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

History

The concept of mental accounting was developed by economist Richard H. Thaler, who published multiple journal articles on the topic including “Mental Accounting and Consumer Choice” (1985), “Saving, Fungibility and Mental Accounts” (1990), and “Mental Accounting Matters” (1999). 3, 4, 5 Throughout these articles, Thaler drew on some of the concepts introduced by Nobel Prize winning psychologists Daniel Kahneman and Amos Tversky, whom Thaler had spent a year collaborating with at Stanford. Thaler provided many real-life examples of mental accounting, some of which expanded on Kahneman and Tversky’s previous findings in the field of behavioural economics. For instance, in Thaler’s 1999 paper, he describes an example from Tversky and Kahneman (1981), where people were asked whether they would drive 20 minutes to a different store to purchase an item for $5 less. Some were presented a version where the item cost $15, and the others were presented a version where the item cost $125. The findings were that most people said they would drive for the $15 item, but most would not for the $125 item. As Thaler explained, this illustrates how even though both cases would result in a saving of $5, we tend to make spending decisions depending on the type of spending, rather than the absolute monetary value.3

Over the course of these 3 articles, Thaler fine tuned his model of mental accounting and provided more examples of how the mental accounting bias may appear in our daily lives. In the 1999 paper, Thaler developed a definition of mental accounting, which he described as “the set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities.” 3 According to Thaler, just like how companies have accounting systems, we also have our own mental accounting systems that we rely on to organize our financial decisions. Therefore, by examining how our mental accounting systems work, we can gain a better understanding of how biases in the system can lead us to make irrational financial decisions.

People

 

Richard H. Thaler

Richard H. Thaler is an American economist who was awarded the Nobel Prize in Economic Sciences in 2017 for his trailblazing contributions to the field of behavioral economics. In particular, he is well-known for developing the theory of nudges, as described in his 2008 book Nudge: Improving Decisions About Health, Wealth, and Happiness, co-authored with Cass R. Sunstein. Thaler has written numerous other books on the field of behavioral economics, such as Quasi Rational Economics and Misbehaving: The Making of Behavioral Economics. Currently, Thaler serves as a Distinguished Service Professor of Behavioral Science and Economics at The University of Chicago’s Booth School of Business, where he has been teaching and conducting research at since 1995.6

Consequences

Most, if not all of us have been susceptible to the mental accounting bias at some point in our lives. Our susceptibility to this bias can lead to poor financial decisions, as demonstrated by the tendency for many lottery winners to go bankrupt after winning the lottery, as a result of spending this windfall much more readily than they would normally spend the rest of their money. By understanding the mental accounting bias and how we make financial decisions, policy makers have been able to apply these insights to design programs that aim to improve our financial decisions. For instance, Thaler has introduced a behavioral intervention called Save More Tomorrow, designed to use the concepts from the mental accounting bias to help American workers set aside more money for retirement savings. In addition, by understanding the biases that people are susceptible to, some financial organizations have also used these insights to help advise customers on how to make better financial or investment decisions.

Controversies

While the mental accounting bias has been widely accepted in the field of behavioral economics, there are some limitations. For instance, much like other concepts in behavioral economics, the mental accounting theory was developed by observing how people make decisions in order to theorize a possible framework, which some may argue lacks scientific validity as these cognitive processes cannot be explicitly studied. In addition, while the mental accounting bias provides a framework for how people tend to make decisions, this is not a definitive model that encompasses everyone’s decision making process. Furthermore, the mental accounting model suggests that our tendency to categorize money into distinct budgets is irrational, however there are arguments as to why the mental accounting model may actually be beneficial. For example, having separate budgets for different purposes, such as saving for college, can enable us to exhibit greater self-control, and may actually prevent overspending in some cases. As a result, the mental accounting model should not be viewed as an entirely irrational decision making process, but rather a framework that can help us organize our financial decisions in ways that lead us toward our goals.

