Mental accounting is a concept associated with the work of Richard Thaler (see Thaler, 2015, for a summary). According to Thaler, 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.
Why are people willing to spend more when they pay with a credit card than cash (Prelec & Simester, 2001)? Why would more individuals spend $10 on a theater ticket if they had just lost a $10 bill than if they had to replace a lost ticket worth $10 (Kahneman & Tversky, 1984)? Why are people more likely to spend a small inheritance and invest a large one (Thaler, 1985)? According to the theory of mental accounting, people treat money differently, depending on factors such as the money’s origin and intended use, rather than thinking of it in terms of the “bottom line” as in formal accounting (Thaler, 1999). An important term underlying the theory is fungibility, the fact that all money is interchangable and has no labels. In mental accounting, people treat assets as less fungible than they really are. Even seasoned investors are susceptible to this bias when they view recent gains as disposable “house money” (Thaler & Johnson, 1990) that can be used in high-risk investments. In doing so, they make decisions on each mental account separately, losing out the big picture of the portfolio. (See also partitioning and pain of paying for ideas related to mental accounting.)
Kahneman, D., & Tversky, A. (1984). Choices, values, and frames. American Psychologist, 39(4), 341-350.
Prelec, D., & Simester, D. (2001). Always leave home without it: A further investigation of the credit-card effect on willingness to pay. Marketing Letters. 12(1), 5–12.
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. (1985). Mental accounting and consumer choice. Marketing Science, 4(3), 199-214.
Thaler, R. H., & Johnson, E. J. (1990). Gambling with the house money and trying to break even: The effects of prior outcomes on risky choice. Management Science, 36(6), 643-660.