Chapter 6

Mental Accounting

Mental Accounting
NATURE AND COMPONENTS
6.2 FRAMING AND EDITING
6.3 BUDGETING AND FUNGIBILITY
6.4 CHOICE BRACKETING AND DYNAMICS
6.5 POLICY IMPLICATIONS

Nature and Components

Mental accounting is the set of cognitive operations used by individuals and households to
code, categorize and evaluate financial activities – Thaler (1980)
Mental accounting theory was developed to overcome descriptive anomalies in the SEM,
and it incorporates the basic elements of prospect theory in its formulation
It helps us to develop a better understanding of the psychological processes that underlie
choices and decisions

Thaler’s papers refer to 3 components of the mental accounting process:

Components
 Framing and editing - the perception of outcomes, and the making and evaluation of
decisions
 Budgeting and fungibility - the assignment of activities to specific accounts
 Choice bracketing and dynamics - the determination of the time periods to which
different mental accounts relate

Framing and editing

Implications of prospect theory
For example, do people prefer to win two separate lotteries paying $50 and $25, or a single
lottery paying $75?
EUT, based on the invariance principle, would ndicate that people would be indifferent
between the two outcomes.
However, Thaler found that in a survey, 64% of subjects predicted that the two-time winner
would be happier

Many transactions are complex, involving several components, simultaneous or sequential;

4 principles:
 Segregate gains (because the gain function is concave due to diminishing marginal
sensitivity).
 Integrate losses (because the loss function is convex, again due to diminishing
marginal sensitivity).
 Integrate smaller losses with larger gains (to offset loss aversion).
 Segregate small gains from larger losses (the utility of a small gain can exceed the
utility of slightly reducing a large loss, again due to diminishing marginal sensitivity).
e.g.: separate lotteries, reference prices, jacket/calculator savings
Thus, the first principle can explain the finding regarding lottery preferences.
These principles have some important implications for marketing strategy, in terms of what
Thalor refers to as “hedonic framing”
For example, instead of marking down a price from $20 to $18, and framing this reduction
as “new low price” or “now only $18”, it may be better to use a reference point of $20, and
emphasise the $2 discount.
This is based on the fourth principle above, sometimes referred as the “silver lining”
principle.
There is a further reason for framing the discount in this way, as will be seen below, in
relation to transaction utility.

evaluation of outcomes and decision making

 2 types of utility from transactions:
- Acquisition utility – this represents the value of the good obtained relative to its
price, equivalent to the concept of consumer surplus.
- Transaction utility – this corresponds to the perceived value of the ‘deal’, in other
words the difference between the reference price and the price paid.
Thaler notes two important implications of the transaction component utility:
 First, people are often tempted to buy “deals”, where transaction utility dominates
acquisition utility
o We often then find out that these items are seldom used
o Marketing strategies skilfully manipulate the framing of offers, using
reference prices and emphasizing savings (“silver linings”)
o Examples of such goods are: clothing, household gadgets, health club
memberships
 For health club memberships, self-control factors are also relevant
 The other implication relates to the opposite situation, where people forgo goods
that have the potential to benefit the customer in terms of acquisition utility, but are
rejected because of a high perceived transaction disutility
 Thaler gives the example of a thirsty beer drinker who will pay $4 for a beer from an
expensive resort , but refuse to pay $2.50 for the same beer from a grocery, on the
grounds that he has a reference price of only $2 in the latter case

 Hedonic editing – different activities edited as gains or losses; transaction utility and
saving
loan – spending is loss
credit – spending is reduction of gain
 Product bundling
 The evaluation process becomes more complex when product components
are bundled together in a product bundle
 Sometimes this happens naturally; for example, when computers are
bought with screens and cars with stereo systems
 Other times, sellers deliberately bundle products together which not
only may be complementary, but may also be substitutes if the
intention is to offer consumer variety
 Thaler claims that in this situation using a consolidated price bundle is
preferable to using a partitioned price in terms of consumer evaluation
  He states two advantages of this form of framing:
 First, it integrates losses in terms of costs to the consumers
 Second, it prevents raising the salience of the expense of individual
items
 There is conflicting empirical evidence regarding the evaluation of
consolidated price versus partitioned prices
 Thus, prices do not merely represent a cost or loss, they can also be
used as a proxy for a benefit
 With this in mind, price partitioning may segregate losses, reducing
consumer evaluations, but at the same time, it may segregate gains,
improving evaluations
 Therefore, price partitioning may have a net effect on evaluations that
is either good or bad, depending on the circumstance
 Neuroeconomic evidence – Knutson (2007) 3 stages: product, price, choice
Different brain areas – excessive prices activate insula
 These show that distinct neural circuits related to anticipatory effect, indicate
that there is a trade-off between the potential pleasure of acquisition and the
pain of paying
 Knutson et al used event-related fMRI to investigate how consumers weigh
preferences and prices in a three-phase dynamic process:
o Consumers see product first,
o Then the price,
o And then have to make a choice whether to buy or not
 Their results indicate that the first phase involves the nucleus accumbens (NAcc),
indicating that this brain region is involved in the subjects reaction to products
 Subjects subsequent reaction to price information was reflected in the activation
of the mesial prefrontal cortex (MPFC) and the insula
o More specifically, it was observed that excessive prices deactivated the
MPFC while activated the insula

