Behavioral Econs 101: Bargains and rip-offs, Richard Thaler and mental accounting Part 2

by HK Lim (hklim [at] thetroublewitheconomics.com)

As part of our second installment in our Behavioral Econs 101 series(see part 1 here), we turn now to tie up some loose ends with mental accounting by discussing how behavioral economics helps us understand when we think of a deal as a bargain or a rip-off. The key question we want to answer is “what exactly goes through our minds when we make a purchase?” To make progress on this we need to recognize that we experience two distinct kinds of utility: acquisition utility and transaction utility, something that the 2017 Economics Nobel Laureate Richard Thaler devoted much of his early career to understanding. What exactly is the difference between the two?

Acquisition utility versus transaction utility
Acquisition utility is what we economists’ term “consumer surplus” in standard economic theory. This can be most simply thought of as the leftover(or excess) utility from an acquired item that remains after we subtract from it the opportunity cost of whatever had to be given up in obtaining this item. Sound a little abstract? Let’s look at a simple example. Suppose you buy a sandwich for $4, the consumer surplus is the excess utility you would derive from consuming that sandwich over and above the value of whatever next best alternative use you could have had for that same $4. A particular purchase would provide a surplus of acquisition utility to a consumer if he or she were to value it more than the market does. If you behave exclusively according to the logic of mainstream economics(and rational choice theory), acquisition utility is the only thing that you would care about when making a decision whether or not to purchase something.

On the other hand, there’s another wholly different aspect to the purchase that we call the “quality” of the deal. This is what the idea of transaction utility captures, and is the difference between the price one actually pays for an object or service(or the value one attaches to the price one pays) and the price that one would normally expect to pay for it. This normally expected price is often also referred to as the reference price. A good example of this can be seen when you visit a movie theatre. When you buy a large soda at the movies for double the price that it would cost at a fast food outlet($5 versus $2.50), while the soda per se is fine, you probably do feel like you just got a little bit ripped-off. What happened here is that this soda deal has generated negative transaction utility because you paid a price in excess of your reference price. On the other hand if your paid price is below your reference price you actually generate positive transaction utility and consequently enjoy the feeling that you’ve scored a “bargain”.

How much would you pay for a beer on the beach

We turn now to discuss a famous example distinguishing these two utilities from a survey questionnaire given to participants by Richard Thaler(1983):

“You are lying on the beach on a hot day. All you have to drink is ice water. For the last hour you have been thinking about how much you would enjoy a nice cold bottle of your favorite brand of beer. A companion gets up to go make a phone call and offers to bring back a beer from the only nearby place where beer is sold (a fancy resort hotel) [a small, run-down grocery store]. He says that the beer might be expensive and so asks how much you are willing to pay for the beer. He says that he will buy the beer if it costs as much or less than the price you state. But if it costs more than the price you state he will not buy it. You trust your friend, and there is no possibility of bargaining with (the bartender) [store owner]. What price do you tell him?”

Before we reveal the study participants’ responses, we should note two key points. First, there is no difference whether the beer is from a fancy resort hotel or the small grocery store, so in effect, the consumption is identical for all intents and purposes as it is consumed on the beach(and there can hence be no ambience effects). Second, since there is no negotiation with either the bartender or store owner, there is no incentive for respondents to disguise their true preferences. [This is what economists term incentive compatibility, where every participant can achieve the best outcome for himself or herself just by acting according to their true preferences.]

What were the actual responses like? As expected, participants were willing to pay more for beer from a fancy resort than for beer from a grocery store. In fact the median responses were $7.25 and $4.10 respectively after adjusting for inflation(Thaler(2015)). These results reveal a peculiar finding(at least from the perspective of standard economic theory), participants were willing to pay different prices for the exact same beer consumed on the same spot on the beach depending on where the beer was purchased!

