Mental Accounting: Why It's Easy to Blow the Tax Refund - Tilted Forum Project Discussion Community

Cynthetiq · 05-31-2007, 05:42 AM

Quote:

Mental Accounting
Why It's Easy to Blow the Tax Refund and Hard to Catch a Cab in the Rain

By Shankar Vedantam
Washington Post Staff Writer
Saturday, May 19, 2007; F01
LINK

Let's say you are headed to a movie. As you are about to enter the theater, you reach into your pocket and find to your dismay that you have lost your ticket. You don't have a receipt, so if you still want to see the movie, you have to pay another $10 for a new ticket.

If you are like most people, you would probably think twice. You may still plonk down the money, but you will now feel that you paid $20 for a $10 movie.

But let's construct the scenario differently. You are going to a movie. As you stand in line at the box office to buy your ticket, you discover that you have dropped a $10 bill on the Metro. You are disappointed, of course, but would this affect your decision to buy the movie ticket? Again, if you are like most people, you may feel sore about the lost money, but it probably won't affect your decision to buy the ticket.

Psychologists once conducted an experiment along these lines. They found that only 46 percent of those who lost a ticket were willing to buy a replacement ticket, whereas 88 percent of those who lost an equivalent amount of cash were willing to buy a ticket. Since the lost ticket and the lost cash had the same value, their loss should have been experienced in the same way -- so why were nearly twice as many people willing to ignore the lost cash but not the lost ticket?

The difference is because of a psychological phenomenon known as mental accounting -- and it has enormous consequences in everyday life. It affects how people spend money and how they save. It influences how people deal with losses and windfall gains. It tells us what to do as we weigh different kinds of payment plans for a luxury item. The effects of mental accounting are felt in domains that seem far removed from the conventional understanding of economics -- it may even help explain why it is so hard to find a cab on a rainy evening. (More on that later.)

Here is the simplest definition of mental accounting: People carry around different running tabs in their heads. You have, for example, an "entertainment account." Losing a movie ticket and having to buy a second one takes $20 out of your entertainment account when you planned to take only $10. Lost cash, on the other hand, is not charged to the entertainment account -- which is why most people don't hesitate to buy a movie ticket after they lose some cash.

However, compartmentalizing income and spending into different mental accounts violates one of the basic rules of economics -- that money is fungible, or interchangeable. The $10 movie ticket is supposed to be worth exactly the same as $10 in cash. Supposed to be, of course, is the operative phrase. This is not the way human beings actually think, which is why economic models of human behavior often turn out to be wrong.

"The source of the money affects how it is spent," said Suzanne Fogel, who heads the marketing department at DePaul University in Chicago. When she was a graduate student, Fogel waited tables to help pay the bills. She found that she carried around a figure in her head; the amount she wanted to make each day. On any day she passed that target, any additional income became "free money" -- even though this money ought to have been a cushion for the days she did not meet her income target.

"Someone gives you money for your birthday and they don't say, 'pay your electric bill,' but money is money and completely fungible, and if you are behind on your electric bill, you should definitely spend your money on that," she added. "But there is a reluctance to do that."

Mental accounting is really the household equivalent of financial accounting, said Richard Thaler, an economist at the University of Chicago who was the first to describe how the phenomenon works. Just as an office expense-account maven might tell you that your budget for lunch is no more than $25, you make projections on how much you will spend using your own money. This mostly ends up saving you time. You don't have to think twice (although maybe you should) about the $3 latte you get each morning because you have a mental account that says you are entitled to a $3 latte each day.

The alternative to having mental accounts, Thaler said, is to consciously ask yourself to ask what every purchase is worth and compare it with every other purchase. Is a latte worth the same as a pair of socks? Just as your boss doesn't want to be bothered with trivial decisions on whether you charge the company $20 or $22 for a meal, you don't want to waste time thinking about trivial purchasing decisions.

The effect of setting up accounts, however, has paradoxical effects -- in exactly the same way that office accounting can create problems in a workplace, Thaler said. At the end of the financial year, your boss may not be willing to let you buy a new laptop, because the hardware budget is down to zero, but will allow you to take a trip to Los Angeles because there is money left in the travel budget. Your argument that you need a laptop more than the trip falls on deaf ears.

Here are some other examples from everyday life:

· A friend of Thaler's once went to buy a bedspread. Where a double, queen and king size usually cost $200, $250 and $300, all three sizes were now priced at $150. Thaler's friend happily snapped up the king-size bedspread -- although she planned to use it on a double bed. The woman had a mental idea of what a bedspread should cost. Buying the double bedspread, which is what she needed, saved her only $50, but buying the king saved her $150. Mental accounting explains why many people eagerly snap up deals on items they do not need: When something sells for below the mental price we have assigned it, the deal takes precedence over the actual utility of the item.

