Association for Public Policy Analysis & Management

Researchers and policymakers alike are increasingly concerned with how individuals manage their personal finances. Recent research shows that individuals report an overwhelmingly low ability to handle financial shortfalls, but most of this work frames these situations as expense shocks (such as a car repair) rather than an income shock (such as a reduction in wages). Using online surveys, participants indicated the extent to which they would be able to weather a small ($400) or large ($2000) financial emergency that was framed as either an expense or income shock. Participants report being significantly more likely to be able to handle a large expense shock, as compared to an income shock of the same value and duration. Furthermore, participants are more likely to report using a greater number of methods to manage an income shock. These distinctions contribute to a more nuanced understanding of decision making in response to financial shortfalls.

When individuals consider a financial shortfall due to a one-time expense shock as compared to a one-time income shock, the change in framing impacts the perceived options for coping. This difference in framing changes the mental accounts that may be drawn upon to resolve the immediate financial shortfall (Thaler, 1999). More specifically, this framing has an impact on the mental accounting system that individuals use to manage their household spending and budget (Thaler & Shefrin, 1981) – a process that seems to be more explicit for individuals with fewer financial resources (Heath & Soll, 1996)

Evidence of differential abilities to respond and cope with income losses versus unexpected expenses of identical amounts can enhance our understanding of how individuals perceive and behave to manage their finances. Our study shows that individuals perceive they are less able to cover a shock in their income relative to an unexpected expense of equal size. This provides evidence that the psychological transaction costs of an income shock are greater than those of an expense shock.

These results have important implications for researchers and policy makers alike who aim to improve the economic security of working families. Earnings volatility is largest for low-wage workers (Dynan et al. 2012). If this volatility leads to increased psychological transaction costs above and beyond the cost of incurring the shock in the first place, income smoothing measures such as secure scheduling laws or guaranteed minimum hours should be promoted.