Now, this wouldn’t be so surprising if you weren’t studying this through the lens of neoclassical economics and rational choice theory, for in our everyday lives, it isn’t at all surprising to have different expectations for the price of the same item depending on where it is sold because of expected differences in underlying costs. Nevertheless, this example demonstrates an extremely peculiar feature that illustrates the departure of actual people’s behavior from what standard economic theory predicts. If you were homo economicus subscribing to behavior according only to the rules of rational choice theory, you’d only care about acquisition utility and would completely ignore transaction utility when buying a beer. The actual purchase location of the beer would be a supposedly irrelevant factor. But in the real world, this isn’t quite true, is it?

Implications of transaction utility
With our newfound understanding of transaction utility, and recognizing that it can be either positive or negative, we see why the mental accounting that distinguishes between acquisition and transaction utility is so important. Our impression of whether we are getting a good deal or being gouged can also discourage purchases that are utility enhancing as well as prompt purchases that are an unnecessary waste of money. Coming back to the example of the beer on the beach again, suppose that you inform your companion that you will be only willing to pay at most $4 for a beer from a run-down grocery store and at most $7 for a beer from a hotel. Your companion would be able to enhance your utility even if he bought the beer at the grocery store for $5 but told you it was purchased from the hotel instead! Only your aversion to being price gouged stops you from agreeing to this transaction provided if you were told the truth.

I. Deals too good to pass up

Good deals that are “too good to pass up” on the other hand, can lead to situations where we end up purchasing something we don’t really need. How often have you been in the situation where, shopping during a sale, you try to convince yourself that you can fit into a pair of shoes either a half size too big or small? It’s almost certainly true that we all have embarrassing examples of such purchases gathering dust in our closets.

II. Infrequently purchased items
There is another angle from which the psychology of transaction utility can be used to induce a purchase more easily. In the category of infrequently purchased products like mattresses, suits(see Fig.1) and carpets, it’s a common sales tactic to always have a “sale” in progress year-round. Chances are you won’t pay attention on a regular basis to this, and won’t notice that whenever you seem to be in the market for such products, there always conveniently seems to be a sale going on.

Fig.1 Suit, I see what you did there.

And whenever an infrequently purchased product’s quality is difficult to assess, the old trick of “suggested retail price” or MSRP can be bundled in to help seal the deal by both suggesting that a product is of high quality(because high suggested retail prices can imply high acquisition utility) and/or combined with a sale to scream out that there’s lots of transaction utility to be had here as well.

III. Everyday low pricing – Macy’s and JC Penny
It can also be the case that shoppers can become addicted to the high from from positive transaction utility. A key example of this can be seen in Macy’s and JC Penney’s separate experiences in trying to reduce the extensive offers of discount pricing as part of their sales strategy in an attempt to shift to an “everyday low pricing” strategy.

In Macy’s case, a 2006/2007 rebranding effort coupled with a plan to reduce the dependence on coupons as a discount strategy backfired spectacularly. Following a cut in coupons by 30% in 2007, a subsequent sharp decline in sales forced the company to return to its original extensive coupon program by the holiday season of 2007.

In the case of JC Penney, in 2012, then CEO Ron Johnson announced an end to what he termed “fake prices” (via the use of suggested retail prices) and a shift to a simpler pricing scheme. Aside from getting rid of traditional coupon sales, prices ending in .99 were also rounded up to the next dollar on the basis that that the overall prices paid by consumers was the same after all the changes. This entire episode will be remembered as a total disaster, with both aggregate sales and JC Penney’s stock price taking a nosedive as consumers now lost out on much of their good old transaction utility. Notably, the positive psychology boost of just paying under a given dollar amount in the well-known .99 pricing strategy was also lost by consumers.

You might ask how this might apply to big discount retailers like Walmart and Costco in contrast? While they may operate under an everyday low pricing strategy, transaction utility is very much integrated into the entire shopping experience as these retailers go the whole nine yards in convincing customers that the entire shopping experience there is one big bargain hunt. (Walmart even has a savings catcher app that allows shoppers to scan in their receipts and receive a refund if a lower price is available anywhere else.)