· A man buys an expensive membership in a tennis club. Right after he puts down the money, which is nonrefundable, he hurts his ankle. He grits his teeth and continues to play through the pain -- even though not playing would mean much less agony. Mental accounting is behind the problem. Playing is the only way to ensure that the tennis club membership remains in the man's mental category of money well spent. To not play would be to write off the membership cost as a loss, which is more painful to the man than the agony of hobbling through games on an injured ankle.

· Another friend of Thaler's used mental accounting to devise an insurance plan against life's vicissitudes. He made a mental contribution to the United Way Campaign at the start of the year and then, every time he was unfairly given a parking ticket or had to fork over money for some other annoyance, he mentally deducted the amount from the sum he had set aside for charity. Assigning the money to charity allowed the man to feel that the money he was paying for parking tickets and other annoyances did not really belong to him anyway. (While this strategy is unlikely to be embraced by charities, Thaler's friend was careful not to set his annual target so low that he was left with nothing to give to charity at year's end.)

Mental accounting also explains why, when people are given a choice to get a cash bonus or a gift such as a free vacation for doing well on the job, they invariably choose cash. That's because people think they want the flexibility of cash. The problem is that flexibility comes with a price. You have to remember your obligations, such as fixing that leaky roof.

This is why studies show that employees who are not given a choice and are given a gift instead of cash usually turn out much happier. A vacation or a gift is "guilt-free" -- yours to enjoy. If you get cash instead, you could spend it buying yourself the same vacation or gift, but mental accounting would remind you that you are wasting money on frivolities.

Ohio State University psychologist Hal Arkes once found that mental accounting influences how people deal with sudden gains, such as lottery winnings. The same phenomenon influences millions of Americans at tax time, when they gleefully look forward to refund checks from the government -- even though refunds are really their own money being returned to them, minus interest. In terms of mental accounting, lottery winnings and refunds are invariably counted in the category of "free money" -- which is why people spend such dough not on health care, utilities and eliminating credit card debt but on discretionary items such as vacations or new patios.

Arkes and his colleagues once cited an anecdote in a study: Employees of a publishing firm who were in the Bahamas for an annual meeting were each given a cash bonus for getting a big contract. Almost to a person, the bonus recipients took the money to a local casino and blew it. What is interesting is that most of these people did not lose more than the $50 -- they slowed down or stopped when they felt they were playing with their "own" money rather than with the $50 of "free" money. The irony, of course, is that the $50 these people lost was their own money, too.

What does mental accounting have to do with the other puzzle we discussed at the start -- the difficulty of finding cabs on rainy evenings? Mental accounting, like financial accounting, requires people to close the books and balance their accounts. But people in different professions unwittingly balance their books at different times -- wage employees may balance books on a biweekly or monthly basis, whereas cab drivers often balance their mental books on a daily basis. Business is brisker on rainy evenings, so once cabbies meet their mental income targets for the day, they go home, leaving fewer cabs on the street, Thaler said.

Viviana Zelizer, a sociologist at Princeton University, noted that a similar phenomenon even affects how prostitutes think about their income. She cited a study of the Oslo prostitution market, which showed that prostitutes tend to spend money acquired through welfare checks and health benefits on essentials such as rent and bills and are far more likely to spend their income acquired from selling sex on drugs and alcohol, even if it means they have no money left over to pay for essentials.

I used to blow my new raises, tax refunds, and bonuses on utter crap luxuries. These things ultimately made no difference to my life but gave me a little more status or "I have arrived feeling." But soon I realized that and just stopped it. I try hard to not do such things any longer. Trying to put most of those monies away.

One of the things like the bottom is "extra" money that I made on the side as a consultant. I'd make a few extra here and there, and that money was always earmarked for drugs and alcohol. ALWAYS. In fact it was always called "beer money." It was simply the money I used for going out. I have recently stopped with all that, but still have the monetary habit of keeping that money off to the side.

Recently I have found myself in the trap of a Jamba Juice in the morning on my workdays. While it is still from the breakfast money I would spend, I never spent $6 every day. In fact I used to chide collegues who would spend the same amount at Starbucks daily, yet now I've fallen into the same trap.

I try to keep it simple, I just try to budget for the day and not the smaller events. So if I spend more on one thing, I spend less on another.

What kind of mental accounting do you do?

Tamerlain · 05-31-2007, 06:15 AM

That's a really interesting article. I read another one a few months ago that had another interesting mental accounting thing people do.

