Topic 4

Mental Accounting
 We begin with anomalies
• Mr. and Mrs. L and Mr. and Mrs. H went on a fishing trip in the northwest and
caught some salmon. They packed the fish and sent it home on an airline, but the
fish were lost in transit. They received $300 from the airline. The couples take the
money, go out to dinner and spend $225. They had never spent that much at a
restaurant before.
• Mr. and Mrs. J have saved $15,000 toward their dream vacation home. They hope to
buy the home in five years. The money earns 10% in a money market account. They
just bought a new car for $11,000 which they financed with a three-year car loan at
15%.
• Mr. S admires a $125 cashmere sweater at the department store. He declines to buy
it, feeling that it is too extravagant. Later that month he receives the same sweater
from his wife for a birthday present. He is very happy. Mr. and Mrs. S have only joint
bank accounts.
• These violate fungibility, reflect on one’s appreciation for self-control and have
budgeting implications
 Mental Accounting
• Mental accounting is the set of cognitive operations used by individuals and
households to code, categorize and evaluate financial activities.

• Considers the Prospect Theory value function and broadens it by including

analysis of compound events or outcomes.

• Introduces the concept of transaction utility.

• And the normative principle of fungibility is relaxed.

 Three ways of Framing Outcomes - KT
• Imagine that you are about to purchase a jacket for ($125)[$15] and a
calculator for (S15)[$125]. The calculator salesman informs you that the
calculator you wish to buy is on sale for ($10)[$120] at the other branch of the
store, located 20 minutes drive away. Would you make the trip to the other
store?
• Minimal account – examines only the difference between the two options; a
decision to drive 20 minutes to save $5 and should be same for both options.
• Topical account – relates the consequences of possible choices to a reference
level; mental accounting is topical.
• Comprehensive account – incorporates all other factors including current
wealth, future earnings, possible outcomes of other probabilistic holdings,
and so on; suggested by economic theories. If W* be existing wealth plus the
jacket and calculator minus $140, Then the choice comes down to the utility
of W* plus $5 versus the utility of W* plus 20 minutes; same as minimal.
 Reference Outcome
• Therefore, the disparity in choice implies that the utility of the saving must
be associated with the differences in values, i.e. (𝑣 −125 − 𝑣 −120 ) or
(𝑣 −15 − 𝑣 −10 ) rather than the value of the difference 𝑣 5 .

• Suppose, someone is expecting x but receives 𝑥 + ∆𝑥.

• Let us define reference outcome as (𝑥 + ∆𝑥: 𝑥)

• 𝑣 𝑥: 𝑥 = 0 i.e. ∆𝑥 = 0

• What if ∆𝑥 ≠ 0? Is it evaluated alone or in conjunction with the expected

value?
 4 Experiments & The Theory Developed
There will be four pairs of scenarios. In each case 2 events occur in Mr. A’s life and
one event occurs in Mr. B’s life. You are asked to judge whether Mr. A or Mr. B is
happier. Would most people rather be A or B? if you think the two scenarios are
emotionally equivalent, say ‘no difference’. In all cases the events are intended to be
financially equivalent.
1. Mr. A was given tickets to lotteries involving the World Series. He won ₹5000 in
one lottery and ₹2500 in the other.
Mr. B was given a ticket to a single, larger World Series lottery. He won ₹7500.
Who was happier?

Choice: A – 64% B: 19% No difference: 17%

Multiple gains – when x, y > 0, segregation is preferred since 𝑣 𝑥 + 𝑣 𝑦 > 𝑣(𝑥 + 𝑦)

due to concavity of the value function.
 4 Experiments & The Theory Developed
2. Mr. A received a letter from the Income Tax Department saying that he made a
minor arithmetical mistake on his tax return and owed ₹10,000. He received a
similar letter the same day from his state income tax authority saying he owed
₹5000. There were no other repercussions from either mistake.
Mr. B received a letter from the Income Tax Department saying that he made a
minor arithmetical mistake on his tax return and owed ₹15000. There were no
other repercussions from his mistake.
Who was more upset?

Choice: A – 76% B: 16% No difference: 8%

Multiple losses – the outcomes are –x, -y where x, y > 0.

Integration is preferred since 𝑣 −𝑥 + 𝑣 −𝑦 > 𝑣(− 𝑥 + 𝑦 ) due to concavity of the
value function.
 4 Experiments & The Theory Developed
3. Mr. A bought his first New York State lottery ticket and won ₹10000. Also, in a
freak accident, he damaged the rug in his apartment and had to pay the landlord
₹8000.
Mr. B bought his first lottery ticket and won ₹2000.
Who was happier?

Choice: A – 25% B: 70% No difference: 5%

Mixed gain – let the outcomes are (x, -y) where x > y.
Since the loss function is steeper than the gain function, 𝑣 𝑥 + 𝑣 −𝑦 < 0 while
𝑣 𝑥 − 𝑦 > 0 for x > y.
Integration is preferred since 𝑣 𝑥 + 𝑣 −𝑦 < 𝑣 𝑥 − 𝑦 .
Integration results in cancellation.
 4 Experiments & The Theory Developed
4. Mr. A's car was damaged in a parking lot. He had to spend ₹20000 to repair the
damage. The same day the car was damaged, he won ₹2500 in the office football
pool.
Mr. B's car was damaged in a parking lot. He had to spend ₹17500 to repair the
damage.
Who was more upset?

Choice: A – 22% B: 72% No difference: 6%

Mixed loss – let the outcomes are (x, -y) where x < y, a net loss.
The possibilities are 𝑣 𝑥 + 𝑣(−𝑦) ≶ 𝑣 𝑥 − 𝑦
Segregation is preferred if 𝑣 𝑥 > 𝑣 𝑥 − 𝑦 − 𝑣 −𝑦 ; more likely the smaller the x
relative to y. This is referred to as silver lining principle.
Integration is preferred when x and y are close resembling a case of cancellation.
 When y is large relative to x.