Ain’t nothing wrong with a bargain and a simple lesson for businesses
We should also carefully note here that standard economic theory doesn't say that homo economics are immune to bargains, but rather that the positive effects of buying a high-end cup coffee for a discounted price of $1 accrues only from acquisition utility(consumer surplus). Conventional economics has trouble addressing the terms of the deal. To sum it all up, there really isn’t anything fundamentally wrong with being on the hunt for bargains except when we end up buying something we don’t really need because the price was too good to pass up. On the other hand, businesses should remember that everybody likes a good bargain, whether via a sale or via genuinely low prices, high transaction utility will always drive customers through your doors. If you need a reminder of this, just take a glance at the large number of expensive cars parked out front of any TJ Maxx or Nordstrom Rack any day. Remember, ain’t nobody gonna pass up a good deal. In our next installment of Behavioral Econs 101 we will discuss the well known but often misunderstood endowment effect.

References
1. Thaler, R. (1983). Transaction utility theory. Advances in Consumer Research, 10, 229-232.

Behavioral Econs 101: Richard Thaler and mental accounting Part 1

by HK Lim (hklim [at] thetroublewitheconomics.com)

Richard Thaler, the 2017 Nobel Laureate for Economics, has spent a career trying to understand individuals as they really are, idiosyncrasies, irrationalities and all and in the process founded the field of behavioral economics. In this series of short essays, we will introduce the basic ideas from various aspects of behavioral economics in an accessible and nontechnical manner and show how immediately relevant(and applicable) these ideas are to our everyday lives. Each piece is not intended as a comprehensive overview of each topic but instead strives to give the reader a broad flavor for the diverse work that has been done in this area. Richard Thaler first developed the idea of mental accounting in order to better understand the cognitive operations used by individuals to organize and evaluate their economic activities. The basic idea here is that individuals can overcome the cognitive limitations encountered when making difficult economic decisions by simplifying the economic environment or decision process in systematic ways. Oftentimes, such simplifications can also lead to suboptimal decisions whereas in other situations they can in fact have tangible benefits as will be discussed in what follows.

Bounded rationality and mental accounting

Thaler’s mental-accounting model describes how boundedly rational individuals adopt internal control systems to evaluate and regulate their budgets and also allows us to predict how this will systematically affect spending, saving, and other household behaviors.  The term bounded rationality(first introduced by the 1978 economics Nobel Laureate Herbert Simon) refers to an individual’s limited inability in solving all complex economic decision problems in the most economically optimal way(read this as consistent with economic "rationality"). This stands counter to traditional economic theory’s(specifically rational choice theory’s) simplifying assumption that all economic actors are capable of solving all economic problems they are faced fully and rationally. [Or, if you'd like, the alternative defense that the assumption of bounded rationality while true is but an “unimportant” concept in aggregate market situations with learning.]



What is mental accounting?

Thaler’s(1985, 1999)  theory of mental accounting marked a radical break with the standard neoclassical model of utility-maximizing consumers(expected utility theory was comprehensively developed by John von Neumann and Oskar Morgenstern and published in 1944 in the 600-page opus, "The Theory of Games and Economic Behavior") that forms the foundation of traditional mainstream microeconomic theory. In contrast, mental accounting is a psychology-based theory of how limited cognition affects individual spending, saving, and other household behavior. In Richard Thaler’s words, this theory tries to address the question “How do people think about money?” The key to Thaler’s insight was in recognizing that decision-making often happens in a piecemeal rather than comprehensive fashion due to the overall complexities of many(if not most) economic decisions. This results in the establishment and use of simplified rules of thumb that guide us in making many economic decisions.



