Mental Accounting

Would you drive 20 minutes out of your way to save $5 on a $15 calculator?

Would you drive the same distance to save $5 on a $125 leather jacket?

According to research from Richard Thaler at University of Chicago, 68% of respondents would drive to get the calculator but only 29% for the leather jacket. On the surface, this result is illogical – the savings is the same ($5) in both cases.  The decision seems to be based on the inherent concept of getting a deal. One third off of an inexpensive calculator is a more powerful motivator than 4% of a leather jacket.

Mental CalculatorThaler describes this irrational decision as an example of mental accounting. Mental accounting can be thought of as the home equivalent of financial accounting; both have charts of accounts, closing periods, and investment trade-offs. Unfortunately, while there are professional financial accountants, the evidence suggests that we’re not very good when it comes to mental accounting.

People mentally create spending accounts with implied budgets for activities like entertainment, food, travel, and clothing. If they feel like they’ve overspent in one category, they will delay needed purchases in that specific category – even though they still spend on other items. A Princeton study showed this effect by asking participants to react to the following scenarios:

Imagine you just arrived at a theater and as you reach into your pocket to pull out the $10 ticket you purchased in advance, you discover that it’s missing. Would you fork over another $10 to see the movie?

Compare that to a second scenario in which you did not buy the ticket in advance, but when you arrive at the theater, you discover you had lost a $10 bill on the way. Would you still buy a movie ticket?

Even though they have the same value, only 46% of those who lost the ticket were willing to buy a replacement, while 88% of those who lost the equivalent amount in cash were willing to buy a ticket.  In the first case, the participants reported that they felt they were paying $20 for the movie because they were withdrawing additional money from their entertainment budget while in the other, the lost money came out of an overhead budget.

By contrast, at work we’re often willing to transfer budget from one category to another. For example, if your travel budget is down to zero but you need to visit an important client, it’s likely that you can use available funds from the third-party consulting budget instead. The impact on cash flow is the same.

Like financial accounting, mental accounting requires people to periodically close the books. As I’ve previously blogged, taxi drivers seem to balance their mental books on a daily basis. Hourly employees spend more on weekends, regardless of their actual account balances. Every year I spend less in the first two weeks of January and the last two weeks of April, even though I know  holiday gift giving and tax paying won’t be repeated for another year.

While some believe that mental accounting is over-hyped, I find that it often explains seemingly irrational financial behavior. Like why I have bought so many calculators on sale…

[Note: An earlier version of this post contained a video with a supporting discussion between actors Gene Hackman and Dustin Hoffman. It is periodically removed from YouTube so the link may not work.]

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4 Responses to Mental Accounting

  1. Arun Krishnaswamy May 23, 2011 at 6:11 am #

    Very true. Tells us that many of our decisions are emotion-based and based on perceived value rather than hard numbers. I feel there is too much of this irrational psychology at play in the stock markets as well which explains why excellent financial performance does not necessarily translate into stock performance and vice versa (witness the Linked In IPO at 500+ times earnings). Maybe that is an example of the emotional power of the brand!

  2. Norman Marks May 23, 2011 at 7:27 am #

    Then there is the cost of the 20 minutes there and back – the value of the time – and the cost of the gas and vehicle depreciation.

    This economist says “no”.

  3. Robert E May 23, 2011 at 7:47 am #

    I wonder if mental accounting is applied to buying software. I have seen time and again where a company will purchase software, but not spend any money on training or consulting services to get the most out of what they bought. Do you think the mental accounting makes them think that is the same as buying the movie ticket again? Or is more to do with thinking of software purchase and training two categories and transfering that training budget to put into the initial purchasing price of the software?

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  1. Mental Accounting (via Manage By Walking Around) « Jamar L. Freeze - May 24, 2011

    […] Mental Accounting (via Manage By Walking Around) Would you drive 20 minutes out of your way to save $5 on a $15 calculator? Would you drive the same distance to save $5 on a $125 leather jacket? According to research from Richard Thaler at University of Chicago, 68% of respondents would drive to get the calculator but only 29% for the leather jacket.  On the surface, this result is illogical – the savings is the same ($5) in both cases.  The decision seems to be based on the inherent concept of … Read More […]

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