, Oscar Wilde is credited with the quote:
“The cynic knows the price of everything and the value of nothing.”
To some degree, determining "price" is easy. Sure, we may need to negotiate or shop for the best price of a good or service, but at the end of the day, “price” is a knowable quantity.
The real challenge is understanding the value a good or service provides for us in our lives. How do you know if a purchase is worth it? Economists refer to value in terms of utility. "Utility" is the core driver of demand and is the aggregation of preferences we have for a good or service. Our economy operates via the interaction between supply and demand. As such, understanding value is at the core of successfully navigating the modern economy. Please see our appendix for a historical discussion of utility determination.
Assessing value - a car buying decision example: Car buying is expensive, plus we have many preferences to weigh. Some of those considerations are objective, like: "I need safe transportation for travel to work." Others are more emotion-derived judgments, like: "It feels good to accelerate fast!" There are many car-buying alternatives and price points. We need to apply our weighted preferences across the many car-buying alternatives. We will also include costs and financing options across the alternatives. Let's not forget confidence, the decision-making emotion. Confidence is when we feel good about the decision to buy a particular car. A confidence-inspiring process minimizes buyer’s remorse. This example shows the challenge of properly determining value.
Reader Resource: We provide tools to help you assess value and explore your own utility. Objectively assessing your utility is central to making the best decision. Assessing utility is essential before making any purchase or other important decision, such as a job change. Check out our smartphone app for more information:
Traditionally, economists assumed we all understand our value well enough to express it in terms of the goods and services we buy. These economists suggest we ought to understand our own utility. Our happiness is assumed to be derived from the proper expression of value via our purchase behavior. Thus, traditional economic theory suggests price and value are equivalent, especially when aggregated over the long run. This theory is mostly aspirational. It would be great if people actually understood their own utility. Also, the traditional economic models are much easier to estimate when analysts are able to assume price and value are equivalent.
However, the fundamental problem with the traditional economic theory is.... well.... the great majority of the time it does not work. The assumption that people actually know what gives them happiness or value is often incorrect. Behavioral economists, those economists that apply behavioral psychology to the field of economics, have determined that people may either fail to understand or fail to act upon their true utility. As such, people generally either:
Do not fully know what makes them happy or
What makes them happy changes frequently and is subject to environmental factors called “framing.”
Nobel prize-winning behavioral economist Daniel Kahneman refers to our challenge to assess value in the context of a “failure of invariance.” Through extensive testing, Dr. Kahneman’s research shows that peoples’ preferences and economic decisions may regularly change and change in inconsistent ways. Kahneman's testing shows that people’s judgments are subject to cognitive biases. These are naturally occurring decision biases resulting from our evolutionary biology. We have evolved to be really good at certain decisions, especially decisions that involve binary outcomes, such as life-and-death situations.
People naturally excel at certain kinds of binary decisions: "Should I run or not run from this lion charging at me!" or "What do I like better, an apple or an orange."
However, we have not yet evolved to be naturally good at many common and complex decisions we face in the modern economy.
People are naturally challenged by certain kinds of complex decisions: "What is important to me about college and which college should I choose?" or "What is important to me about buying a car and which car should I choose?"
Richard Thaler is a Nobel-winning economist from the University of Chicago. He provides a failure of invariance example based on how questions are framed, especially concerning losses.
Failure of invariance example: In an experiment, Dr. Thaler asked one group of students, “How much would you be willing to pay to eliminate a 1-in-one-thousand chance of death?” He then asked a different group of students, “How much would you require to accept a 1-in-one-thousand chance of death.” On average students said they would only pay $200 but would require $50,000!
While the underlying death probability is the same, a question framed as a loss has a much higher value perception than a question framed as a gain - $50,000 as compared to $250.
People regularly demonstrate inconsistency or inaccuracy when assessing their value, preferences, and utility. This recognition is the first step toward improvement. We suggest you build a value assessment ability in two ways.
Train yourself to improve your value assessment ability. It is more challenging than you may think. There are tools and apps today that help you gather, define, and weigh your preferences.
Recognize it takes time to build your value assessment ability. Build habits and behaviors that create discipline and provide wealth for you so that when you do learn what gives you value, you will have the resources to acquire it.
The Stoic’s Arbitrage Personal Finance Journey provides content and tools to help with both these "value understanding" and "value behaviors" suggestions. You may start the journey here:
Appendix
I am a classically trained economist. This is known as the "neoclassical school." Most undergraduates are still trained this way today. The neoclassical school assumes people will follow a rational decision-making path when it comes to their utility. So, whatever provides an individual the most self-interested value is the likely utility. Certainly, all people do not have the same self-interests, but, in the aggregate, it is assumed people make rational, utility-maximizing decisions in the long run. It is assumed that rational, utility-maximizing decisions converge on a single point in the long run
For people like Paul Samuelson and other mathematically oriented economists, this was a necessary assumption. Having a single point of aggregate utility was very helpful in building mathematical models. They built utility-based models to estimate demand. Theories like the Rational Choice Theory, the Efficient Markets Hypothesis, and others rely upon the rationality assumption.
Honestly, for me, this never made much sense. The rationality assumption is very elegant and taught a useful way of thinking about how the world "ought" to be. But how the world ought to be and how it actually is are very different when it comes to rationality and economics. It always left me thinking something was wrong, even though I could not quite put my finger on it.
Finally and slowly over the last few decades, the economic rational assumption establishment was blown up. This was done by behavioral economists like Daniel Kahneman and Richard Thaler. Kahneman and Thaler have both earned Nobel prizes for their pioneering work in behavioral economics. Behavioral economists integrated behavior psychology into microeconomics. This conversion of disciplines resulted in the newer behavioral economics discipline. Behavioral economists appreciate the incredible impact that naturally occurring glitches in thinking have when an individual is determining utility. These glitches in thinking are known as cognitive biases.
From a utility determination standpoint, it turns out that actual utility for a group of people is found in a relatively broad distribution. This broad distribution results from the specifics of the decision situation called "framing." Often, "rationality" is only an edge case in an aggregated multimodal distribution. Certainly, utility almost never converges on a single point of rationality. In other words, "Rationality is user defined... and all users are different!"
You may ask, "why do they still teach the rationality assumption in college?" Good question! I am not 100% sure but I do have a few theories:
With the tenure system, tenured professors have little incentive to change.
The "ought to be rational" assumption teaching does have value as a way of thinking.
Academics, both university departments and scholarly journals, are organized by relatively narrow departments. It takes time to integrate separate departments like economics and psychology. There may be some organizational turf battles.
Resources:
Next are amazing and accessible behavioral economics books, written by Nobel-prize-winning authors:
Thaler, Sunstein, Nudge, The Final Edition, 2021
Kahneman, Thinking, Fast and Slow, 2011
For a deeper dive into "utility" in the context of everyday buying decisions, especially concerning the potential pitfalls of not understanding your utility, please see our article:
Hulett, The subtleties of lending discrimination, The Curiosity Vine, 2022
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