Mental Accounting
washingtonpost.com
Mental Accounting
Why It's Easy to Blow the Tax Refund and Hard to Catch a Cab in the Rain
By Shankar Vedantam
Washington Post Staff Writer
Saturday, May 19, 2007; F01
Let's say you are headed to a movie. As you are about to enter the
theater, you reach into your pocket and find to your dismay that
you have lost your ticket. You don't have a receipt, so if you
still want to see the movie, you have to pay another $10 for a new
ticket.
If you are like most people, you would probably think twice. You
may still plonk down the money, but you will now feel that you
paid $20 for a $10 movie.
But let's construct the scenario differently. You are going to a
movie. As you stand in line at the box office to buy your ticket,
you discover that you have dropped a $10 bill on the Metro. You
are disappointed, of course, but would this affect your decision
to buy the movie ticket? Again, if you are like most people, you
may feel sore about the lost money, but it probably won't affect
your decision to buy the ticket.
Psychologists once conducted an experiment along these lines. They
found that only 46 percent of those who lost a ticket were willing
to buy a replacement ticket, whereas 88 percent of those who lost
an equivalent amount of cash were willing to buy a ticket. Since
the lost ticket and the lost cash had the same value, their loss
should have been experienced in the same way -- so why were nearly
twice as many people willing to ignore the lost cash but not the
lost ticket?
The difference is because of a psychological phenomenon known as
mental accounting -- and it has enormous consequences in everyday
life. It affects how people spend money and how they save. It
influences how people deal with losses and windfall gains. It
tells us what to do as we weigh different kinds of payment plans
for a luxury item. The effects of mental accounting are felt in
domains that seem far removed from the conventional understanding
of economics -- it may even help explain why it is so hard to find
a cab on a rainy evening. (More on that later.)
Here is the simplest definition of mental accounting: People carry
around different running tabs in their heads. You have, for
example, an "entertainment account." Losing a movie ticket and
having to buy a second one takes $20 out of your entertainment
account when you planned to take only $10. Lost cash, on the other
hand, is not charged to the entertainment account -- which is why
most people don't hesitate to buy a movie ticket after they lose
some cash.
However, compartmentalizing income and spending into different
mental accounts violates one of the basic rules of economics --
that money is fungible, or interchangeable. The $10 movie ticket
is supposed to be worth exactly the same as $10 in cash. Supposed
to be, of course, is the operative phrase. This is not the way
human beings actually think, which is why economic models of human
behavior often turn out to be wrong.
"The source of the money affects how it is spent," said Suzanne
Fogel, who heads the marketing department at DePaul University in
Chicago. When she was a graduate student, Fogel waited tables to
help pay the bills. She found that she carried around a figure in
her head; the amount she wanted to make each day. On any day she
passed that target, any additional income became "free money" --
even though this money ought to have been a cushion for the days
she did not meet her income target.
"Someone gives you money for your birthday and they don't say,
'pay your electric bill,' but money is money and completely
fungible, and if you are behind on your electric bill, you should
definitely spend your money on that," she added. "But there is a
reluctance to do that."
Mental accounting is really the household equivalent of financial
accounting, said Richard Thaler, an economist at the University of
Chicago who was the first to describe how the phenomenon
works. Just as an office expense-account maven might tell you that
your budget for lunch is no more than $25, you make projections on
how much you will spend using your own money. This mostly ends up
saving you time. You don't have to think twice (although maybe you
should) about the $3 latte you get each morning because you have a
mental account that says you are entitled to a $3 latte each day.
The alternative to having mental accounts, Thaler said, is to
consciously ask yourself to ask what every purchase is worth and
compare it with every other purchase. Is a latte worth the same as
a pair of socks? Just as your boss doesn't want to be bothered
with trivial decisions on whether you charge the company $20 or
$22 for a meal, you don't want to waste time thinking about
trivial purchasing decisions.
The effect of setting up accounts, however, has paradoxical
effects -- in exactly the same way that office accounting can
create problems in a workplace, Thaler said. At the end of the
financial year, your boss may not be willing to let you buy a new
laptop, because the hardware budget is down to zero, but will
allow you to take a trip to Los Angeles because there is money
left in the travel budget. Your argument that you need a laptop
more than the trip falls on deaf ears.
