Mental accounting

A concept first named by Richard Thaler, mental accounting (or psychological accounting) attempts to describe the process whereby people code, categorize and evaluate economic outcomes. Mental accounting deals with the recollection and perception of our various expenditures; its purpose is to keep track of our money-related decisions so as to give us a model with which to evaluate future financial decisions. It is a way of making sense of the world. Like many other cognitive processes, it can prompt biases and systematic departures from rational, value-maximizing behavior, and its implications are quite robust. Understanding the flaws and inefficiencies of mental accounting is essential to making good decisions and reducing human error. A concept first named by Richard Thaler, mental accounting (or psychological accounting) attempts to describe the process whereby people code, categorize and evaluate economic outcomes. Mental accounting deals with the recollection and perception of our various expenditures; its purpose is to keep track of our money-related decisions so as to give us a model with which to evaluate future financial decisions. It is a way of making sense of the world. Like many other cognitive processes, it can prompt biases and systematic departures from rational, value-maximizing behavior, and its implications are quite robust. Understanding the flaws and inefficiencies of mental accounting is essential to making good decisions and reducing human error. As Thaler puts it, “All organizations, from General Motors down to single person households, have explicit and/or implicit accounting systems. The accounting system often influences decisions in unexpected ways”. We often see consumer behavior deviate from the standard economic prediction; mental accounting is a framework that seeks to further explain consumer behavior, and describe when consumers might violate standard economic principles. Particularly, individual expenses will usually not be considered in conjunction with the present value of one’s total wealth; they will be instead considered in the context of two accounts: the current budgetary period (this could be a monthly process due to bills, or yearly due to an annual income), and the category of expense. People can even have multiple mental accounts for the same kind of resource. A person may use different monthly budgets for grocery shopping and eating out at restaurants, for example, and constrain one kind of purchase when its budget has run out while not constraining the other kind of purchase, even though both expenditures draw on the same fungible resource (income). One detailed application of mental accounting, the behavioral life cycle hypothesis (Shefrin & Thaler 1988), posits that people mentally frame assets as belonging to either current income, current wealth or future income and this has implications for their behavior as the accounts are largely non-fungible and marginal propensity to consume out of each account is different. In mental accounting theory, framing means that the way a person subjectively frames a transaction in their mind will determine the utility they receive or expect. This concept is similarly used in prospect theory, and many mental accounting theorists adopt that theory as the value function in their analysis. It is important to note that the value function is concave for gains (implying an aversion to risk) and convex for losses (implying a risk-seeking attitude). This can influence the way people evaluate transactions. Given this framework, how do people interpret, or ‘account for’, multiple transactions/outcomes, of the format (x, y)? They can either view the outcomes jointly, and receive Value(x+y), in which case the outcomes are integrated, or Value(x) + Value(y), in which case we say that the outcomes are segregated. Due to the nature of our value function’s different slopes for gains and losses, our utility is maximized in different ways, depending on how we code the four kinds of transactions x and y (as gains or as losses): 1) Multiple Gains: x and y are both considered gains. Here, we see that Value(x) + Value(y) > Value(x+y). Thus, we want to segregate multiple gains. 2) Multiple Losses: x and y are both considered losses. Here, we see that Value(-x) + Value(-y) < Value( -(x+y) ). We want to integrate multiple losses. 3) Mixed Gain: one of x and y is a gain and one is a loss, however the gain is the larger of the two. In this case, Value(x) + Value(-y) < Value(x-y). Utility is maximized when we integrate a mixed gain. 4) Mixed Loss: again, one of x and y is a gain and one is a loss, however the loss is now larger than the gain. In this case, Value(x) + Value(-y) >Value(x-y). Clearly, we don't want to integrate a mixed loss. This is often referred to as a silver lining.