A key motivation for the theory of mental accounting can be traced to the observation that individuals tend to group their expenditures into different categories(e.g.: housing, food, clothing, entertainment etc), with each category corresponding to a separate "mental account" akin to the movie cliched imagery of separate mason jars(or envelopes or nowadays some financial planning app) set aside for various types of household spending. By assigning to each "mental" account its own budget and its own separate reference point, this practice effectively limits the fungibility(of money) between the various accounts. This practice breaks with the fundamental economic notion of the universal fungibility of money, as traditional economic thinking will tell you that a dollar from any one account will also be good for spending in any other category of account. According to mental accounting, the value a person attributes to a given amount of money may in fact dependent crucially on the account it was originally assigned to, as well as depend on its context and framing. Thaler argued that mental accounting can in this way be used by boundedly rational individuals as a way to simplify financial and economic decision-making, and in effect serve as a simplifying heuristic.

 Imagine for a moment that instead of deciding how much to spend on each category of purchase of product at the supermarket(breakfast items, lunch items, dinner items, household cleaning items etc) you instead treat your supermarket budget as a super-optimizing problem(as conventional economic theory does) of choosing the combination of products that provides you with maximal utility. You see the difficulty of this approach?

Thaler found from initial surveys that many households, especially those on tight budgets use explicit budgeting rules. The same budgeting rules can also be found in many organizations were department specific budgetary allotments are common. All these practices violate the fundamental economic notion that money is fungible, and that there should be no real limitation on what it can be spent on if we all aim to maximize some overall utility. There is a strongly compelling basis to this economic notion of fungibility, for example, if there is leftover in a household’s utilities budget from a mild winter, this money will spend perfectly well on new clothing or travel. While there are many sensible reasons for budgets(for example in helping delegating decisions away from a central planner or with cost containment as an objective), sometimes it can lead to frustrating outcomes when  funds are needed for an urgent purpose(in an organization) but idle funds cannot be tapped into because such funds lie in another budget. The key idea here from economics(and utility maximization) being that money should be spent in whatever way that best serves the overall interests of the organization, household or individual, but sometimes such an optimizing problem can become so unwieldy that mental accounting can also help prevent decision paralysis or suboptimal default decisions.



Examples and consequences of mental accounting

We will discuss mental accounting in the context of several broad examples to illustrate its widespread relevance as well as outline the benefits and limitations of its use.

I. Sunk costs

A sunk cost refers to an amount of money spent that cannot be retrieved. In traditional economic theory, economists admonish us to not pay attention to sunk costs, but in practice this is much harder to follow(even for neoclassical economists). Let’s consider the quintessential example taught to beginning economics students. You and a friend have both purchased an expensive $120 ticket to a NBA basketball game and it snows heavily on the day of the game and driving to the game venue is now challenging or even potentially hazardous. Do you still try to drive to the game or choose instead to forego your ticket? What happens if you both got the tickets for free? [We also assume here that you are unable to sell or physically give the tickets to someone else who can make it to the arena in the short time available before the game.] A larger fraction of respondents will typically indicate that they would likely still try to make the game in the first scenario compared to the second scenario where the tickets were free. This goes against economists’ advice(based off rational choice theory) to ignore “sunk costs” and is so well known a phenomena that it even has its own official name, the “sunk cost fallacy.”

How does mental accounting explain this behavior? Paying $120 for a ticket to a game you do not attend sounds a lot like losing $120. To use a financial accounting analogy, failing to use a purchased ticket forces you to “recognize” the loss in your mental accounting books as you try to close out the account. Going to the event allows you to settle the account without taking a loss. In a similar way, the more you use something that you have paid for, the better you will end up feeling about the transaction. A particularly good example of this can be seen in health club or gym memberships. If you buy a gym membership and fail to utilize it, you will have to confront that purchase as a loss. [As a side note, some people actually purchase gym memberships as an effective commitment mechanism to help them overcome problems with willpower in maintaining regular attendance, or so they hope.] This mental accounting interpretation has been supported by survey work by John Gourville and Dilip Soman(1998) at a health club that bills its members twice yearly. They found that attendance at the health club jumps the month after the first bill arrives, but then tails off over time until the arrival of the next bill. They termed this “payment depreciation” to denote how the effects of sunk costs dissipate over time. 