Here are some other examples from everyday life:
· A friend of Thaler's once went to buy a bedspread. Where a
double, queen and king size usually cost $200, $250 and $300, all
three sizes were now priced at $150. Thaler's friend happily
snapped up the king-size bedspread -- although she planned to use
it on a double bed. The woman had a mental idea of what a
bedspread should cost. Buying the double bedspread, which is what
she needed, saved her only $50, but buying the king saved her
$150. Mental accounting explains why many people eagerly snap up
deals on items they do not need: When something sells for below
the mental price we have assigned it, the deal takes precedence
over the actual utility of the item.
· A man buys an expensive membership in a tennis club. Right after
he puts down the money, which is nonrefundable, he hurts his
ankle. He grits his teeth and continues to play through the pain
-- even though not playing would mean much less agony. Mental
accounting is behind the problem. Playing is the only way to
ensure that the tennis club membership remains in the man's mental
category of money well spent. To not play would be to write off
the membership cost as a loss, which is more painful to the man
than the agony of hobbling through games on an injured ankle.
· Another friend of Thaler's used mental accounting to devise an
insurance plan against life's vicissitudes. He made a mental
contribution to the United Way Campaign at the start of the year
and then, every time he was unfairly given a parking ticket or had
to fork over money for some other annoyance, he mentally deducted
the amount from the sum he had set aside for charity. Assigning
the money to charity allowed the man to feel that the money he was
paying for parking tickets and other annoyances did not really
belong to him anyway. (While this strategy is unlikely to be
embraced by charities, Thaler's friend was careful not to set his
annual target so low that he was left with nothing to give to
charity at year's end.)
Mental accounting also explains why, when people are given a
choice to get a cash bonus or a gift such as a free vacation for
doing well on the job, they invariably choose cash. That's because
people think they want the flexibility of cash. The problem is
that flexibility comes with a price. You have to remember your
obligations, such as fixing that leaky roof.
This is why studies show that employees who are not given a choice
and are given a gift instead of cash usually turn out much
happier. A vacation or a gift is "guilt-free" -- yours to
enjoy. If you get cash instead, you could spend it buying yourself
the same vacation or gift, but mental accounting would remind you
that you are wasting money on frivolities.
Ohio State University psychologist Hal Arkes once found that
mental accounting influences how people deal with sudden gains,
such as lottery winnings. The same phenomenon influences millions
of Americans at tax time, when they gleefully look forward to
refund checks from the government -- even though refunds are
really their own money being returned to them, minus interest. In
terms of mental accounting, lottery winnings and refunds are
invariably counted in the category of "free money" -- which is why
people spend such dough not on health care, utilities and
eliminating credit card debt but on discretionary items such as
vacations or new patios.
Arkes and his colleagues once cited an anecdote in a study:
Employees of a publishing firm who were in the Bahamas for an
annual meeting were each given a cash bonus for getting a big
contract. Almost to a person, the bonus recipients took the money
to a local casino and blew it. What is interesting is that most of
these people did not lose more than the $50 -- they slowed down or
stopped when they felt they were playing with their "own" money
rather than with the $50 of "free" money. The irony, of course, is
that the $50 these people lost was their own money, too.
What does mental accounting have to do with the other puzzle we
discussed at the start -- the difficulty of finding cabs on rainy
evenings? Mental accounting, like financial accounting, requires
people to close the books and balance their accounts. But people
in different professions unwittingly balance their books at
different times -- wage employees may balance books on a biweekly
or monthly basis, whereas cab drivers often balance their mental
books on a daily basis. Business is brisker on rainy evenings, so
once cabbies meet their mental income targets for the day, they go
home, leaving fewer cabs on the street, Thaler said.
Viviana Zelizer, a sociologist at Princeton University, noted that
a similar phenomenon even affects how prostitutes think about
their income. She cited a study of the Oslo prostitution market,
which showed that prostitutes tend to spend money acquired through
welfare checks and health benefits on essentials such as rent and
bills and are far more likely to spend their income acquired from
selling sex on drugs and alcohol, even if it means they have no
money left over to pay for essentials.
