There are several reasons that our mental accounting processes lead us to make bad decisions about money. These reasons are all rooted in the fact that people do not think of value in absolute terms. Instead, an object’s value is relative to various other factors.2
We give money mental labels
One of the core properties of money is that of fungibility, meaning that it is made up of units that are all interchangeable and indistinguishable from one another. Money is fungible because a dollar is worth the same no matter where it came from or how it is spent. Additionally, money doesn’t come with any labels; the same dollar that you put towards your morning coffee could also be spent on a bus ticket, or put towards a new dress.
In mental accounting, however, we tend to treat money as less fungible than it is.2 This can be thought of as filing money into different mental bank accounts that we apply different rules to. There are many ways people go about categorizing money. Often, money is put into “accounts” based on where it came from. Many studies have shown that people tend to label additional income either as “regular income” or as a “windfall gain.” (The above example about finding $100 randomly is an example of a “windfall.”) What’s more, people are more likely to spend windfall gains than regular income—and are more likely to spend them on luxury goods than essential ones.3 Even though there is nothing different about money received unexpectedly compared to money from any other source, we feel like it’s special, so we feel justified in spending it extravagantly.
Money is also often labelled based on its intended use. An interesting example of this comes from a study on gift card use. When people receive gift cards for a specific retailer, they tend to use them on items that are highly representative of that retailer. For example, when using a gift card at a Levi’s store, people are more likely to buy a pair of jeans, which Levi’s is famous for, than something like a sweater, which is not specific to Levi’s.4 The researchers argue that this is because people have put the gift card into a mental account for that specific store, so they feel compelled to spend it in a way that is congruent with the brand.
Our idea of a “good deal” depends on the situation
It is common knowledge that there are certain venues where one can expect to pay much more for the same product than one would elsewhere. For example, when seeing a movie in the theatre, most film goers know they will have to pay significantly more for a pack of M&M’s than they would at a convenience store. The same goes for many other venues, such as sporting events, concerts, or amusement parks. Often, the expectation that one will pay exorbitant prices for basic goods has become an accepted part of a broader experience: yes, a simple hotdog costs $10 when you’re buying it from a vendor during a baseball game, but that’s just how these things always are, and eating while you watch is part of the fun!
Why are we so willing to pay for goods that we know are overpriced? The answer is rooted in the fact that, when we buy something, we don’t just care about the objective value of the thing we’re purchasing; we also care about whether we’re getting a good deal. This concept is known as “transactional utility,” meaning the merits of the transaction itself.1
Transactional utility can have a major influence on our willingness to pay for something. In one experiment that looked at transactional utility, participants were split into two groups and asked to imagine themselves lying on the beach on a hot day, craving a ice-cold bottle of their favorite beer. (The researchers made sure all participants were regular beer drinkers.) In this scenario, a friend volunteers to go and fetch some beer from the only place nearby that sells it. For one group, the vendor was a “fancy resort hotel”; for the other, it was a “small, run-down grocery store.” The friend asks how much the participant is willing to pay for beer, and says he will only buy it if the beer costs as much or less than the price they give.1
The groups responded with very different numbers: while the median answer for the hotel group was $2.65, the median for the grocery store group was $1.50. (This study was done in 1985, so those figures aren’t as low as they sound—in 2020 US dollars, they’re equivalent to $6.35 and $3.59, respectively.)
This result is especially interesting, considering that in this hypothetical scenario, both groups would end up consuming their beer in the same place: on the beach. Ordinarily, places like “fancy hotel resorts” might be able to justify higher prices by arguing that they provide a luxurious “atmosphere” for their customers—but the participants in this study were still willing to pay a premium, even without being able to enjoy that atmosphere.
The main take-away from this experiment is that our definition of a “reasonable” price is flexible, depending on the situation. If we were only concerned about objective value, we likely wouldn’t be willing to shell out nearly $3 extra to drink the same beer in the same place. But transactional utility, or getting a “good deal,” can alter our judgment.
We perceive gains and losses differently depending on their framing
In a study by Daniel Kahneman and Amos Tversky, two of the most influential figures in behavioral economics, participants were told to imagine they were about to purchase a jacket for $125 and a calculator for $15. The calculator salesman then informs the buyer that the same calculator is on sale for $10 at a different branch of the store, which is a 20 minutes’ drive away. 68% of respondents said that they would be willing to make the drive to save $5 on the calculator.
However, with another group of participants, the question was altered: now, the calculator costs $125, and the jacket $15. The calculator is on sale at the other branch for $120. In this case, only 29% of respondents said they would make the trip. In both scenarios, the amount of money being saved is the same.5
These different patterns of behavior are related to framing effects, which were first described by Kahneman and Tversky. Their work, and many others’, has shown that the way an option is described can have a major impact on our decision-making.
The scenario described in the calculator study is an example of a “topical frame”: the situation is worded in terms of the price of the calculator.5 This causes people to perceive the gain of $5 relative to the base price of the calculator. When the calculator ordinarily sells for $15, getting $5 off seems like a great deal, but $5 off a $125 seems like a much smaller gain.
Another factor that affects how we perceive losses and gains is whether they are integrated or segregated—in other words, whether they happen altogether, or are spread out over separate events. Consider the hypothetical example of Mr. A and Mr. B, who have been given some lottery tickets. Mr. A wins $50 in one lottery and $25 in another, while Mr. B won $75 from a single ticket. Who do you think is happier?
When participants in a study were asked this question, 56 said Mr. A would be happier, 16 said Mr. B., and 15 said they would be equally happier. Even though both men come away with the same amount of money, a large majority of people agreed that two smaller wins would make somebody happier than a single, larger one.
However, the opposite is true for losses. In another hypothetical scenario, Mr. A finds out some mistakes have been made on his tax return, and he owes $100 to the IRS. Later that same day, he receives a separate letter informing him he also owes $50 on his state income tax. Meanwhile, Mr. B receives one letter from the IRS, informing him he owes them $150. Again, the amounts of money are the same; and yet, the majority of study participants said that Mr. A would be more upset by these events.
These examples show that people are generally happiest when gains are segregated and losses are integrated. Even if the outcome is the same, we respond very differently depending on how things are presented. This tendency can be taken advantage of by companies trying to separate us from our money. For instance, when buying something expensive like a new car, salespeople often try to tack on “extras,” such as paint protection and entertainment systems. Because these smaller losses are integrated into the much bigger loss of buying the car itself, we don’t feel like it’s such a big deal, and are much more vulnerable to springing for additions we don’t need.1