Mental accounting is a theory developed by American economist Richard Thaler, which proposes that people make economic decisions not based on a purely rational, neutral system, but rather through a mental accounting system that can lead to behaviors inconsistent with standard economic models. This theory suggests that individuals compartmentalize their finances into different mental accounts, and how money is categorized within these accounts significantly
influences their economic choices, often resulting in irrational behavior concerning consumption and savings. It's a key concept within behavioral economics and has been instrumental in shaping the field of behavioral finance.
The Non-Neutral Nature of Mental Accounts
Unlike the neutral accounting systems used by businesses, mental accounts are not always logical or consistent. They are influenced by psychological insights, aiming to enrich the descriptive value of economic models. For instance, mental accounts are often "closed" after a certain period, similar to business accounting cycles. This dynamic aspect becomes particularly relevant in risky decision-making. When individuals face a series of risky decisions, such as in a casino or financial markets, the outcomes of previous decisions can affect their risk appetite for subsequent choices. If a mental account related to a gambling session or a trading period (day, month, or year) is in surplus, the theory predicts an increased propensity for risk-taking. Money earned in this context might not be perceived or treated the same as other funds.
Transaction Utility and Perceived Value
A significant component of mental accounting is the idea that a purchase generates utility not only from the enjoyment of the good itself but also from the satisfaction of "getting a good deal." This is known as transaction utility. It's an additional layer of satisfaction that depends on the difference between the purchase price and a "reference price" that the consumer associates with the item. Thaler (1985) suggested that if a price is considerably lower than what a consumer considers normal or fair, the strong transaction utility generated might encourage the purchase of goods that aren't particularly useful. Marketing strategies frequently aim to create this transaction utility by suggesting high reference prices, making the actual purchase price seem like a bargain.
Anomalies in Economic Behavior
Mental accounting offers explanations for several economic anomalies—behaviors frequently observed but not easily explained by standard economic theory. One such anomaly is the endowment effect, which describes the discrepancy between how much value someone places on a good they own versus one they don't. Experimentally, it's been shown that people tend to value items they already possess more highly. This leads to reduced market activity because individuals struggle to equate the opportunity cost of not selling an owned item (the money foregone) with the out-of-pocket costs of buying an item they don't own. Mental accounting explains this by suggesting people interpret opportunity costs as foregone gains and out-of-pocket costs as losses, with loss aversion driving the endowment effect.
Another anomaly is the sunk cost effect. Standard economic theory dictates that costs already incurred and irreversible (sunk costs) should not influence future decisions. However, in practice, people often consider these past investments when evaluating future projects or investments, alongside marginal costs and benefits. Mental accounting posits that this effect arises because economic agents try to avoid "waste," meaning they dislike paying for goods or services they don't use, as this generates loss aversion and a significant decrease in utility.