Mental Accounting
Why It's Easy to Blow the Tax Refund and Hard to Catch a Cab in the Rain
By Shankar Vedantam
Washington Post Staff Writer
Saturday, May 19, 2007; F01
Let's say you are headed to a movie. As you are about to enter the
theater, you reach into your pocket and find to your dismay that
you have lost your ticket. You don't have a receipt, so if you
still want to see the movie, you have to pay another $10 for a new
ticket.
If you are like most people, you would probably think twice. You
may still plonk down the money, but you will now feel that you
paid $20 for a $10 movie.
But let's construct the scenario differently. You are going to a
movie. As you stand in line at the box office to buy your ticket,
you discover that you have dropped a $10 bill on the Metro. You
are disappointed, of course, but would this affect your decision
to buy the movie ticket? Again, if you are like most people, you
may feel sore about the lost money, but it probably won't affect
your decision to buy the ticket.
Psychologists once conducted an experiment along these lines. They
found that only 46 percent of those who lost a ticket were willing
to buy a replacement ticket, whereas 88 percent of those who lost
an equivalent amount of cash were willing to buy a ticket. Since
the lost ticket and the lost cash had the same value, their loss
should have been experienced in the same way -- so why were nearly
twice as many people willing to ignore the lost cash but not the
lost ticket?
The difference is because of a psychological phenomenon known as
mental accounting -- and it has enormous consequences in everyday
life. It affects how people spend money and how they save. It
influences how people deal with losses and windfall gains. It
tells us what to do as we weigh different kinds of payment plans
for a luxury item. The effects of mental accounting are felt in
domains that seem far removed from the conventional understanding
of economics -- it may even help explain why it is so hard to find
a cab on a rainy evening. (More on that later.)
Here is the simplest definition of mental accounting: People carry
around different running tabs in their heads. You have, for
example, an "entertainment account." Losing a movie ticket and
having to buy a second one takes $20 out of your entertainment
account when you planned to take only $10. Lost cash, on the other
hand, is not charged to the entertainment account -- which is why
most people don't hesitate to buy a movie ticket after they lose
some cash.
However, compartmentalizing income and spending into different
mental accounts violates one of the basic rules of economics --
that money is fungible, or interchangeable. The $10 movie ticket
is supposed to be worth exactly the same as $10 in cash. Supposed
to be, of course, is the operative phrase. This is not the way
human beings actually think, which is why economic models of human
behavior often turn out to be wrong.
"The source of the money affects how it is spent," said Suzanne
Fogel, who heads the marketing department at DePaul University in
Chicago. When she was a graduate student, Fogel waited tables to
help pay the bills. She found that she carried around a figure in
her head; the amount she wanted to make each day. On any day she
passed that target, any additional income became "free money" --
even though this money ought to have been a cushion for the days
she did not meet her income target.
"Someone gives you money for your birthday and they don't say,
'pay your electric bill,' but money is money and completely
fungible, and if you are behind on your electric bill, you should
definitely spend your money on that," she added. "But there is a
reluctance to do that."
Mental accounting is really the household equivalent of financial
accounting, said Richard Thaler, an economist at the University of
Chicago who was the first to describe how the phenomenon
works. Just as an office expense-account maven might tell you that
your budget for lunch is no more than $25, you make projections on
how much you will spend using your own money. This mostly ends up
saving you time. You don't have to think twice (although maybe you
should) about the $3 latte you get each morning because you have a
mental account that says you are entitled to a $3 latte each day.
The alternative to having mental accounts, Thaler said, is to
consciously ask yourself to ask what every purchase is worth and
compare it with every other purchase. Is a latte worth the same as
a pair of socks? Just as your boss doesn't want to be bothered
with trivial decisions on whether you charge the company $20 or
$22 for a meal, you don't want to waste time thinking about
trivial purchasing decisions.
The effect of setting up accounts, however, has paradoxical
effects -- in exactly the same way that office accounting can
create problems in a workplace, Thaler said. At the end of the
financial year, your boss may not be willing to let you buy a new
laptop, because the hardware budget is down to zero, but will
allow you to take a trip to Los Angeles because there is money
left in the travel budget. Your argument that you need a laptop
more than the trip falls on deaf ears.
