Mental Accounting


There is a concept in the science of behavioral economics, which is referred to as "mental accounting." It is the process by which we label and treat different sources of money. The labeling, as the phrase suggests, is largely in our minds.

For example, we may think carefully before spending hard-earned money on a frivolous purchase, but if we won the same amount of money we spend it more easily because we categorize that income as "found money" or "extra cash." This is the way we think even though it is the same amount of money and is just as much ours as any other money we have. Win $10,000 at the casino and it somehow feels different than $10,000 you saved over the years.

Another classic example used by researchers in this area involves the difference between "cash" and other categories of money. For example, researchers will ask people, "Suppose you bought tickets to the opera for $100, and then lost them on the way to the event; would you buy another set for another $100 if you had the money on you?" Most people answer no when asked this question.

On the other hand, the typical reaction is very different when people are presented a second scenario: "You are on your way to the opera and plan to buy the tickets once you get there. Along the way you lose $100 in the street. However, you still have enough cash on hand for the tickets, so do you go to the opera as planned?" Interestingly most people answer yes to this scenario, even though in both cases the financial outcome is absolutely identical.

In our first scenario, the person has already spent $100 from the mental category "opera," so it seems too expensive to spend another $100 to buy the tickets all over again. But in the second scenario, the person lost $100 cash, which is a separate category in his or her mind, making it much easier to buy the tickets as planned. The two events seem unrelated, after all. This mental accounting has its consequences, as you can imagine, and they are often seen as negative, with some degree of irrationality--or at least non-rationality--ascribed to this thinking pattern by researchers.

The negative examples are easy to imagine, and one or two are mentioned above. For example, most people would hesitate to waste $3,000 that they had saved up by setting aside $30 per week for two years, but a tax refund of $3,000 is much easier to fritter away on things that are unimportant to one's goals--even though it is the same amount and could be used in the same ways.

But the effects of mental accounting are not all negative. Perhaps you can identify a more positive example of mental accounting in your own life. Many of us use mental accounting tricks to keep from spending money, for example. You might think of money you make from an side job as different than your regular income, and thus set it aside for a special purpose. You might even reverse the usual pattern, and see windfalls as an opportunity to save all of the extra cash to start a business or travel the world.

Mental accounting, then, is something you should be aware of. Watch to see how it you are doing it now, and choose better ways to think about money.

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