It is a Saturday night and you decide to go to a movie. You reach the multiplex and buy the ticket. As you enter the theater, you realize that your ticket and the receipt of payment are lost. Now the only option you have is to spend another $8 and watch the movie. If you are like most people, you’ll think twice before putting in your money for a new ticket, though, may eventually buy but with the feeling that you have spent $16 for an $8 movie.
Now let's take a different situation.
You reach the mall and take out your wallet to pay the ticket money at the counter. Suddenly you realize that you have misplaced $8 cash while on your way to the multiplex.
Will this affect your movie plan? Again, if you are like most people, you will be upset about the lost money but it probably won't affect your decision to buy the ticket.
Psychologists conducted an experiment in a similar fashion and found out that only 46% of people who had lost the ticket were willing to buy another one whereas 88% of people who had lost the same amount of cash, were willing to buy a new ticket. The interesting thing here is that the value of loss in both cases was the same ($8), so the loss experience should have been the same. But nearly double the percentage of people were able to ignore the loss of cash over the loss of the movie ticket.
The answer is a concept of behavioral economics, called mental accounting. It was first introduced by Nobel Prize Laureate Richard Thaler. In his journal paper “Mental Accounting Matters'', he defines mental accounting as the set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities. It refers to the different values people assign to their money on a subjective basis. In simple words, people compartmentalize income and spending into different mental accounts like a budget account, a wealth account, etc.
This different treatment of money violates the “principle of fungibility”, which states that money is interchangeable or the same irrespective of its source or intended use.
There are three main components of mental accounting highlighted through the anecdotes used by Thaler in his paper which are as follows-
1. One of Thaler’s friends had gone to buy a bedspread. It was available in three sizes- double, queen, and king size costing $200, $250, $300 respectively but due to sale, all were available for $150. She quickly bought the king-size though she had the plan of using it on a double bed. Now the woman had an idea of what the bedspread would cost. The purchase of a double bedspread which was her need would have saved her $50 whereas her ultimate purchase had saved her $150.
This reflects the first component about how outcomes are perceived and experienced, and how decisions are made and evaluated. Here an ex-ante and ex-post cost-benefit analysis can be done. The woman’s choice can be understood by incorporating the value of the 'deal' (transaction utility) into the purchase decision ciphering.
2. One of Thaler’s colleagues and an Economics professor adopted a clever strategy to deal with life’s mishaps. He would establish a target donation to United way charity at the onset of each year and if anything unfortunate would happen with him during the year like an undeserved speeding ticket, he would deduct the amount from the charity account thinking of it as insurance against petty misfortunes.
This anecdote represents the second component of assigning activities to specific accounts and labeling both source and funds in real and mental accounting systems. Expenditures are grouped (food, housing, etc.) and funds are labeled (regular income versus windfalls). The notional United way the mental account was a way to make losses less painful (deduction from the charity which is anyway not my money now).
3. Consider the decision to smoke or not. If choices are made one cigarette at a time then the pleasure from consumption transcends the adverse ramifications on health. However, if we think of 7300 cigarettes combined (a year's stock with one pack/day), then the adverse effect on health may outweigh the consumption pleasure. So, the individual who makes 7300 individual insignificant choices to smoke may dismiss the idea had all the choices been bracketed together.
The above example reflects the third component-frequency of evaluation of accounts called choice bracketing. It refers to how accounts are evaluated- daily, monthly, yearly basis and narrow (1 cigarette at a time) and broad (7300 cigarettes together) bracketing.
The bias of mental accounting can be seen in many real-life instances, mostly in windfall situations like a tax refund. It is considered as free money that people can use on any item but they fail to realize that originally the money belongs to them and it's merely a restoration of their own money.
We often say that people spend more on a credit card over cash. This is because of “pain of paying theory.” A plastic credit card is less tangible than cash because one cannot visibly see the loss in resource (money) through the swipe of a card and obviously the payment is deferred. Another interesting example is lottery winnings. Most people use this unexpected money extravagantly, making futile purchases than they would have done with their regular income and end up going bankrupt. Hamilton lotto winner Sharon Tirabassi who had won a lottery cheque of $10.5 million had to go back to her part-time job, nine years after her win as she had wasted all her money.
A dollar earned at work is the same as a dollar received as a gift. But often, people spend their earned money with a lot more caution than a windfall profit forgetting that “each money is the same” The resonating answer to the why of this, is mental accounting.