[Another complimentary way to think about the above sunk cost phenomenon is in terms of opportunity costs and the phenomenon of loss aversion(to be covered in a future piece). The key idea here is that if you got the ticket to the NBA game for free, by not going you would be just giving up a positive experience through the lens of opportunity cost which will not also be counterbalanced by a negative monetary loss, whereas if you’d paid for the ticket, missing the game is experienced as an actual monetary loss without the benefit of the offsetting positive benefit of attendance. Additionally, according to loss aversion, losses hurt more than gains (to be precise with respect to changes in levels and not solely in absolute terms), this thus gives rise to the phenomena of sunk costs via a type of endowment effect(also to be discussed in future).]

II. Regular versus premium grade gasoline

A study by Justine Hastings and Jesse Shapiro(2013) provides the clearest “smoking gun” evidence for a key prediction of mental accounting to date: the lack of fungibility of money. In their work, they studied consumers’ choice between regular and premium gasoline when the price of gasoline fell by about 50% in 2008 from a high of about 90 cents a liter to just below 45 cents using customer data from a grocery store that also sold gasoline. Consider the following scenario: Suppose a household is currently spending $80 a week on regular gasoline and the price drops from 90 cents to 45 cents a liter, so the household’s gasoline expenditure would then drop to $40 a week. If a typical economically rational individual were confronted with such a drop in gasoline prices, what would you expect him or her to do? Firstly, since gasoline is cheaper, the household could be expected to make more road trips. That sounds reasonable. Secondly, since gaining the equivalent of $40 a week in extra take-home pay, he or she could foreseeably spend that on anything that enhances utility, from more entertainment to more luxuries as long as the extra $40 is spent in ways that maximize overall utility. Some of that extra money might even be spent on a higher grade of gasoline(despite this not having any established tangible benefits), but “rational” economic theory would only predict a minuscule amount would be spent in this way. 

But what actually happened? Hasting and Shapiro's study found that the shift to premium gasoline was 14 times greater than predicted by a standard demand model built from a world where money is considered fungible. Mental accounting with a specific account for gasoline explains this huge shift. 

Further supporting a mental accounting interpretation of these results, they also found that in contrast, there was no tendency for families to upgrade the quality of two other regular grocery store purchases, namely milk and orange juice during this same period. This was not at all surprising since the period under study was right at the beginning of the 2007 financial crisis, which happened to be the very event that had triggered the drop in gasoline prices and also a time where most families were trying to cut back on spending where they could. So mental accounting resulted in consumers splurging unnecessarily on premium grade gasoline at a time when they really shouldn’t be.



III. Wealth

Wealth too is often separated into various mental accounts. Money in the form of cash sits at the bottom of this hierarchy, since it’s the easiest to spend. (The old expression that “money burns a hole in your pocket and cash on hand only exists to be spent” does seem to hold some truth.) While money in a checking account is just slightly less accessible than cash, money in a savings account can be subject to greater resistance in drawdowns. This can give rise to the unexpectedly strange behavior(well at least to mainstream economists) of simultaneously borrowing at a high rate of interest and saving at a low rate, by keeping money in a savings account that earns virtually no interest while also keeping an outstanding balance on a credit card at more than 20% APR. 

But there is also a benefit to maintaining separate “mental” accounts for different spending categories since this can provide a credible commitment mechanism against overspending, especially for non-essential or addictive goods. A person who suffers from a lack of self-control may be expected to quickly run up his or her credit-card debt anew after paying it off. Thus, maintaining savings as a separate account with a separate reference point may deter the person from using his or her savings to pay off the credit card and thus provide an effective commitment mechanism against excessive spending. A similar situation coupled to the notion of limited willpower(to be discussed in a future piece) is observed in how smokers tend to buy more expensive single packets of cigarettes instead of larger cases(aside from any convenience issues associated with carrying around larger cases) as a means of curbing excessive smoking.

