In a study by Kahneman, Knetsch and Thaler, subjects were asked to judge the fairness of pay cuts and pay increases, in a company located in a community with substantial unemployment. One group of subjects was told that there was no inflation in the community and was asked whether a 7 percent wage cut was “fair.” A majority, 62 percent, judged the action to be unfair. Another group was told that there was 12 percent inflation and was asked to judge the perceived fairness of a 5 percent raise. Here, only 22 percent thought the action was unfair. Similar results suggesting this money illusion have been reported by Shafir, Diamond, and Tversky.
People fail to notice how inflation eats up savings, people fail to notice how inflation eats up returns, people fail to notice convenience fees on air tickets, people fail to notice fees on mutual funds, people fail to notice brokerage on stocks bought and sold, the list goes on.
Do you suffer from the money illusion too?
Daniel Kahneman, Jack L. Knetsch and Richard Thaler – Fairness as a Constraint on Profit Seeking: Entitlements in the Market – The American Economic Review Vol. 76, No. 4, pp. 728-741 (Sep, 1986)
Eldar Shafir, Peter Diamond Amos Tversky – Money Illusion – The Quarterly Journal of Economics, Volume 112, Issue 2, Pages 341–374 (May 1997)