Mental accounting is a concept to describe how individuals can separate their budget into different accounts for specific purposes. For example, we may earmark $50 a week for entertainment and $100 for food. Mental accounting suggests people do not treat money as fungible (the concept all money is interchangeable), but mentally link spending to particular budgets.
For example, if we win £40 on a lottery ticket, we may feel that this bonus win enables us to spend on going out for a meal. However, if we got a tax rebate of £40, we would be more likely just to save it.
Mental accounting is related to concepts of
Transactional utility – the perceived joy we get from the quality of the buying transaction – ‘deal’. If we see a piece of clothing 50% off, we are happy to get the deal and may buy more clothes because we now have more in our ‘clothing budget’ than expected.
Sunk cost fallacy – If we spend money on an item, our ‘mental accounting’ can make us feel we should try and get value from our past purchase. For example, if we buy an expensive ticket, we may feel obliged to go to the concert, even in a snowstorm or if we are very busy. If the ticket was received free, we have no feeling of a sunk-cost so feel happier to miss the concert if it is not in our interests.
Pain of paying – If we have $10,000 in the bank account, but get an unexpected $50 parking fine, we may feel we ‘can’t afford to spend $50 going out’ because we have just had this unexpected loss of $50 on parking. Not going out is a way to get this $50 back. In this sense, we focus more on the visible $50 we pay, rather than the less visible $9,950 in our bank account.
Loss aversion. Investors can be subject to loss aversion. If we spend $1,000 on a stock, there is an aversion to selling at a loss, but an incentive to sell at a small profit. If investors frequently check their stocks, it can make them risk-averse and sell as soon as stocks move into profit. It can make investors reluctant to sell at a small loss because that stock would be deemed a ‘failure.’ when we close that particular account. But, this can lead to irrational investment behaviour. It is better to sell at a small loss than risk an even bigger loss.
Richard Thaler and Mental accounting
Richard Thaler’s paper on Mental Accounting Matters (1999) is considered the most important work on this aspect of behavioural economics
Thaler states the three aspects of mental accounting which receive the most attention:
- How outcomes are perceived and experienced and how decisions are made and subsequently evaluated.
- The assignment of activities to specific accounts
- The frequency which accounts are evaluated
Examples of mental accounting in practice
Thaler observed a friend who came across a sale of bedspreads. They came in three sizes: double, queen and king. The usual prices for these quilts were $200, $250 and $300 respectively, but during the sale, they were all priced at only $150. His friend bought the king-size quilt and was quite pleased with her purchase, though the quilt did hang a bit over the sides of her double bed.
Here there is an incentive to buy a bigger quilt than necessary, because of the transactional utility from getting a $150 discount. The double sized quilt may have been more appropriate, but that purchase only gains $100 discount. The desire for transactional utility can encourage us to make irrational purchases.
Would you replace a lost ticket?
Kahneman and Tversky (1984) investigated whether people would purchase a theatre ticket after:
- Losing an original ticket
- Losing the equivalent amount of money.
They found that people were more willing to purchase a ticket after losing the equivalent sum of money. They were less willing to buy a ticket after having lost their original ticket.
One explanation is that after we have spent $50 on a concert ticket, our mental budget for concert tickets is already constrained.
Mental accounting and means of payment
It has been observed that payment by credit card reduces the salience and vividness of payment and can make it easier to purchase goods on credit card than paying with cash. Our mental account for spending cash is smaller than our mental account for putting onto a credit card.
Soman (1997) finds that students leaving the campus bookstore were much more accurate in remembering the amount of their purchases if they paid by cash rather than by credit card.
Income accounting
Shefrin and Statman (1984) state investors like dividends because it provides a simple self-control rule. Investors feel confident to spend dividends and leave capital alone.
Camerer et al. (1997) found that New York taxi drivers exhibited the behaviour of targeting a set level of earnings per day. In other words, on busy days when demand for taxis are higher, they can gain their target income quicker and so work shorter days. Inversely on quieter days, it takes longer to earn their target income and so spend longer. This leads to a situation of more taxis on quiet days and fewer taxis on busy days.
Personal experience of mental accounting
Recently, I had an unexpected charge hiring a car. The firm charged £800 for small dint. I have applied to my third party insurer to claim the £800 back. If I get the £800 back from the insurance company, I feel like I will be happy to support a charitable project (a friend in need). However, if they don’t pay up, I won’t be able to support the charitable project. In other words, getting £800 back would be a bonus; if gained, I’m more inclined to help a friend. But, if I have to absorb this loss of £800 I’m not willing to dip into my main bulk of savings.
In theory, I should treat all money as fungible, but it is very tempting to separate money into main savings and unexpected bonus/loss.
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