Mental Accounting
The Basic Idea
Have you ever decided to treat yourself after receiving an end-of-year bonus, tax refund, or birthday money? In these situations, many of us decide to spend this extra money on something we wouldn’t ordinarily spend our money on, such as splurging on a fancy meal or buying a wishlist item that we’ve been eyeing for a while. While we may normally be much more frugal with our monthly paychecks, we tend to view these unexpected sources of money differently, and therefore spend it differently too.
This is what economists describe as mental accounting: how we tend to value things (in particular money) differently depending on the mental category we assign it to. This goes against the principle in fungibility in economics, which implies that money is interchangeable – i.e. a dollar is still worth a dollar no matter where it is from or how we spend it. In practice, we tend to apply different spending rules to our money depending on the mental labels we have assigned it.1
Richard Thaler, the economist who introduced the idea of mental accounting, conducted experiments on this phenomenon, which illustrate how this bias can occur in our day to day lives. For example, imagine you have decided to go and watch a movie. You spent $10 on your ticket, but when you enter the theater you realise that you’ve lost the ticket. Would you pay $10 to purchase another ticket? When participants were asked this question, less than half of the participants (46%) said that they would purchase another movie ticket. However, imagine the next scenario: you have decided to watch a movie, but as you enter the theater you realise that you have lost a $10 bill. Would you still pay $10 to purchase a ticket? This time, 88% of participants said they would purchase the ticket—almost double compared to the first scenario.2
In theory, we have lost the same amount of money ($10) in both scenarios, so our response should be the same for both questions. However, according to the mental accounting model, we tend to categorize our money into different budgets. In the first scenario, $10 has already been spent from our movie budget, and so spending an additional $10 on the movie would make it seem incredibly expensive. In the second scenario, we attribute the lost $10 cash to a general spending budget instead, so we don’t feel that the lost cash has affected our movie budget, despite the same loss of $10. As we can see, by treating the same value of money differently based on how we have categorized it in our minds, we are more prone to making illogical financial decisions, such as irrational spending or poor investment decisions.
My own thinking about mental accounting began with an attempt to understand why people pay attention to sunk costs, why people are lured by bargains into silly expenditures, and why people will drive across town to save $5 on a small purchase but not a large one.
– Richard H. Thaler in his 1999 paper “Mental Accounting Matters”3
About the Authors
Dan Pilat
Dan is a Co-Founder and Managing Director at The Decision Lab. He is a bestselling author of Intention - a book he wrote with Wiley on the mindful application of behavioral science in organizations. Dan has a background in organizational decision making, with a BComm in Decision & Information Systems from McGill University. He has worked on enterprise-level behavioral architecture at TD Securities and BMO Capital Markets, where he advised management on the implementation of systems processing billions of dollars per week. Driven by an appetite for the latest in technology, Dan created a course on business intelligence and lectured at McGill University, and has applied behavioral science to topics such as augmented and virtual reality.
Dr. Sekoul Krastev
Sekoul is a Co-Founder and Managing Director at The Decision Lab. He is a bestselling author of Intention - a book he wrote with Wiley on the mindful application of behavioral science in organizations. A decision scientist with a PhD in Decision Neuroscience from McGill University, Sekoul's work has been featured in peer-reviewed journals and has been presented at conferences around the world. Sekoul previously advised management on innovation and engagement strategy at The Boston Consulting Group as well as on online media strategy at Google. He has a deep interest in the applications of behavioral science to new technology and has published on these topics in places such as the Huffington Post and Strategy & Business.