Case Studies

Public Policy x People and Organizations

Hastings and Shapiro (2018) conducted a study on the Supplemental Nutrition Assistance Program (SNAP), a U.S. federal program providing food benefits for low-income households. Most of these households were spending more on groceries than the benefit amount, so the program’s intention was to allow these families some extra cash that they could save or spend on whatever they liked. . According to economic theories of rational decision making, while we may expect a slight increase in food spending, we would not expect a significant increase in consumption. However, what Hastings and Shapiro found is that recipients significantly increase their food purchases, as they viewed the food benefits as money to be spent on food. This finding falls in line with the mental accounting model, as people would see the added benefits as simply an increase to the food budget, rather than viewing their money as interchangeable.7

Since we have seen that people often behave quite differently to what theories and models would predict, and often do not make “rational” decisions, it is important to take these biases into account when designing policies. For example, since recipients in the SNAP program tend to increase just their food spending rather than using the freed-up money to increase spending in other areas, the program may lead to households purchasing unnecessary food items. For instance, this could lead to increased purchases of unhealthy items such as candy and soda, which may not have been purchased before. By understanding the role that the mental accounting bias plays, policymakers can gain a better understanding of how people actually behave, and therefore be able to design more impactful policies and programs.

Climate and Energy X Innovation and Design

Psychologists at the University of Geneva and the University of Applied Sciences and Arts in Western Switzerland have recently published an article in the Nature Energy Journal where they studied the impact of mental accounting on behaviors relating to sustainability and energy consumption. In the article, they describe how our tendency to create different mental budgets can be counterproductive (and even harmful) towards attempts to save energy. For instance, driving an energy efficient car should lead you to save money on fuel. However, if people who have purchased an energy efficient car have not adjusted their mental budget accordingly, they may feel that they are actually able to spend more, since their mental budget for fuel has not been filled. As a result, this may encourage them to actually drive more, which is counterproductive towards the efforts to reduce energy consumption. Through this article, the researchers examine how the mental accounting bias may hinder sustainability efforts, and use these insights to propose strategies to improve climate control measures in order to design more impactful measures in the future. 8

Related TDL Content

Why do we think less about some purchases than others?: A detailed explainer on the mental accounting bias, including why this bias occurs, why it is important, and how we can avoid being susceptible to it.

Mental Accounting Influences How We Spend Our Time: This article applies the concepts of mental accounting to how we spend our time. Similar to how we budget money, we also budget our time into different categories, which can affect our time management and productivity.

This Is Your Brain On Money: The psychology of money. This article explores the psychological factors affecting spending, how our spending is influenced by use of cash and credit cards, and how we can leverage our biases to enable better financial decision making.

Richard Thaler: Thinker guide on Richard Thaler, founder of mental accounting. This article covers Thaler’s historical biography and introduces other ideas he is known for developing, such as the endowment effect, naive diversification, and the famous nudge theory.

Sources

  1. Segal, T. (2020). Mental Accounting. Investopedia. https://www.investopedia.com/terms/m/mentalaccounting.asp
  2. Lehrer, J. (2011). The Curse of Mental Accounting. Wired.https://www.wired.com/2011/02/the-curse-of-mental-accounting/
  3. Thaler, Richard. (1999). Mental accounting matters. Journal of Behavioral Decision Making. 12. 183-206. 10.1002/(SICI)1099-0771(199909)12:3%3c183::AID-BDM318%3e3.0.CO;2-F. https://onlinelibrary.wiley.com/doi/abs/10.1002/%28SICI%291099-0771%28199909%2912%3A3%3C183%3A%3AAID-BDM318%3E3.0.CO%3B2-F
  4. Thaler, Richard. (1985). Mental Accounting and Consumer Choice. Marketing Science. 4. 199-214. 10.1287/mksc.4.3.199. https://www.researchgate.net/publication/227356174_Mental_Accounting_and_Consumer_Choice
  5. Thaler, Richard. (1990). Saving, Fungibility, and Mental Accounts. Journal of Economic Perspectives. 4. 193-205. 10.1257/jep.4.1.193. https://www.researchgate.net/publication/4727260_Saving_Fungibility_and_Mental_Accounts
  6. Duignan, B. (2017). Richard Thaler. Encyclopaedia Britannica. https://www.britannica.com/biography/Richard-Thaler
  7. Smith, T. (2019). Mental accounting and grocery shopping. American Economic Association. https://www.aeaweb.org/research/spending-SNAP-mental-accounting
  8. University of Geneva Communication Department (2020). Mental accounting is impacting sustainable behavior. University of Geneva. https://www.unige.ch/communication/communiques/en/2020/la-comptabilite-mentale-impacte-le-developpement-durable/

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