Mental accounting
Mental accounting is a concept in behavioral economics introduced by Richard Thaler in 1999, which examines how individuals subjectively perceive and manage their money based on various factors such as the source of the funds or their intended use. This theory highlights that, despite the economic principle of fungibility—where every dollar is equal—people often categorize money into separate mental "accounts," leading to irrational financial decisions. For instance, many individuals tend to spend tax refunds or lottery winnings more freely, viewing them as "extra" money rather than as part of their overall wealth. Additionally, mental accounting can explain behaviors such as the sunk cost fallacy, where people continue to invest resources into unproductive endeavors due to prior commitments, rather than making decisions based solely on current value. These cognitive biases can significantly influence financial behavior, often resulting in suboptimal choices that detrimentally affect personal finances. Understanding mental accounting is essential for recognizing and potentially correcting these irrational spending habits, which are prevalent across diverse economic contexts.
Mental accounting
Mental accounting is an important theory of behavioral economics, or the psychological study of economic decisions. Introduced by American economist Richard Thaler in 1999, mental accounting refers to the common human behavior of viewing money subjectively based on factors such as how the money was gained or its intended use. This perception is flawed because, in reality, every dollar is worth the same as every other dollar. By considering unrelated factors and putting money into invented mental categories, people can hamper their economic decision-making and make poor choices with their money.
Background
The economy is a fundamental part of human society, encompassing all decisions and behaviors related to buying, selling, and trading goods and services. The study of economics includes countless measurable factors pertaining to how people make and use their money. The study also includes many factors that can be more difficult to determine and analyze. These include the internal processes of people’s financial decisions and the attitudes and mindsets that influence them.
To study the thinking behind financial decisions, some economists explore the psychological side of economics. In the twentieth century, as financial markets grew and spread immensely, economic psychologists became a crucial aspect of economic studies. They sought to determine what makes people view money as they do and choose to make monetary transactions, whether by earning, spending, or saving it.
Two notable members of this group of analysts were Daniel Kahneman and Amos Tversky. Although they were cognitive psychologists rather than professional economists, they made great contributions to the study of psychology in the economic realm. Their findings helped to establish the field of behavioral economics, which combines these studies in an attempt to answer important economic questions.
Prior to in-depth psychological analysis of people’s economic decisions, most economists assumed that the average member of an economy more or less abided with established economic laws. In other words, most people would follow the rational and reasoned processes of economics as outlined by centuries of economic experts. However, the introduction of behavioral economics strongly departed from that notion.
The work of psychologists such as Kahneman and Tversky showed that people tend to make serious errors in their economic decision-making. Instead of using rational thinking, research, mathematical analysis, or other scientific approaches, many people in an economy apply instead to deeply set beliefs and instincts that are frequently inefficient or downright incorrect. Many of the forces that guide economic decisions are fallacious and biased.
Other psychologists and economists were exploring behavioral economics topics in the hopes of identifying some common errors in financial thinking that may lead people into serious problems. One of the most important economists in this study was Richard H. Thaler, who developed the theory of mental accounting to explain the sometimes puzzling and irrational choices and behaviors demonstrated by individuals and groups in the world’s economies. Thaler would win the 2017 Nobel Memorial Prize in Economic Sciences for his work.
Overview
In 1999, University of Chicago Booth School of Business economics professor Richard Thaler first described the phenomenon of mental accounting in a paper titled “Mental Accounting Matters.” Here, he refers to mental accounting as a process of cognitive operations that people use to manage the tasks in their lives that relate to money. This thinking process relates both to individuals and households and covers all areas of economic activity.
The main point of “Mental Accounting Matters” is that people tend to view money in different and unexpected ways. In scientific and logical reality, money is all the same and contributes equally to the so-called “bottom line” of a person’s financial state. Dollars are fundamentally the same no matter how a person gets them or what he or she does with them—every dollar is worth a dollar. This is stated in economic terms as the fungibility of money.
Despite this reality, people tend to view and treat money differently based on a variety of factors. These factors may include how a person received the money or plans to use the money. Incorporating such factors may seem sensible to the person or even influence economic decisions unconsciously. Regardless, treating some money as different from other money is a fallacious idea. The decisions this idea motivates may not be sound or beneficial. Many decisions made based on these flawed perceptions, in fact, can be very harmful to a person’s finances.
Likely the clearest and most well-known example of mental accounting involves tax refunds. In the United States and most other countries, citizens pay taxes on their income throughout the year. Sometimes, for a variety of reasons, they end up paying more than they owe. When that occurs, the government sends a tax refund check. Millions of people look forward to receiving their refund check each year. A large percentage of these people plan to use their refund money for splurges, rather than saving the money or paying living expenses.
This behavior is very common, yet based on flawed reasoning. Many people view income tax refunds as “gifts” or “windfalls.” People who might normally be very careful with their money and budget and save regularly may be tempted by their perception of tax refunds to spend the money frivolously. They may feel it is somehow special money, meant to be enjoyed. However, in reality, these refunds represent the taxpayers’ own regular money that was simply overpaid to the government. People are also more likely to frivolously spend lottery winnings, holiday or birthday gifts, and bonuses from employers, even though this money is actually the same as any other money.
Another aspect of mental accounting involves the “sunk cost fallacy.” This refers to a belief system in which a person makes an investment (whether it is money, time, or effort) in one action or idea and then feels compelled to stick with it even if it proves to ultimately have a negative effect. For example, a person may buy a movie ticket and find the movie offensive but stays for the entire show to “get her money’s worth.” The result of the choice was doubly negative because the person spent money on a ticket and then had to suffer through an unpleasant experience. Humans tend toward this behavior due to psychological factors such as loss aversion (disliking the feeling of losing).
Bibliography
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