Lecture 34 Applications of Mental Accounting

What determines Reference Price?¶

Situation

I have an extra ticket to sell or give away
Marked price of ticket $5
- Free ticket from friend
- Paid for your ticket
- Bought them from another friend for $10
Price to ask if
1. He's a friend (5: , 10:)
2. He's a stranger (5: , 10:)

Friend's = seller's costs, except when seller's cost (10) > market (5), when the friend charged him 5 (market price, making a loss)

$\implies$ Buyer's perceptions of a seller's cost will influence $p^*$

Paper gain/loss $\to$ Realized gain/loss
Realized loss is more painful than paper loss
On selling a stock, the gain/loss has to be 'declared'
MA says, people will be reluctant to sell securities that have declined in value.
Suppose investors needs to raise some cash… choose between selling two stocks
- MA favors selling the winner
- Rational analysis favors selling the loser
- Explains the disposition effect
Firms use discretionary power to avoid announcing decrease in earnings and losses
- Plot of EPS shows a sharp discontinuity at zero
- Small losses are converted into small gains
- Large gains seem to be trimmed down to increase the chance of an increase again next year
- moderate losses are inflated = 'taking the big bath'
- All because firms believe that shareholders will react to these announcements in a manner consistent with prospect theory

₹1000 for two tickets for a cricket match in a month's time
Transaction utility = 0 $\impliedby$ $p = p^*$
Consumer opens an account at the point at which the tickets are purchased. Now, Account has negative balance**… Once the date comes, game is attended, account is closed.

The loss has to be recognized. This event turns a cost $\implies$ loss

Why does the prior expenditure make someone more willing to go the game in a blizzard?

So, consider how transactions are evaluated.

There is no ex post evaluation for a routine purchase when the account is closed
But failing to attend and event that has been paid for makes the purchase highly salient.
By driving through the storm, consumer wants to close the account and doesn't want it explicitly evaluated, the cost of driving through the storm is not included in the evaluation.
Because cost of driving is not monetary, they are not included in the analysis. (Call them incidental)
Lost a $10 bill, would you still pay $10 for the ticket? (80% yes)
Lost a $10 ticket, would you still pay $10 for another ticket? (54% no)

Buying a second ticket is aversive, it is included in the mental account for the theatre outing, but loss of the money is not included.

The more you pay for shoes, the more you wish to wear them. Rational: since they will be replaced…
Eventually you stop wearing them, but keep them. The more you paid, the longer they remain with you. Not rational: since they take space…
Finally, we throw them the payment having fully 'depreciated'
Sunk Cost evidence (buy Season ticket¹)
- Group 1: Full price
- Group 2: Small discount (13%)
- Group 3: Large discount (47%)
First half of season, people who paid full price… attended more plays… next half … no difference.

People eventually ignore sunk costs…

Gourville and Soman.
- Attendance at a health club is highest in the month in which dues are paid
- Declines over the next five months
- "Payment Depreciation" = gradual reduction in the relevance of prior expenditures
Wine collectors buy wine to store for 10 years.
- What after 10 years?
- (50%+) Drinking the bottle either costs nothing or actually saves money.
$400 bottle $\implies$ $500 after 10 years.

The typical wine connoisseur thinks of his initial purchase as an investment and later thinks of the wine as free when he drinks it.

Time share vacation… initial purchase of a week at the resort is an investment, subsequent visits feel free.