Let's say a coffee costs you $1 usually. If the place you go to for some reason increases the price by $5, so your coffee is now $6, you'll likely go somewhere else to buy your coffee that day. But, if you want to buy a television and it's $100 at one store and $105 at another, you likely won't care where you buy it.

I'm guilty of that kind of mental accounting. From reading that article, it must be because I assign a different value to coffee versus a television. And even now that I'm aware that I do it, there's still no way I would spend $6 for a coffee; but I have no problem spending $100 or $105 on a television.

-Tamerlain

ngdawg · 05-31-2007, 09:40 AM

Any time I make extra money from streetfairs, etc., I put at least half back into wherever the supply money came from, like the charge card or checking account. I really feel like it's not mine, just paid back borrowed money.
I also 'stash cash' for anything planned, trips, etc.-$5, $1 bills go into a box a few times a week-again, I feel like it's not mine when it's in the box. I have tried to get the spouse to do this, but he is of the thinking that ALL the money, regardless of where it is, is his to spend, which has at leastly partly created the mess we're now in. And, because of that line of thinking, when I go somewhere or buy something, he gets angry that I'm spending 'his' money on my things. It's as if he has no mental accounting at all.
His debit card seems to not be real money and he uses it way too much, causing even more stress and screwing up my own 'accounting'.
I used to be of the mental accounting that 'extra' money, like seeing more hours paid in the check than I thought, was 'free' and I'd buy lottery tickets, wine, maybe a shirt with it. I changed that line of thinking-'found' money now is not mine, it's a bill's or the saving's account's money-I claim no rights to it. Same with the income tax refunds-every year that pays our car insurance for the year and/or buys whatever appliance we're overdue to replace.
When we realize that we only have so much to ourselves and so much to what we owe, I think we can control finances better, but it has to be a joint effort; even seeing the figures in the checkbook don't register to the spouse, telling him 'hey, that $1800 is due in two weeks and I bought this thing I don't need'. Meanwhile, my internal calculator is smoking and churning.

Jinn · 05-31-2007, 10:37 AM

I'm a bit of each. When it comes to big ticket items, I never mentally accounted, for which I am glad.

When I was looking at buying a $1000 bed or a $1600 TV, I was considering it in how many other fun things that could be, not by some arbitrary amount that I had or had mentally earmarked for the purchase. It was more like.. Is this $1000 bed worth the loss of an XBOX360 with 10 games? Is this $500 skydiving trip worth two months of eating? If I can justify a big ticket purchase in terms of equivalent things I can buy with that same money, I'm usually satisfied.

But when it comes to anything under $50, I have to admit that I do the sort of mental accounting described above. If I lost $10 on the subway, I wouldn't even hesitate to buy the movie ticket. But if I lost the ticket, there's almost no way I'd buy another. Quite odd.

ngdawg · 05-31-2007, 10:58 AM

Quote:

Originally Posted by JinnKai

I'm a bit of each. When it comes to big ticket items, I never mentally accounted, for which I am glad.

When I was looking at buying a $1000 bed or a $1600 TV, I was considering it in how many other fun things that could be, not by some arbitrary amount that I had or had mentally earmarked for the purchase. It was more like.. Is this $1000 bed worth the loss of an XBOX360 with 10 games? Is this $500 skydiving trip worth two months of eating? If I can justify a big ticket purchase in terms of equivalent things I can buy with that same money, I'm usually satisfied.

But when it comes to anything under $50, I have to admit that I do the sort of mental accounting described above. If I lost $10 on the subway, I wouldn't even hesitate to buy the movie ticket. But if I lost the ticket, there's almost no way I'd buy another. Quite odd.

Maybe there's pessimistic accounting and optimistic accounting? I'd see that $1000 bed as frivilous, thinking all the bills that could be paid with at least half of it and then look for something cheap...on the other hand, I justified the camera at $700, paid it down, went and got a lens for $250, justification being it's all needed to further pursue my advocation, but I haven't made it back yet and may not.
Losing $10 would and has upset me; I'd probably buy another ticket, though.

Jinn · 05-31-2007, 11:05 AM

Sleep is my second most important pursuit, so it's very possible that we simply justify it differently.

Also when comparing across individuals, its important to consider that the actual wage of each person would directly influence how much money was "frivolous." What's pocket change to one might be a total waste to another.

Cynthetiq · 05-31-2007, 06:11 PM

Quote:

Originally Posted by JinnKai

I'm a bit of each. When it comes to big ticket items, I never mentally accounted, for which I am glad.

When I was looking at buying a $1000 bed or a $1600 TV, I was considering it in how many other fun things that could be, not by some arbitrary amount that I had or had mentally earmarked for the purchase. It was more like.. Is this $1000 bed worth the loss of an XBOX360 with 10 games? Is this $500 skydiving trip worth two months of eating? If I can justify a big ticket purchase in terms of equivalent things I can buy with that same money, I'm usually satisfied.

