But That’s Special Money: Mental Accounting
Episode #5 of the course How cognitive biases are messing up your decisions by Abasi Latcham
Today, we’re going to talk about mental accounting.
What Is It?
Mental accounting is how your brain treats money differently depending on its source or intended use. At its core, it’s a denial of the fungibility of money (fungibility means individual units of a good are interchangeable, e.g. grains of sand, drops of water, or dollars of money). This denial means that different mental accounts are not treated as perfect substitutes for one another (which they actually are), which leads to some weird decisions.
Thaler argues that mental accounting has three components:
1. The perception of the deal: This refers to how you frame the deal. In addition to the benefit (aka utility) from acquiring a good, Thaler argues that you also get transaction utility, “the difference between the amount paid and the ‘reference price’ for the good” (i.e. the price you expect to pay). Consider buying a $15 beer from a corner store compared to a fancy resort; you would be much less happy paying $15 at a corner store than a resort due to your expectations of a “proper” price. This is not captured in traditional economic thinking.
2. The money’s “mental account”: You might have mental accounts for everyday expenditures (food, housing, etc.), wealth (savings account, retirement account, etc.), and income (salary, cash, windfalls, etc.). If money were treated as fungible between these accounts, they wouldn’t matter. But it’s not, so they do. Thought experiment: You’re going to the movies. You have a pre-purchased $20 movie voucher. You get to the theater, but—oh no, you’ve lost your voucher! Do you buy a new ticket? Slight difference: Instead of a voucher, you had a $20 bill put aside. Now instead of losing a voucher, you have lost cash. Do you buy a ticket? Most people have an easier time buying a ticket in the second situation, regardless of the fact that in both instances, the cost is the same: “The loss of the cash is not posted to the mental account of the movie, so we don’t mind forking over another $20.”
3. The frequency with which accounts are “balanced”: Kahneman and Tversky found that longshot bets at racetracks increases significantly during each day’s final race. This suggests gamblers seek more risk at the end of the day (by betting on longshots) in order to make sure their “gambling winnings” mental account has a positive balance before the races stopped. Why? Because if this mental account had a negative value when it was balanced, it would cause psychological pain (i.e. loss aversion). Thus, gamblers taking more risk at the end of each day indicates that their “gambling winnings” accounts are balanced daily. But if these accounts were balanced each week or month, there would be more time to recoup the losses of that account, which would diminish the urge to take risks.
Almost everyone has indulged in mental accounting. Any time you treat money differently because of where it comes from or where it’s going, that’s mental accounting.
• Windfalls: Tax returns, lotteries, bonuses, and birthday money are all spent differently to salaries, but rationally, they should be treated the same.
• Money jars: “People often have a special ‘money jar’ or fund set aside for a [large purchase], while still carrying substantial credit card debt.” This is illogical because the growing debt will harm total wealth more than any additions to the money jar will help it.
• Sunk costs: When we spend money on something, we often feel as though we should try and get value from our past expenditure. For example, if we buy an expensive event ticket, we may feel obliged to go, even if the costs of getting there outweigh the benefits of attending.
The normative status of mental accounting is uncertain, so I’m going to let Thaler have the last word here:
A question that has not received much attention is whether mental accounting is good for us … I see no useful purpose in worrying about whether or not mental accounting is “rational.” Mental accounting procedures have evolved to economize on time and thinking costs and also to deal with self-control problems.
Tomorrow, we will cover how ownership of something affects perceptions and look at the endowment effect.
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The Curse of Mental Accounting
Why Smart People Make Big Money Mistakes and How to Correct Them: Lessons from the Life-Changing Science of Behavioral Economics by Gary Belsky and Thomas Gilovich
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