Mental Accounting Theory

Mental Accounting

• Mental accounting are cognitive operations used by individuals and

households to code, categorize and evaluate financial activities
• Very similar to firms maintaining its accounting system
• May lead a person to follow irrational steps of treating various sums of
money differently based on where these sums are mentally categorized.
– for example, the way that a certain amount of money have been
obtained from; work, inheritance, gambling or bonus and where the
money to be spend; vacation or for necessities.
Rational person would never fall into this sort of psychological process.
• Insights of PT (evaluation of gains & losses)
• To explain various anomalies
• Can create various biases too
 Mental Accounting
Dan Ariely : Duke University
https://www.youtube.com/watch?v=plvmigGxU
ZA&ab_channel=LongLuong
 A thought experiment

• Imagine you just arrived at a theater and discover that you have lost
$10 ticket you purchased in advance. Would you fork over another
$10 to see the movie?

• You did not buy the ticket in advance, but when you arrive at the
theater, you discover you had lost a $10 bill on the way. Would you
still buy a movie ticket?
• Imagine you just arrived at a theater and discover that you have lost
$10 ticket you purchased in advance. Would you fork over another
$10 to see the movie?
• only 46% of those who lost the ticket were willing to buy a
replacement,

• You did not buy the ticket in advance, but when you arrive at the
theater, you discover you had lost a $10 bill on the way. Would you
still buy a movie ticket?
• 88% of those who lost the equivalent amount in cash were willing to
buy a ticket.
• In the first case, the participants reported that they felt they were
paying $20 for the movie because they were withdrawing additional
money from their entertainment budget while in the other, the lost
money came out of an overhead budget
 Mental Accounting heuristic
Cognitive

• People’s tendency to code, categorize, and evaluate economic

outcomes by grouping their assets into any number of
nonfungible (noninterchangeable) mental accounts

• a cognitive process whereby people treat resources differently

depending on how they are labeled and grouped (Thaler 1999).

• Retirement fund, child’s education fund, home or property

purchase fund, etc. are all “labels”
• Violations of the normative economic principle of fungibility
of wealth
• Marginal Propensity to Consume (MPC) from all types of
wealth should be equal.
• Thaler (1990) argues that as the MPCs of the various
“accounts” are not equal, it results in the violation of
fungibility.
• By assigning relative values to different sources of wealth,
people risk spending too quickly, saving too slowly or
investing too conservatively (Belsky and Gilovich, 2010,
Heath and Soll 1996).
 • Processes in mental accounting
1. Perception about outcomes and editing & evaluation of outcomes
2. Assignments of activities to specific accounts
3. Determination of time frame to which different accounts are related
 Found Money & Mental Accounting

Group 1: $30 and 2 choices were offered : either save the money or gamble
on a coin toss. where a winner would got $9 and a loser would pay $9 from
the initial $30.
• Gamble [70%]
• Accept to take $30 with no gamble :[30% ]

Group 2: Would you rather gamble on a coin toss, in which you will receive
$39 for a win and $21 for a loss? or, would you rather simply take $30 and
forget the coin toss? ($30 were not awarded directly)

• Gamble [34%]
• Accept to take $30 with no gamble :[66% ]

• Sometimes people create mental accounts in order to justify actions that

seem attractive but in fact, unwise.
 Mental Accounting

‘Found money’ can caused

• gamble/easy spending
• excessive risk-seeking behavior
• One plausible argument: Exceptional gains in house pricing –
leading to risk seeking behavior – house bubbles
 MTA : Hedonic Editing

• Would you drive 20 minutes out of your way to save $5 on a $15

calculator?