Budgeting and Flexibility

FUNGIBILITY - substitutability of different budget categories
NM – budgets completely fungible (buy if MU > MC, unless BC), no need for
budgeting.
 Consumption budgeting – 2 reasons:
 Facilitate comparisons
 Faciliatate comparisons or trade-offs between the different uses of funds;
for example, should I spend the money I saved from the last three months
on a holiday or a new computer?
2. Self-control device
 Second purpose is as a self-control device, for example, if I have already
spent my weekly budget on eating out on restaurants, then I will have to wait
till next week before I eat out again
Gifts, denomination effect, malleability, effect of time frame
 Income budgeting
Serious/frivolous scale – matching, e.g. children’s’ clothing
 Wealth budgeting
 NM – PIH: income smoothing – young and old spend more than income/
borrow, middle-aged save
Empirical evidence – people have short time horizons, spending related to
current income
Range of liquidity of wealth – current a/cs, stocks, home equity, future income
(long term saving). MPC varies from 0 to 1.

Anomalies of NM
- Credit cards vs cash and savings – 3 aspects
- Segregation of asset types; narrow framing
- Emotional accounting and laundering

Choice bracketing and dynamics

 How people segregate or aggregate choices over time periods
 Opening and closing accounts
- Buying and selling stock (disposition effect)
- Odean (1998) found that people are more likely to sell stocks that had
decreased in value rather than sell stocks that had decreased in value, which
is known as the disposition effect
- In addition, he finds that stocks sold subsequently outperformed the stocks
bought, underlining further irrationality (in the conventional sense) of the
strategy
- Thus, appears that unrealised losses in particular are not coded as losses in
the same way as realised losses, and do not cause the same degree of loss
aversion
- Reporting earnings (small profits or large losses)
- If firms want to boost their reported earnings, it can “pre-book” revenues
that it has not yet received, and delay recording costs or spread them over
several time periods
- A study conducted by Burgstahler and Dichev§ indicates that firms are
reluctant to announce losses or decreases in earnings
- Small reported gains and increases are much more common than small
reported losses and decreases, conforming to the predictions of PT regarding
loss-aversion
- Sunk costs (camera trade-ins)
- When people buy durables with a lump sum, you want to get your money’s
worth, otherwise you are suffering a loss
- Therefore, the money which have paid, and not getting your money’s worth
is a sunk cost – involves a feeling of loss
- People like to be able to recover these sunk costs in some kind of usage or
resale, people don’t like to write-off their sunk cost (write of it as a loss)
- Payment decoupling (flat rate bias)
- Essentially relates to situation where you buy a service, and do not use the
service at the same time (e.g. buying something on credit card – where you
buy the good and pay later)
 - Other cases, e.g. vacations – pay in advance before you actually experience
the vacation
- People have different attitudes depending on whether they get the benefit
first, or the cost first
- People who get paid upfront may not feel like working, or they do not work
as effectively – big gain at beginning, and no benefits at latter stage
- In general people like to couple losses and benefits together
- Flat rate bias - Flat rates have been recognized as having positive influence
upon the usage of telecommunications services. Selective tariffs are often
applied to such services and subscribing to a flat rate plan is considered an
attractive option for many consumers.
- People prefer to have a flat rate rather than pay as you go
-
- Credit cards (salience and aggregation)
- Aggregation – another aspect of bias regarding credit cards
- Paying by credit card, all your transactions are aggregated together for a 4
week period before you receive your bill
- Aggregation makes thing less salient
- Paying by singular transactions are more salient

Prior outcome effects

 House money effect – to do with risk taking
o Relates to gamblers
o Start off with £300, and later on find out you have £500 on person – gamblers
do not regard the £500 as fungible
o The £300 is their own money – acts as a reference point
o £200 is house money – which people are more risk taking with
o Keep these two different amounts separately
o If you lose the £200, it doesn’t matter, as you still have the £300, your
reference point
 Myopic loss aversion (MLA) – narrow bracketing; EPP – Equity Premium Puzzle
o If you evaluate stocks on a yearly basis, it makes stocks more riskier
o If you evaluate stocks over a longer period of time, stocks are less likely to go
down, and are less riskier
 Diversification bias – (1/n) – heuristic
o People with fairly large portfolios, and they are offered different types of
investments
o 3 categories
 D – stocks (Domestic)
 F – stocks (Foreign)
 T – bills
o Divide funds equally between the 3 different categories
o Change categories
 D – stocks – just stocks
 F – stocks – US treasury bonds
 T – bills
o People still divide their funds equally based on: 1/n
Policy Implications
 Individual agents – self-control devices: unambiguous categories, small
denominations; commitment
 Where we need to use self-control devices when we need to make
intertemporal decisions
 Unambiguous categories – budget categories, better to have categories
which are not too malleable
 Having rigid categories will help us budget for the future
 Small denominations
 Use to be able to buy 10 pack of cigs, which were more expensive
than 20 pack cogs
 Marketers –
 sales promotions
 discounts,
 freebies,
 bundling,
 pricing structure;
 reference points;
 cash and credit cards
 Labour markets – reference points, money illusion, labour supply curve

 Financial markets – disposition effect, diversification bias, EPP

 Government policy – public provision (health care and pensions); government
influence (environment, obesity, smoking, safe sex, drugs) – framing (nudging)