Mental accounting
[2] Mental accounting incorporates the economic concepts of prospect theory and transactional utility theory to evaluate how people create distinctions between their financial resources in the form of mental accounts, which in turn impacts the buyer decision process and reaction to economic outcomes.
[3] People are presumed to make mental accounts as a self control strategy to manage and keep track of their spending and resources.
[5] People also are assumed to make mental accounts to facilitate savings for larger purposes (e.g., a home or college tuition).
As Thaler puts it, "All organizations, from General Motors down to single person households, have explicit and/or implicit accounting systems.
[7] Particularly, individual expenses will usually not be considered in conjunction with the present value of one's total wealth; they will be instead considered in the context of two accounts: the current budgetary period (this could be a monthly process due to bills, or yearly due to an annual income), and the category of expense.
A person may use different monthly budgets for grocery shopping and eating out at restaurants, for example, and constrain one kind of purchase when its budget has run out while not constraining the other kind of purchase, even though both expenditures draw on the same fungible resource (income).
[11] The concept of framing is adopted in prospect theory, which is commonly used by mental accounting theorists as the value function in their analysis (Richard Thaler Included [12]).
The choice to integrate or segregate multiple outcomes can be beneficial or detrimental to overall utility depending on the correctness of application.
In the event of multiple gain and mixed loss, mental accounting will segregate outcomes resulting in maximised utility.
In the event of multiple losses and mixed gain, mental accounting will segregate outcomes resulting in minimized utility.
Prototypical examples are the unpleasant feeling that one experiences when watching the fare increase on a taximeter or at the gas pump.
[17] A $30 t-shirt, for example, would be a subjectively larger expense when drawn from $50 in one's wallet than $500 in one's checking account.
The larger the fraction, the more pain of paying the purchase appears to generate and the less likely consumers are to then exchange money for the good.
As a result the impact of prior outcomes integrate into the current decision when determining overall utility.
An example was posed by Thaler where gamblers were more inclined to make risk-seeking bets on the last race of the day.
[19] It can then be interpreted that end-of-day risk-seeking bets is an example of loss aversion where gamblers attempt to equalize their daily account.
Mental accounting is subject to many logical fallacies and cognitive biases,[20] which hold many implications such as overspending.
[21] Another example of mental accounting is the greater willingness to pay for goods when using credit cards than cash.
Furthermore, the payment is no longer perceived in isolation; rather, it is seen as a (relatively) small increase of an already large credit card bill.
Mental accounting can be useful for marketers predict customer response to bundling of pricing and segregation of products.
Automotive dealers, for example, benefit from these principles when they bundle optional features into a single price but segregate each feature included in the bundle (e.g. velvet seat covers, aluminum wheels,anti-theft car lock).
[24] Cellular phone companies can use principles of mental accounting when deciding how much to charge consumers for a new smartphone and to give them for their trade-in.
Inherently, the way that people (and therefore tax-payers and voters) perceive decisions and outcomes will be influenced by their process of mental accounting.
Policy-makers and public economists could potentially apply mental accounting concepts when crafting public systems, trying to understand and identify market failures, redistribute wealth or resources in a fair way, reduce the saliency of sunk costs, limiting or eliminating the Free-rider problem, or even just when delivering bundles of multiple goods or services to taxpayers.
The following examples exist where mental accounting applied to public policy and programs produced positive outcomes.
A good example of the importance of considering mental accounting while crafting public policy is demonstrated by authors Justine Hastings and Jesse Shapiro in their analysis of the SNAP (Supplemental Nutritional Assistance Program).
They "argue that these findings are not consistent with households treating SNAP funds as fungible with non-SNAP funds, and we support this claim with formal tests of fungibility that allow different households to have different consumption functions"[26] Put differently, their data supports Thaler's (and the concept of mental accounting's) claim that the principle of fungibility is often violated in practice.
[27] The research paper applied the ideology of the three pillars of optimal taxation, and incorporated mental accounting concepts (as well as misperceptions and internalities).
Outcomes included novel economic insights, including application of nudges present in optimal taxation frameworks, and challenging the Diamond-Mirrlees productive efficiency result and the Atkinson-Stiglitz uniform commodity taxation proposition, finding they are more likely to fail with behavioral agents.
[28] The power of the labeling effect was observed to vary based on the savings success history of the participants.
