Mental accounting

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People have a variety of “mental” accounts that they use to organise, evaluate and keep track of a variety of financial activities such as money for vacation, monthly budget and other. We apply strikingly different decision rules to different mental accounts.

When costs come out of the same account, they seem less important than they come out of different accounts. For instance: spending a lot on a trip in Switzerland when you get a Swiss salary but spending the same amount on a trip in Lithuania does not seem reasonable.

We do not think of our assets based on what they are currently worth. We either treat costs as something that we have already expensed, as the costs paid or value transactions. Once you have some money set aside, the details of how you spend it becomes less bothersome.

Satisfaction

Mental accounts can also affect satisfaction with outcomes that you do not choose. When assessing each loss that hits us, the first dollar hurts more than any additional dollars. Most people are more upset of $2 losses that hit in the beginning than large losses that hit later. In contrast, the benefit of a given amount of money would be perceived as greater if it was given in smaller discrete payments rather than all at once.

Experiment

To illustrate this, Thaler (1985) designed an experiment. Assume you are laying on a beach and crave for a nice cold beer. Your friend suddenly calls you and says he could bring it to you. What price would you pay to buy this from a fancy hotel? How much would you value a bottle of beer from a rundown grocery store?

According to expected utility theory, people should we willing to pay the same amount. Nevertheless, when presented with a same price of an expensive beer, individuals evaluate it in different means. Paying a high cost at a fact hotel is considered as “expected annoyance” but giving out the same amount at a grocery store is named as “outrageous rip-off”. Similarly, people are willing to pay $2.5 for a beer at a fancy hotel, but only $1.5 at a rundown grocery store.

Transactional utility

Consider the following problem. A high tech mouse costs $50 at one store, but is on sale in another store (20 minutes away from here). What is the highest price you are willing to pay? Furthermore, a laptop costs $2,000 at one store but is on sale in another one (20 minutes away from here). What’s the highest price you would pay?

Most people are willing to travel 20 minutes to get a “very good” deal. Additionally, they demand a greater discount in absolute dollars to make the computer trip than a mouse trip. Rationally thinking, we should compare the savings obtained to the value of the time spent and this value should remain consistent across all decisions.

We are inconsistent with our preference of choice. Logically, we should spend more time on expensive good (and searching for those goods) than on cheap ones. However, many people go to multiple stores to save $2 but fails to search thoroughly when making large purchases e.g. house or car.

Bazerman, M.H. and Moore, D.A., 1994. Judgment in managerial decision making (p. 226). New York: Wiley.

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