Lecture 31 Mental Accounting

Sairam

Introduction
- All organizations have accounting systems which influence decisions in unexpected ways.
Anecdote 1 (Mr. & Mrs. L and Mr. & Mrs. H)
- H: Fishing trip to NW, caught salmon, packed, lost in transit. Airport paid $300 and they spent $225 on dinner. Never spent that much before
- $\implies$ Violates the Principle of fungibility
  - Substitutability of different budget categories.
  - Overspending in one is compensated by underspending in another if budgets are fungible.
  - If we have budget categories then money is NOT fungible.
- A/c to NM, if Marginal Util $\gt$ Marginal cost $\implies$ worth buying, so completely fungible with no need of budgeting
- NM: "Money is not supposed to have labels attached to it."
  - But couples behaved such $\impliedby$ $300 was put into "windfall" gain and "food" accounts
  - The extravagant dinner wouldn't happen if it was due to an yearly salary increase of $150 each.
Anecdote 2 (Mr. & Mrs. J)
- Saved $15,000 $\to$ Dream vacation home (5 years ETA)… earns 10% in a money market account.
- Just bought a new car $11,000 financed by a three-year car loan (15%)
- Bro, you already have the amount for that ($11,000/$15,000) yet you borrowed money at a higher interest rate. Why?
  - $\impliedby$ worried about their own self-control problems, their vacation home money shouldn't be drained down.
- Violation of fungibility
- How to exercise control upon oneself?
Anecdote 3: (Mr. S)
- $125 cashmere sweater (but doesn't buy, too extravagant)
- Later that month, receives the same sweater from his wife… very happy… joint bank account
- $\implies$ People tend to give as gifts items that recipients wouldn't buy for themselves,
  - the recipients too approve of this strategy.
Mental Accounting
- set of cognitive operations $\to$ code, categorize and evaluate financial activities
- Like PT, MAT was developed to overcome descriptive anomalies of SM
- Comparison with financial & managerial accounting (by orgs)
  - Accounting = system of recording and summarizing transactions in books: analyzing, verifying and reporting the results
  - Individuals, Households and Organizations need to do so.
  - Why? To keep trace of where the money is going, keep spending in control. $\impliedby$ Mental accounting is the way they do these things.
MA - Nature & Components (3)
- How do people perform MA operations?
- Components
  1. how outcomes are perceived/experienced $\implies$ decisions (how they are made and evaluated subsequently?)
    - Shopping for a quilted bedspread (Usual price: double ($200), queen ($250) and king ($300))
    - That day sale… all sizes for $150. She got the king-size
    - Though she has a double size at home, which hang a bit over the sides.
    - $\implies$ Purchase decision based on value of the 'deal'
  2. Assignment of activities to specific accounts.
    - Source & Use of funds are labelled (in real and MA system)
    - Expenditure grouped into housing, food etc.
    - Spending constrained by implicit or explicit budgets.
    - Funds to spend are labelled:
      - flows: regular income vs windfalls
      - stocks: cash in hand, equity, pension
    - An Anecdote by Thaler (1999)
      - Talk to group of execs in Switzerland.
      - Swiss franc was at an all time high $\implies$ high prices everywhere.
      - He received a fee for the talk so it could cover the outrageous costs. (thought of it as windfall, additional amount spent on additional expenses)
      - But, had he received the same fee a week ago for another talk in NY, this vacation would have been much less enjoyable (thought of it as regular income)
  3. Frequency with which accounts are evaluated: 'choice bracketing'
    - can be balanced daily, weekly, yearly and so on.
    - can be defined narrowly¹ or broadly.
- Overall MA helps better understand choices and decisions.
- The #psychologist Thaler's 'Mental Accounting and Consumer Choice' (1985) $\to$ behaviorally based theory of consumer choice.
MA - Features (3)
1. ~~Utility function~~ Value function from PT, extended to apply compound outcomes
2. Price $\to$ Value function, using reference price $\implies$ Transaction Utility concept
3. Normative principle of fungibility is relaxed
  - Numerous marketing implications derived
  - Some empirical puzzles explained
Why MA?
- Primary reason: enhance understanding of the psychology of choice
- because MA rules are not neutral $\implies$ The perceived attractiveness of the choice depends on accounting decisions:
  - to which category to assign a purchase?
  - combine outcome with others in the same category?
  - how often books are balanced?
- Why? Because MA violates economic notion of fungibility.
  - "Money in one mental account is not a perfect substitute for money in another account"
- How does a person make an economic decision: what to buy? how much to save? Buy or lease? How are outcomes evaluated or experienced?²
The Framing of Gains and Losses
- Value function is a representation of a central component of the human "perceived pleasure machine". Features:
  1. Defined over gains and losses relative to some reference point. (focus on change rather than wealth level)
    - Piecemeal nature of MA: transactions are often evaluated one-at-a-time, rather than in conjunction to everything else
  2. Gain and loss function $\to$ Diminishing sensitivity
    - Gain function: concave
    - Loss function: convex
    - Weber-Fechner Law: Difference between $10 $\to$ $20 seems bigger than $1000 $\to$ $\1010, irrespective of sign.
  3. Loss aversion
    - Losing $100 hurts more than gaining $100 yields pleasure.
    - $v(x) \lt -v(-x)$

Narrow bracketing ↩
Woodland sandals, purchased because it was on a discount. But the size was 36, her size was 37. Since, it hardly fits, she doesn't use it much. It's been 10 years, and woodland shoes are sturdy, she's unable to throw them. So answer the question: What is the right time to throw away those shoes? ↩