But when it comes to anything under $50, I have to admit that I do the sort of mental accounting described above. If I lost $10 on the subway, I wouldn't even hesitate to buy the movie ticket. But if I lost the ticket, there's almost no way I'd buy another. Quite odd.

ahh yes, I used to do that with things that were just over $100. I finally made a simple rule, anything over $100 I have to wait 24 hours. Now I do it with $20 items.

05-31-2007, 06:15 AM	#2 (permalink)
Tamerlain Insane Location: Victoria	That's a really interesting article. I read another one a few months ago that had another interesting mental accounting thing people do. Let's say a coffee costs you $1 usually. If the place you go to for some reason increases the price by $5, so your coffee is now $6, you'll likely go somewhere else to buy your coffee that day. But, if you want to buy a television and it's $100 at one store and $105 at another, you likely won't care where you buy it. I'm guilty of that kind of mental accounting. From reading that article, it must be because I assign a different value to coffee versus a television. And even now that I'm aware that I do it, there's still no way I would spend $6 for a coffee; but I have no problem spending $100 or $105 on a television. -Tamerlain __________________ I never let school interfere with my education.

05-31-2007, 09:40 AM	#3 (permalink)
ngdawg peekaboo Location: on the back, bitch	Any time I make extra money from streetfairs, etc., I put at least half back into wherever the supply money came from, like the charge card or checking account. I really feel like it's not mine, just paid back borrowed money. I also 'stash cash' for anything planned, trips, etc.-$5, $1 bills go into a box a few times a week-again, I feel like it's not mine when it's in the box. I have tried to get the spouse to do this, but he is of the thinking that ALL the money, regardless of where it is, is his to spend, which has at leastly partly created the mess we're now in. And, because of that line of thinking, when I go somewhere or buy something, he gets angry that I'm spending 'his' money on my things. It's as if he has no mental accounting at all. His debit card seems to not be real money and he uses it way too much, causing even more stress and screwing up my own 'accounting'. I used to be of the mental accounting that 'extra' money, like seeing more hours paid in the check than I thought, was 'free' and I'd buy lottery tickets, wine, maybe a shirt with it. I changed that line of thinking-'found' money now is not mine, it's a bill's or the saving's account's money-I claim no rights to it. Same with the income tax refunds-every year that pays our car insurance for the year and/or buys whatever appliance we're overdue to replace. When we realize that we only have so much to ourselves and so much to what we owe, I think we can control finances better, but it has to be a joint effort; even seeing the figures in the checkbook don't register to the spouse, telling him 'hey, that $1800 is due in two weeks and I bought this thing I don't need'. Meanwhile, my internal calculator is smoking and churning. __________________ Don't blame me. I didn't vote for either of'em.

05-31-2007, 10:37 AM	#4 (permalink)
Jinn Lover - Protector - Teacher Location: Seattle, WA	I'm a bit of each. When it comes to big ticket items, I never mentally accounted, for which I am glad. When I was looking at buying a $1000 bed or a $1600 TV, I was considering it in how many other fun things that could be, not by some arbitrary amount that I had or had mentally earmarked for the purchase. It was more like.. Is this $1000 bed worth the loss of an XBOX360 with 10 games? Is this $500 skydiving trip worth two months of eating? If I can justify a big ticket purchase in terms of equivalent things I can buy with that same money, I'm usually satisfied. But when it comes to anything under $50, I have to admit that I do the sort of mental accounting described above. If I lost $10 on the subway, I wouldn't even hesitate to buy the movie ticket. But if I lost the ticket, there's almost no way I'd buy another. Quite odd. __________________ "I'm typing on a computer of science, which is being sent by science wires to a little science server where you can access it. I'm not typing on a computer of philosophy or religion or whatever other thing you think can be used to understand the universe because they're a poor substitute in the role of understanding the universe which exists independent from ourselves." - Willravel

05-31-2007, 11:05 AM	#6 (permalink)
Jinn Lover - Protector - Teacher Location: Seattle, WA	Sleep is my second most important pursuit, so it's very possible that we simply justify it differently. Also when comparing across individuals, its important to consider that the actual wage of each person would directly influence how much money was "frivolous." What's pocket change to one might be a total waste to another. __________________ "I'm typing on a computer of science, which is being sent by science wires to a little science server where you can access it. I'm not typing on a computer of philosophy or religion or whatever other thing you think can be used to understand the universe because they're a poor substitute in the role of understanding the universe which exists independent from ourselves." - Willravel