Mental accounting is a concept associated with the work of Richard Thaler (see Thaler, 2015, for a summary). The overarching notion behind the theory is that people think of value in relative rather than absolute terms. They derive pleasure not just from an object’s value, but also the quality of the deal – its transaction utility (Thaler, 1985). In addition, humans often fail to fully consider opportunity costs (tradeoffs) and are susceptible to the sunk cost fallacy.
A core idea of mental accounting it that people treat money differently, depending on factors such as the money’s origin and intended use, rather than thinking of it in terms of formal accounting. An important term underlying the theory is fungibility, the fact that all money is the same and has no labels. In mental accounting, people treat assets as less fungible than they really are; they frame assets as belonging to current wealth, current income, or future income. Marginal propensity to consume (MPC: The proportion of a rise in disposable income that is consumed) is highest for money in the current income account and lowest for money in the future income account (Thaler, 1990). Consider unexpected gains: Small windfalls (e.g. a $50 lottery win) are generally treated as ‘current income’ that is likely to be spent, whereas large windfalls (e.g. a $5,000 bonus at work) are considered ‘wealth’ (Thaler, 1985). Another example from mental accounting is credit card payments, which are treated differently than cash. Mental accounting theory suggests, credit cards decouple the purchase from the payment by separating and delaying the payment. Credit card spending is also attractive because on credit card bills individual items (e.g. a $50 expense) will lose their salience when they are seen as a small part of a larger amount due (e.g. $843) (Thaler, 1999). (See also partitioning and pain of paying for ideas related to mental accounting.)
Thaler, R. H. (2015). Misbehaving: The making of behavioral economics. New York: W. W. Norton & Company.
Thaler, R. H. (1999). Mental accounting matters. Journal of Behavioral Decision Making. 12, 183-206.
Thaler, R. H. (1990). Anomalies: Saving, fungibility, and mental accounts. The Journal of Economic Perspectives, 4, 193-205.
Thaler, R. H. (1985). Mental accounting and consumer choice. Marketing Science, 4(3), 199-214.