What is... | July 20, 2012

What is mental accounting?

One euro is identical to any other euro, or is it?

People often behave as if money meant to be spent one way cannot simply be repurposed according to need. For example, if a couple gets a payout for a lost package of food – and then goes for an expensive dinner. This very scenario opens a famous paper about “mental accounting”, the way people tend to separate money into separate “buckets” for food, shelter, transport and other expenses.

Mental accounting goes against the idea of fungibility, that one euro or dollar or pound is identical to another. It can explain why people might feel they can splurge in certain circumstances and not in others. This has broad implications for the way individuals budget and manage money (as well as how stores price and market products).

But I’d never spend that much on a meal
Research by Richard Thaler, co-author of behavioural economics book Nudge, suggests that because the couple in the anecdote got a $300 financial windfall in the “food” category, they felt comfortable spending it on a lavish dinner, as that is also in the "food" category. He writes: “The extravagant dinner would not have occurred had each couple received a yearly salary increase of $150, even though that could have been worth more in present value terms.”

Another example involves a couple earning 10% interest on money they have saved to buy a holiday home, but who also borrowed a smaller amount at 15% interest to buy a car. It is a “violation of fungibility (at obvious economic costs)” because they are effectively paying to borrow for the car despite having money saved for the house. Mental accounting is used widely but only about a third in an eZonomics poll knew what it was and how it related to managing money.

Use your buckets wisely
This tendency to divide money into separate buckets has implications for individuals and their budgeting. Research summarised on the Brown University website explains how mental accounting can have big influences on household spending.

Examining petrol price rises, associate professor of economics Justine Hastings writes that people typically changed their petrol-buying habits when prices went up, rather than cutting back in a different area of spending, such as food. She says an equivalent fall in household income had a much smaller effect on petrol-buying habits – which is consistent with the mental accounting idea.

“A clear pattern emerged,” the researcher says. “People behaved as if they were much poorer, buying cheaper gasoline as if a $2 increase in gasoline prices had decreased their annual income by tens of thousands of dollars.” The full research paper is here.

Mental accounting can help – and hinder
In his 2011 book Thinking, Fast and Slow, psychologist Daniel Kahneman writes that mental accounting can be an easy way to control spending. Like Thaler’s couple who borrowed to buy a car (despite having the money saved for a holiday home), people can use the method to avoid spending on indulgences, such as barista-made coffee or to limit building debt on credit cards.

However, the petrol-price research suggests it might pay to revise the household budget as a whole if prices noticeably rise. Perhaps savings can be made in other areas – and money moved from one “bucket” to another – to help ease the pain of price hikes.

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eZonomics team
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