A Presentation on the concept of Mental Accounting in Behavioural Economics.

1. Mental Accounting
PROFESSOR RAVI KIRAN

2. Mental Accounting
• Mental accounting is a concept in the field of behavioral economics.
• Developed by economist Richard H. Thaler, it contends that
individuals classify funds differently and therefore are prone to
irrational decision-making in their spending and investment behavior.
• Mental accounting is concerned with how people perceive and
evaluate situations when there are two or more possible financial
outcomes, in particular with how people combine these outcomes.

3. Mental Accounting
• For example, purchase decisions, even for a single item, always involve both a
cost and a benefit. Such decisions become more complex when there are
special offers like discounts, prize draws or two-for-one offers.
• Multiple purchases, when the items are complementary, like buying a
holiday with airfare, hotel, car rental, meals and so on, are also more complex.
• Sequential outcomes also need to be evaluated. For example, do people prefer
to win two separate lotteries paying $50 and $25 respectively, or a single
lottery paying $75? Expected Utility Theory (EUT), based on the invariance
principle, would indicate that people would be indifferent between the two
outcomes.

4. Mental Accounting
• However, Thaler found that in a survey 64% of subjects predicted that the two-time
winner would be happier.
• Prospect Theory contains some important implications as far as this process of evaluating
joint outcomes is concerned. Thaler summarized these in his 1985 paper:
• 1 Segregate gains (because the gain function is concave due to diminishing marginal
sensitivity).
• 2 Integrate losses (because the loss function is convex, again due to diminishing
marginal sensitivity).
• 3 Integrate smaller losses with larger gains (to offset loss-aversion).
• 4 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).

5. Mental Accounting
• Mental accounting attempts to describe the process whereby people
code, categorize and evaluate economic outcomes.
• Mental accounting deals with the budgeting and categorization of
expenditures.
• People budget money into mental accounts for expenses or expense
categories.

6. Mental accounting refers
to the tendency for
people to separate
their money into
different accounts
based on a variety of
subjective criteria, like
the source of the money
and intent for each
account

9. In economics, fungibility
is the property of a
good or a commodity
whose individual units
are essentially
interchangeable and
each of whose parts is
indistinguishable from
another part.

11. Fungibility
• Fungibility means that different types of account within some aggregate variable,
like consumption or wealth, are perfectly substitutable.
• In consumption budgeting some people may have fixed budgets for particular
categories of spending, while others may have more flexible budgets and categories.
• More flexibility tends to cause people to spend more than they would with less
flexibility.
• People often classify types of income on a serious–frivolous scale, and match
increases in income in one category with increases in spending in the same category.

12. Mental accounting
• Offering gift cards instead of cash is one way to promote mental accounting in a
way that benefits both the customer and your brand.
• Gift cards can lead one to “regard, allocate, and consume these funds differently
than if the gift is given as cash” (White, 2008).

13. Mental Accounting and Investment
• Some investors divide their investments between
• a safe investment portfolio and
• a speculative portfolio
in order to prevent the negative returns that speculative investments
may have from affecting the entire portfolio.

14. How to deal with Mental accounting?
• One simple way to avoid mental accounting is by understanding your money
perspective.
• Money is fungible — it is the same regardless of its source or intended purpose.
• You can reduce wasteful spending of bonuses or unexpected money by
understanding that it is identical to money earned through your job.

15. Mental Accounting
• Money kept in a current account will be treated differently from the money
spent on shares and securities.
• Individuals might use their bonuses, birthday money, tax refunds, etc., to make
more unnecessary purchases instead of investment purposes.
• They must wisely use mental accounting to gain financial flexibility so that the
participants can align their financial goals appropriately.

16. Mental Accounting and Marketers
• The marketers can design appropriate sales and marketing strategies upon
learning the weaknesses in customers’ mental accounting and use them to
convince them to buy things.
• With the help of this, marketers can market their products to customers in
various ways.
• Marketers’ most common method is offering their goods and services at a
lucrative discount.
• Since the customers are unaware of how mental arithmetic works, they fall into
the marketer’s trickery and make unnecessary purchases.

17. Mental Accounting and Marketers
• Mental accounting even assists marketers in building a strong customer base.
• With the help of mental accounting, investors can set up a savings budget plan
for every month and learn how they can allocate their assets
• It also allows investors to review their assets regularly.

18. Mental Accounting Bias in Finance
The treatment of money is not the same for all physical accounts. For example,
money in a savings account is treated differently from the funds maintained in the
brokerage account.
• Withdrawing money from a savings account might be an inconvenient option
compared to the short-term losses suffered from the investments.
• Individuals might compromise on their financial progress by spending more on
certain inflows like tax refunds, bonuses, etc.
• Individuals might lose gains if they pay off their low-rate debts faster than what
is necessary instead of investing the same money and receiving better returns.

