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The Behavioral Economics of Payment Methods

A Historical Perspective

Within Conventional economics, it took a long time to accept that not all money is the same. But as credit cards became increasingly normalized and popularized, so did credit card research. And the findings were astounding.

Research throughout the late 20th century and early 2000s have found that compared to cash, credit cards lead to increased willingness to pay, increased spending, reduced awareness of spending, reduced product attachment, increased impulsiveness, and, unsurprisingly, more debt. These findings have been well-corroborated and show that the shape of money matters.

Of course, credit cards have a key difference when compared to cash: they allow for deferring a payment (the cost) to the future, whilst obtaining the good/service (the enjoyment) immediately. Given that people are impatient and present bias-minded, this is a very attractive payment option.

So, can all of the findings with regards to the difference between credit card usage and cash be explained by the present bias and immediate gratification? No, that would be oversimplifying matters. Debit cards were also found to lead to increased willingness to pay and reduced product attachment. Whether they also lead to increased spending and increased debt has not been established by research, yet.

Money Now

Now, in 2022, we have moved far beyond exclusively paying with either cash or card. A plentitude of options has arisen that allows for more variety in the choice of payment method. In the cards domain, contactless features have become a popular way of paying; with a single tap of the card a transaction is made. Contactless, so far, is the quickest in-store payment method currently available, apart from, well, not paying at all.

This contactless feature also helped establish mobile phone payments, which work very similarly, but via one’s mobile device. The phone gets tapped against the in-store payment terminal, and the transactions have been made. Quick, easy, and always available, as most people, especially younger generations, would not leave their homes without their phones.

So what’s the skinny on these payment methods according to behavioral economics? Much like the credit card, contactless card payments were found to lead to increased spending, reduced spending recall, and a perceived lack of control over one’s own money. Looking at mobile phone payments, which can be classed as a subset of contactless payments, the research found that they were associated with increased debt and increasingly costly credit card behaviors (e.g. only repaying the minimum balance on a credit card). Again, we can establish a clear link between payment methods and reduced financial decision-making.

You might notice a trend here in the development of payment methods: they are becoming easier and easier. The consumer experiences less and less friction when having to pay for things, and the transaction becomes less and less salient. Could this possibly explain the findings?

The Behavioral Theory of Paying

Several theories have been proposed to explain the different effects on personal finance management associated with different payment methods. The oldest and most well-known theory is the Pain of Paying, as described by Ofer Zellermayer. He argues that the pain of paying (all the negative feelings associated with the loss of monetary resources for the obtaining of a good/service) is driven by payment method, as it is the payment method that determines the transparency, concurrency, and physicality of the money being exchanged. For clarification, transparency is how easy it is “to see” how much is being spent (very easy with cash, as all notes/coins have denominations); concurrency is the timing of the payment (concurrent with cash, as it is exchanged upon transaction); and physicality is the actual physical act of handing over a resource, and getting less of it in return (cash has to be physically handed over, rather than electronically). These three key characteristics drive the pain of paying.

As you can tell, cash, as it ranks high in all these domains, should be most painful. As a result of this, cash leads to the least spending, least recall error, the highest form of product attachment, and lowest likelihood of debt, if we align ourselves with prior research. On the opposite end of the spectrum, we find the credit card which ranks lowest in terms of the pain of paying as it is non-transparent, non-concurrent, and non-physical. Looking at prior research, these effects do bear out. All other forms of payment (debit card, contactless (both card and mobile)), fall somewhere between cash and card on this spectrum, and their effects on financial decision-making arguably do as well.

The concept of “pain” was meant to be literal, and several studies have shown increases in insular cortex activity (for simplification, the brain’s physical pain center, amongst many other things) when conducting payments. It was even shown to vary per individual, classifying them as spendthrifts (those who love to spend money, with low levels of pain associated with a transaction) and tightwads (those who hate to spend money, with high levels of pain associated with a transaction). However, not all studies replicated this finding, some did not find differing levels of physical pain when consumers conducted transactions. And putting the final nail in the coffin, the most recent study on the pain of paying in the domain of neuroscience did not find differing levels of pain (insular cortex activation) when comparing cash and credit card transactions at all. What they did find, however, was that credit cash usage made people less sensitive to prices, increasing the likelihood of them completing a transaction.

If these findings get replicated and become increasingly robust, we will have to reshape the way we think about payment methods and their implications for financial decision-making.

The Future of Payments

Where does this leave us? During the pandemic (2020-2022) we have seen a shift in how people spend money: almost all transactions had to move online. This gave rise to a wave of online payments, and online payment platforms, most notably Amazon’s 1-click-buy and several buy-now-pay-later (BNPL) products such as Klarna, AfterPay, and PayPal’s in 4.

Don’t think the revolution is exclusively online. It’s been well-documented that Amazon is trialing “paying without payment” in its physical stores, where a consumer walks in, picks up their shop, and leaves the store without the action of paying. Through facial recognition, the money required to actually pay for the shop done can be debited from the account associated with the face of the consumer.

Regardless of the pain of paying, or price sensitivity, what all of these newer, quicker, and easier payment methods are doing is psychologically distancing the actual cost of the purchase from the pleasure experienced of obtaining the purchase. All the fun and none of the pain (or sensitivity). It is likely, or rather, expected, that this will lead to increases in spending (in both frequency and value), increases in impulsive spending, and as a result, increases in debt. Because whichever way you turn this, at the end of it all, there will be a bill to pay.

From a consumer perspective, this is far from ideal. Sure, paying has become easier, which is nice. But being overdrawn at the end of the month isn’t. Consumers need to be wary of easier payment methods and make an informed decision of which payment method aids them best in achieving their goals. If you need to be on a strict budget, credit cards are not likely to be the right option, given what research says about them. Although it seems to be on its way out, sometimes cash is still king.

Written by Merle van den Akker. Behavioural Science Manager at the Commonwealth Bank Australia. Before this, she was at the Warwick Business School completing her PhD in behavioural science, researching the effect of different payment methods on personal finance management and the psychology of money. In her free time she writes for her blog, Money on the Mind.

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