Common, noneconomist level advice for dealing with your finances are all really wacky!

Dave Ramsey: Use cash envelopes. Grocery budget in one envelope, entertainment in another. When the envelope is empty, stop spending. Pay off your smallest debt first, regardless of interest rate.

Says Brian today at Economic Forces, this drives economists MAAAD:

Money is fungible—a dollar in one envelope is worth the same as a dollar in another. Paying low-interest debt before high-interest debt leaves money on the table. These rules violate basic principles of optimization.

"what constraints make this behavior sensible? What problem does it solve? Why do people rely on heuristics when making decisions?""what constraints make this behavior sensible? What problem does it solve? Why do people rely on heuristics when making decisions?"

Armen Alchian made similar points about how market institutions economize on information costs.

Wait, thermostats?!

Really, truly treating money as fungible and everything having an opportunity cost would have us all go insane.

Every dollar has an opportunity cost—the best alternative use across your entire lifetime. We introduce opportunity cost as some simple idea in Econ 101 but taking it literally in some omniscient sense would be crazy. To optimize perfectly, you’d need to compare this jacket against next year’s vacation, your retirement savings, and every other possible expenditure. Nobody does this. Nobody can.

Someone who puts grocery money in one envelope and entertainment money in another probably understands fungibility just fine. They know they can move the dollars between envelopes, and probably have many times, breaking their own rules.

But the envelope system reduces the cognitive cost of evaluating purchases. Mental accounting—separating money into categories like “entertainment” or “clothing”—creates a simpler optimization problem than tracking every dollar against every possible use.

PRICE IS INFORMATIONPRICE IS INFORMATION

When you see a price of $50 for a jacket, you don’t need to know anything about the supply chain, the cost of materials, the wages of workers, or the scarcity of retail space. The price summarizes all of that for you. Friedrich Hayek made this point about the price system as a whole.

Some more examples of information on the individual level: brand names ("The brand reduces the shopper's cost of estimating reliability"), culture ("pre-packaged beliefs that save the cost of reinventing the wheel")

If cognitive constraints lead to systematic mistakes, what keeps those mistakes from overwhelming the whole system, leading to chaos? The answer is that reality eventually intrudes. ... Wrong beliefs don’t get corrected immediately or completely. Competition works slowly and imperfectly. Some mistakes persist because the stakes are too low to justify the cognitive cost of fixing them.

As long as the budget heuristic produces errors smaller than the effort necessary to calculate optimally, they still work!

The heuristics that survive are the ones that work well enough in the domains where people actually use them. These heuristics persist because, for everyday discretionary spending, they produce acceptable results at low cognitive cost.

It's one of the reasons, "behavioral" economics is so stupid... people making (microscopic) cognitive errors in an unfamiliar lab setting, whereas in the real world of consumer decision-making, the equivalent error is much less impactful, much less frequent, and often more expensive to correct than the error itself is worth.

EXCITING STUFF!