19. Mental Accounting Bias in Investing
• Individuals might miss out on considering the risks or correlations
of mental accounts when they place every goal and the wealth
supposed to be used to meet each goal concerning a separate
mental account.
• It might generate portfolios similar to a layered pyramid of assets
instead of viewing the portfolios as one

20. Case 1
• Jim rented a car from Carrentals Ltd. Unfortunately, the rented car got a little
dint when Jim was driving it, and the company charged him $800 for that dint.
So, Jim applied to his third-party insurer to claim back $800. Jim thought that
upon receiving the claim, he would contribute this amount to a charitable cause,
and if he didn’t get that back, he would not be able to do so.
• Jim is unwilling to absorb this loss and dip it into his main savings account.
• As per mental accounting theory, Jim must treat all the money as fungible.
However, it is very difficult to differentiate savings and unexpected gains/losses
in reality.

21. Case 2
• A hungry person can pay $500 for a meal at an expensive restaurant, but at the
same time, he will not be determined to pay $200 for a better dinner at a
mediocre restaurant.
• The former expenditure will fall into the “sophisticated” mental account, while
the latter would fall into the “normal” mental account.

22. Advantages
• It can help an individual meet investment-related goals. When a certain amount of money is
invested in a retirement account, that money cannot be used by the account holder for
spending purposes. In this way, they can skip unnecessary expenditures and save the same
money for the future.
• It helps in the identification and classification of every single goal. It allows retailers,
marketers, and individuals to focus on every plan.
• Investors can review and assess the performance of their investments from time to time.
• It helps marketers in building a strong relationship with their buyers.
•

23. Disadvantages
• It causes individuals to treat money received from different sources differently.
Individuals might feel the urge to spend the inherited money faster than the
money earned as a salary.
• It encourages individuals to spend money on useless things and activities.
• It enables individuals to keep too much money as a cash emergency instead of
investing the same or using the same to repay high-interest debts.
• It results in financial inflexibility where individuals cannot realize and adjust
their goals and budgets based on updated financial information.

24. How to overcome mental accounting?
• One may overcome mental accounting by following the three ways:
• Firstly, one must systemize their finances.
• Secondly, note it down instead of keeping it in mind.
• Thirdly, keep an accounting person to help you from the accounting traps.

25. Mental Accounting Components
• The mental accounting components are value function, transaction utility, and
fungibility.
• The value function displays the gains and losses concerning a particular
reference.
• The transaction utility applies that through a transaction, people may benefit
from the value of the good and the transaction’s value.
• Finally, fungibility refers to the concept that money has no labels, and
individuals do not relate money with anything.

26. Cognitive bias mental accounting
• The cognitive bias mental accounting makes ordinary investors avert interaction
between assets in various mental accounts.
• Hence, one must prefer portfolios, not on the mean-variance effective boundary.

27. Why is mental Accounting bad ?
• Mental accounting is our tendency to mentally sort our funds into
separate “accounts,” which affects the way we think about our
spending.
• Mental accounting leads us to see money as less fungible (replaceable
by another identical item or mutually interchangeable) than it is, and
makes us susceptible to biases such as the sunk cost fallacy.

28. Mental Accounting Theory
• The importance of this theory is illustrated in its application towards
the economic behavior of individuals, and thus entire populations
and markets.
• Rather than rationally viewing every dollar as identical, mental
accounting helps explain why many investors designate some of their
dollars as "safety" capital which they invest in low-risk investments,
while at the same time treating their "risk capital" quite differently.

29. Nature and Components
Mental accounting: set of cognitive operations used to code, categorize
and evaluate financial activities.
Framing and editing-perception of outcomes, decision making,
evaluation of decisions
Budgeting and fungibility - assignment of activities to specific accounts
Choice bracketing and dynamics - determination of the time periods to
which different mental accounts relate

30. Wealth budgeting
• In wealth budgeting, the standard model assumes that people
smooth consumption over their lifetimes, and treat different types of
wealth as being fungible.
• Anomalies relate to the use of credit cards, attitudes towards stock
returns, segregation of asset types as investments, and the impact of
social interactions.
• Like any accounting system, mental accounting requires making
decisions regarding when to open and close accounts.

31. Mental Accounting and Decision Making
• Typical situations when such decisions have to be made are:
• buying and selling stock;
• reporting earnings;
• depreciating sunk costs; and
• payment decoupling.

32. • Payment decoupling means that spending and consumption cannot be directly
matched, even when they are simultaneous. The consequence is that we cannot
easily allocate a consumption item to a particular cost.
• An example of payment decoupling is when people pay a flat rate for something,
like internet use, which does not depend on the hours of use. People tend to like
this option rather than ‘having the meter running’; this is known as ‘flat rate
bias’.

33. Budgeting and Fungibility
• Fungibility - substitutability of different budget categories.
• Budgets completely fungible in standard model:
•  Rationale of consumption budgeting
• Facilitate comparisons
• Self-control device
• buy if MU > MC.
• Note: Gifts, denomination effect, malleability, effect of time frame