Taxi Cab Confessions

When New York City started requiring taxi drivers to accept credit-card payments two years ago, cabbies hit the roof. Some went on strike. Many lied to passengers for months, saying the new credit-card machines weren’t working. The New York Taxi Workers Alliance still calls the system the “5% heist,” referring to the fees drivers pay on each electronic transaction.

But one thing is clear two years later: The drivers who complained so vehemently about the credit-card machines are now making more money because of them. New York City’s Taxi and Limousine Commission reports that revenues are up 13% from the end of last year, despite a recession which is hitting the taxi industry hard in other cities. Tips, meanwhile, have risen to an average of 22% on credit-card transactions, up from around 10% under the old, cash-only system.

How did the folks in the front seat — the people whose very livelihoods depend on taxi cab revenue — get things so wrong? Because they gave into their most basic cognitive biases, and because they didn’t recognize how passengers’ cognitive biases would put more money on their meters.

Let’s start with that 5% transaction fee. That’s what the drivers focused on. But why, exactly, did they focus on it? And what, exactly, were they focusing on?

They were focusing on their losses. Economists and social psychologists have a term for this, “loss aversion,” and there could hardly be a more basic or pervasive cognitive error when it comes to money. Basically, what it boils down to is that we value what we have in a way that is wildly disproportionate to how we should value it, were we fully rational.

Laboratory experiments have consistently shown that a person is highly unlikely to take a bet where, for instance, he or she puts down $10 with a 50-50 chance of winning $20 on a coin flip. It’s a good bet statistically (if you took it 100 times, you’d have a good chance of coming out ahead), but people focus more on the possibility of the $10 loss than on the possibility of a $20 gain.

The consequences of this bias are far-reaching, particularly for investing. First off, loss aversion can bias people against investing enough in the stock market, for fear of losing some of their investment. Worse, once that money is in the stock market, loss aversion biases people toward holding onto “losers” for too long while selling “winners” too quickly. Selling a loser, after all, means accepting the loss; you have to admit your mistake and give up on the possibility that maybe the stock will bounce back. Even professional money managers tend to hold onto a losing stock for twice as long as a winning stock. A study by UC Berkeley’s Terrance Odean of 10,000 accounts at a large discount brokerage house found that traders were far more likely to cash-in their gains than their losses; but the stocks they sold outperformed those they kept by 3.4 percentage points.

So, the drivers — like lab subjects or stock traders — were focused on what they’d be losing. But could they have seen the potential upside? If you assume that an all-cash system and a cash-and-credit-card system are identical (aside from that pesky 5% fee), you’d be right to see no upside. But does anyone still think that people treat paper and plastic the same, when it comes to money?

Aside from practical considerations, such as that people who don’t carry much cash are now more likely to take cabs in New York City, there’s the well-established fact that credit cards encourage people to be looser with their money than when they pay with tactile, sticky bills. In just one study out of MIT, in which NBA tickets were auctioned off to MBA students, researchers found that the students were willing to pay more than twice as much when able to pay with credit card instead of cash.

Aside from this anesthetizing effect from plastic, the new credit-card system in New York comes with one other major plus for drivers: default tip amounts, set at 20%, 25%, and 30% (or $2, $3, or $4 for shorter trips). Industry estimates are that the preset fare buttons are used roughly 70% of the time. Of course, any behavioral economist could have predicted that people will typically use a default option as opposed to calculating their own tip — as Richard Thaler and Cass Sunstein put it in their book "Nudge," people will use the “yeah, whatever” method whenever possible.

Focusing on what we’re losing and not being able to anticipate hard-to-see gains — they’re just two of the most important ways our cognitive biases take us for a ride.

Ryan Sager writes the blog Neuroworld at TrueSlant.com.