IV. Home equity lines of credit

Home equity provides another interesting case study in mental accounting. For the longest time, people tended to treat dipping into the money in their homes as off limits, frowned upon much like dipping into your retirement savings. Families tended to try to pay off their mortgages as quickly as possible and even as recently as the early 1980s, individuals over 60 had little or no mortgage debt. This began to shift in the United States as a consequence of an unintended side-effect of a Reagan-era tax reform. Prior to this point, all interest paid(including automobile loans and credit cards) was tax deductible but after the reform, only home mortgage payments remained tax deductible. The most obvious things happened next. Banks were incentivized to create home equity lines of credit that encouraged households to borrow in a tax deductible way. From this perspective, it clearly made sense for households to use home equity loans to finance a car purchase as opposed to a car loan, especially since the interest rate on the former was typically lower as well as tax deductible. However, this put an abrupt end to the social norm that dipping into home equity to finance spending should be off-limits. Soon, home equity stopped being a “safe” mental account, and this was seen in the changing borrowing behavior of households. In 1989, for households with a head that was seventy-five or older, only 5.8% had any mortgage debt. By 2010, the fraction of such debt rose to 21.2%. And for those with mortgage debt, the median debt owed rose from $35,000 to $82,000 over this period(in constant 2010 dollars). So during the housing boom of the early 2000s, home owners effectively spent the paper gains they had accrued as quickly as a lottery windfall!



This phenomenon also helps explain why the bursting of the tech bubble in the early 2000s wasn’t nearly as economically catastrophic(as evidenced by the depth and duration of the subsequent recession) as the bursting of the housing bubble in 2007/2008. Noting that most non-wealthy households mainly hold stocks in their retirement 401(k) accounts and these remain relatively illiquid places to park one’s money, it's not surprisingly that the fall in stock prices did not impact spending as much as the fall in home prices.



V. Driving taxis in New York City

To round out our examples of mental accounting in action, let us consider the fascinating study by Thaler and his co-authors that focused on the labor-supply decisions of taxi drivers in New York City(Camerer et al. 1997). In this study, they also found evidence for reference-dependent preferences and what is termed narrow bracketing(the extent to which choices are separated as opposed to grouped together) in the sense that taxi drivers appear to behave as if they try to achieve a specific target income every day(termed the reference point) and thereby suffer from loss aversion if they fail to reach that target. Thus each working day seems to correspond to a separate mental account for the drivers, and consequently, drivers drive less on days when there is high demand and more on days with low demand, which is the exact opposite of what standard economic theory predicts for labour suppy given demand shocks. So mental accounting strikes again.




So non-fungible budgets aren't so silly after all, are they?




In the above discussion, we can see that in many examples of mental accounting, non-fungible budgets are not completely pointless or silly after all. In fact, whether by using envelopes, mason jars or a financial planning app, any household that makes a serious effort to create a realistic financial plan will likely have find it much easier to live within their means. The same logic applies to organizing a business as well. Nevertheless, there are instances where mental accounting can lead to suboptimal decision making, like splurging on premium gasoline at the beginning of a financial crisis or supporting an extravagant lifestyle beyond your means through excessive home equity financing during property boom years. In the next installment in this series, we will explore how mental accounting is intimately related to the how one perceives whether a deal is interpreted as a rip-off or a bargain via the notions of acquisition and transaction utility.




References

1. Thaler, R.H. 1985. Mental Accounting and Consumer Choice. Marketing Science 4, 199- 214.

2. Thaler, R.H. 1999. Mental Accounting Matters. Journal of Behavioral Decision Making 12, 183-206.

3. Gourville, J., and Soman, D. 1998. Payment Depreciation: The Behavioral Effects of Temporally Separating Payments From Consumption. Journal of Consumer Research, 25(2), 160-174.

4. Hastings, J.S. and J.M. Shapiro. 2013. Fungibility and Consumer Choice: Evidence from Commodity Price Shocks. Quarterly Journal of Economics 128, 1449-1498.
5. Camerer, C.F., L. Babcock, G. Loewenstein, and R.H. Thaler. 1997. Labor Supply of New York City Cab Drivers: One Day at a Time. Quarterly Journal of Economics 112, 407-442