• Would you drive the same distance to save $5 on a $125 leather

jacket?
 MTA : Hedonic Editing

• Would you drive 20 minutes out of your way to save $5 on a $15

calculator?
• [68% responded in affirmation ]

• Would you drive the same distance to save $5 on a $125 leather

jacket?
• [29% responded in affirmation ]
 Calculator vs. leather Jacket example

• Minimal account frame of EUT: Is it worth to drive 20 minutes to

save $5?
– Prices of products will be irrelevant
• Comprehensive account frame (incorporating wealth, overall
budgeting) of EUT
– Price reduction will be irrelevant
MTA :
• Calculator: v(-10) - v(-15)
• Jacket : v(-120) - v(-125)
• Diminishing Marginal Sensitivity makes saving on calculator more
attractive than saving on jacket
Evaluation of Joint Outcomes
Source: Thaler (1985)
Segregate small gains from large losses
Integrate small losses with larger gains
 Applications of Evaluation of Joint Outcomes
• Based PT’s value function
• Segregate gains
– Two lotteries v($50)+v($100) > v(150)
– Multiple small gifts rather than one giant gift
• Integrate losses
– Two losses: -v(-2000) -v(-200) > -v(-2200)
– One larger loss rather than multiple losses

Applications:
1) Integrated monthly bill at the end of the month
2) Gains from spending distributed over the month
3) Selling costly item like cars with its accessories together
4) Credit card payment over cash payment
5) Owning a car (costly from long run) vs. hiring a car every day (can be
cost-effective)
 Evaluation of joint Outcomes – Hedonic Editing

• Segregate large losses from small gains (Silver-lining)

– Purchasing of home/car with cash-back offer
– Rewards points for every credit card spending
• Integrate small losses with larger gains (Cancellation)
– Winning lottery ($10000) with tax payment ($1000) will be
valued as v($9000)
 MTA : Hedonic Framing

• External usage of principle by sellers: segregate small gains from

large losses
– Price reduction by a company
– Set old price as the reference point
– New price as gain/discount over the reference point
 Choice Bracketing
How people segregate or aggregate choices over
time periods?
Opening & closing (mental) accounts:
Buying & selling stocks:
● the account is left open in case if the portfolio has fallen in value
but retained - paper loss
● Selling the stocks & closing the account is painful because of
realized loss
In case of liquidity requirement:
rational strategy: sell losing stocks (as they are tax-deductible), rather
than selling winning stocks & pay capital-gain tax
Empirically observed strategy: sell winning stocks (Disposition effect)
unrealized losses is not coded similar to realized losses, leading
suboptimal strategy
 Mental Accounting Bias
Drazen Prelec and Duncan Simester (MIT)
• A sealed-bid auction for tickets to a game
• Group I: the winning bidder would need to pay for the tickets
in cash within 24 hours.
• Group II: winning bidder would pay by credit card.
• The average bids put forth within each group were compared
• Results: bidders using credit cards bet, on average, nearly
twice the average cash bid.
 Credit card payments
• Cash was valued more highly than credit card payment, even
though both forms of payment draw, ultimately, from the
participant’s own money.
•
Credit cards increases spending by
• reducing the salience of the costs of the purchase (customers
less likely to remember the bill if paid through cards than by
cash)
• aggregating the expenses over the number of items so
reducing the salience of each item (integrating of losses w.r.t.
PT)
 Evaluation of joint Outcomes – Hedonic Editing

• Hedonic-editing/bundling to maximize the amount of value

people experience/hedonic utility
Temporal Spacing & Integration of loss
weak support
• Except ‘integration of losses’, all other principles were supported
empirically
• People prefer to segregate losses rather than to integrate at least
temporally
• First loss increases sensitivity for another loss rather than decreasing
it
• A short time period to recover from loss would reduce the sensitivity
to the second loss
• Loss aversion concept in PT may be refined
 Equity Premium puzzle
Loss aversion and Myopic Loss aversion
MLA: occurs when investors evaluate their investments more
frequently, leading them to react too negatively to recent losses,
which may be at the expense of long-term benefits (Thaler et al.,
1997).
caused by narrow framing - investors focuses on specific
investments (e.g. an individual stock or a trade) without taking
into account the bigger picture (e.g. a portfolio as a whole or a
sequence of trades over time) (Kahneman & Lovallo, 1993).
Case STudy