Here are some other examples from everyday life:
· A friend of Thaler's once went to buy a bedspread. Where a
double, queen and king size usually cost $200, $250 and $300, all
three sizes were now priced at $150. Thaler's friend happily
snapped up the king-size bedspread -- although she planned to use
it on a double bed. The woman had a mental idea of what a
bedspread should cost. Buying the double bedspread, which is what
she needed, saved her only $50, but buying the king saved her
$150. Mental accounting explains why many people eagerly snap up
deals on items they do not need: When something sells for below
the mental price we have assigned it, the deal takes precedence
over the actual utility of the item.
· A man buys an expensive membership in a tennis club. Right after
he puts down the money, which is nonrefundable, he hurts his
ankle. He grits his teeth and continues to play through the pain
-- even though not playing would mean much less agony. Mental
accounting is behind the problem. Playing is the only way to
ensure that the tennis club membership remains in the man's mental
category of money well spent. To not play would be to write off
the membership cost as a loss, which is more painful to the man
than the agony of hobbling through games on an injured ankle.
· Another friend of Thaler's used mental accounting to devise an
insurance plan against life's vicissitudes. He made a mental
contribution to the United Way Campaign at the start of the year
and then, every time he was unfairly given a parking ticket or had
to fork over money for some other annoyance, he mentally deducted
the amount from the sum he had set aside for charity. Assigning
the money to charity allowed the man to feel that the money he was
paying for parking tickets and other annoyances did not really
belong to him anyway. (While this strategy is unlikely to be
embraced by charities, Thaler's friend was careful not to set his
annual target so low that he was left with nothing to give to
charity at year's end.)
Mental accounting also explains why, when people are given a
choice to get a cash bonus or a gift such as a free vacation for
doing well on the job, they invariably choose cash. That's because
people think they want the flexibility of cash. The problem is
that flexibility comes with a price. You have to remember your
obligations, such as fixing that leaky roof.
This is why studies show that employees who are not given a choice
and are given a gift instead of cash usually turn out much
happier. A vacation or a gift is "guilt-free" -- yours to
enjoy. If you get cash instead, you could spend it buying yourself
the same vacation or gift, but mental accounting would remind you
that you are wasting money on frivolities.
Ohio State University psychologist Hal Arkes once found that
mental accounting influences how people deal with sudden gains,
such as lottery winnings. The same phenomenon influences millions
of Americans at tax time, when they gleefully look forward to
refund checks from the government -- even though refunds are
really their own money being returned to them, minus interest. In
terms of mental accounting, lottery winnings and refunds are
invariably counted in the category of "free money" -- which is why
people spend such dough not on health care, utilities and
eliminating credit card debt but on discretionary items such as
vacations or new patios.
Arkes and his colleagues once cited an anecdote in a study:
Employees of a publishing firm who were in the Bahamas for an
annual meeting were each given a cash bonus for getting a big
contract. Almost to a person, the bonus recipients took the money
to a local casino and blew it. What is interesting is that most of
these people did not lose more than the $50 -- they slowed down or
stopped when they felt they were playing with their "own" money
rather than with the $50 of "free" money. The irony, of course, is
that the $50 these people lost was their own money, too.
What does mental accounting have to do with the other puzzle we
discussed at the start -- the difficulty of finding cabs on rainy
evenings? Mental accounting, like financial accounting, requires
people to close the books and balance their accounts. But people
in different professions unwittingly balance their books at
different times -- wage employees may balance books on a biweekly
or monthly basis, whereas cab drivers often balance their mental
books on a daily basis. Business is brisker on rainy evenings, so
once cabbies meet their mental income targets for the day, they go
home, leaving fewer cabs on the street, Thaler said.
Viviana Zelizer, a sociologist at Princeton University, noted that
a similar phenomenon even affects how prostitutes think about
their income. She cited a study of the Oslo prostitution market,
which showed that prostitutes tend to spend money acquired through
welfare checks and health benefits on essentials such as rent and
bills and are far more likely to spend their income acquired from
selling sex on drugs and alcohol, even if it means they have no
money left over to pay for essentials.