This Is Your Brain On Money

Mental accounting, which plays an instrumental role in helping us make financial decisions, explains how we treat money differently (place it under different categories) depending upon its source and its intended use. A classic explanation of the concept uses the example of movie tickets:

"Imagine you just arrived at a theatre and as you reach into your pocket to pull out the $10 ticket you purchased in advance, you discover that it’s missing. Would you fork over another $10 to see the movie? Compare that to a second scenario in which you did not buy the ticket in advance, but when you arrive at the theatre, you discover you had lost a $10 bill on the way. Would you still buy a movie ticket? "

Kahneman & Tversky (1983) used this hypothetical in their research, and although in both cases the amount of money lost equals $10, more people (88%) were willing to buy a ticket in the latter case, compared to the former. The 44% who were willing to replace the missing ticket in the first scenario felt the cost of watching the movie had doubled, since it was drawing from the money (mentally) allocated for movies, which was not the case with the lost cash.

Mental accounting also explains why small windfall gains, like a $50 lottery win, or gift cash from a friend, are more likely to be spent easily, as they are considered unexpected gains, rather than regular income. By creating mental accounts, we essentially ignore the fact that money is fungible, i.e. that all money is the same, and interchangeable.

The phenomenon also helps us understand why we tend to treat credit card payments differently from cash payments. First, credit cards “decouple” the purchase from the payment, by separating the two and delaying the payment to a later point in time. Second, they makes individual costs less salient; a $50 purchase on a $1000 bill has less impact than a $50 purchase by itself. This has its basis in loss aversion – that is, in our mind, losses are more salient than gains, and we usually seek ways to make them less noticeable, which is why credit cards are useful.

Mental accounting is just the tip of the iceberg; there are several other forces shaping our financial decisions. One key game-changer in the psychology of money is the mode of payment. In this article, we will explore two common forms of payments – cash and credit cards. We will also look at how concepts like opportunity cost, pain of paying, and others, factor into our decisions under the two contexts.