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