When x and y are relatively close.

Source: Thaler (1985)
 Hedonic-Editing Hypothesis
1. Segregate gains (because the gain function is concave due to diminishing
sensitivity).
2. Integrate losses (because the loss function is convex, due to diminishing
sensitivity).
3. Integrate or cancel smaller losses with larger gains (to offset loss-aversion),
and
4. Segregate small gains from larger losses (because the gain function is
steepest at the origin, the utility of a small gain can exceed the utility of
slightly reducing a large loss; a case in favour of diminishing sensitivity).
 Is Hedonic Editing a Good Descriptive Model?
• Evidence suggests that hedonic editing hypothesis provides good description
of the way people behave with the exception of multiple losses.
• Thaler & Johnson (1990) examined the preference for temporal spacing in
two financial outcomes.
• If a subject wanted to segregate the outcomes x and y, he would prefer to
have them occur on different days, whereas if he wanted to integrate them,
he would prefer to have them occur together.
• For a large majority of subjects, temporal separation of both losses and
gains produced happiness.
• Therefore, for gains, hedonic editing was supported but not for losses.
• Diminishing sensitivity of the loss function was not observed.
A Few Concepts

• Acquisition utility

• Transaction utility
 Experiment
• You are lying on the beach on a hot day. All you have to drink is ice water. For the
last hour you have been thinking about how much you would enjoy a nice cold
bottle of your favorite brand of beer. A companion gets up to go make a phone
call and offers to bring back a beer from the only nearby place where beer is sold,
either
• a fancy resort hotel, or
• a small, rundown grocery store.
• He says that the beer might be expensive so asks how much you are willing to pay
for the beer. He says he will buy the beer if it costs as much or less than what you
state. But if it costs more than the price you state, he will not buy it. You trust
your friend, and there is no possibility of bargaining with either
• the bartender, or
• store owner.
• What price do you tell him?

• The median answers, adjusted for inflation, were $2.65 and $1.50 in 1984 dollars.
 Acquisition Utility
• Three prices are introduced
• The actual price charged for some good z, call it p
• The value equivalent of z, 𝑝ҧ
• The reference price for z, p* that is, the regular price that the consumer expects to pay
for this product
• Acquisition utility is a measure of the value of the good obtained relative to its
price, similar to the economic concept of consumer surplus.
• Conceptually, acquisition utility is the value the consumer would place on
receiving the good as a gift, minus the price paid.
• The compound outcome can be written as 𝑧, −𝑝 = (𝑝,ҧ −𝑝)
• The associated value scale 𝑣 𝑝,ҧ −𝑝 will be coded as the integrated
outcome 𝑣 𝑝ҧ − 𝑝 where the cost of goods sold is not treated as a loss as
it will be hedonically inefficient.
 Transaction Utility
• Transaction utility measures the perceived value of the 'deal’.
• It is defined as the difference between the amount paid and the 'reference
price' for the good.
• Alternatively, it is defined as the reference outcome 𝑣 −𝑝: −𝑝∗ , i.e. the
value of paying p when the expected or reference price is p*.
• Total utility from a purchase is just the sum of acquisition utility and
transaction utility.
• Thus the value of buying good z at price p with reference price p* is defined
as w(z, p, p*) where
𝑤 𝑧, 𝑝, 𝑝∗ = 𝑣 𝑝,ҧ −𝑝 + 𝑣 −𝑝: −𝑝∗
• Transaction utility explains the differences in the prices of the same product
at different locations that a consumer is willing to pay.
 What Determines Reference Price?
• Imagine that you are going to a sold-out Cornell hockey playoff game, and you have
an extra ticket to sell or give away. The price marked on the ticket is $5
• but you were given your tickets for free by a friend, or
• which is what you paid for each ticket or
• but you paid $10 each for your tickets when you bought them from another student.
• You get to the game early to make sure you get rid of the ticket. An informal survey
of people selling tickets indicates that the going price is $5. You find someone who
wants the ticket and takes out his wallet to pay you. He asks how much you want for
the ticket. Assume that there is no law against charging a price higher than that
marked on the ticket. What price do you ask for if
1. he is a friend
2. he is a stranger
• What would you have said if instead you found the going market price was $10?
1. Friend
2. stranger
 Results

Market Friend Stranger

Cost N
value 0 5 10 Other 0 5 10 Other
0 5 68 26 3 3 6 77 10 6
31
0 10 65 26 6 3 6 16 58 19
5 5 14 79 0 7 0 79 7 14
28
5 10 7 79 4 9 0 14 57 29
10 5 0 69 23 8 0 42 46 12
26
10 10 0 15 69 15 0 0 73 27
 Implications
• The modal answers in the friend condition are equal to the seller’s costs except in
the unusual case where seller's cost was above market price.
• The modal answers in the stranger condition are equal to market price with the
same lone exception.
• The implication of this is that buyers' perceptions of a seller's costs will strongly
influence their judgments about what price is fair, and this in turn influences their
value for p*.
• Overall, transaction utility suggests that we buy certain things just because it
appears to be a good deal.
• Second, some purchases that would seemingly make the consumer better off may
be avoided because of substantial negative transaction utility.
Exercise 1
• Yesterday, you had a decent day: you first received a ₹4800 tax
refund, and then an old friend repaid a ₹2700 loan you had forgotten
about.
• Considering the usual prospect theory value function and parameter
values find out
(a) If you integrate the two gains, what is the total value?
(b) If you segregate the two gains, what is the total value?
(c) From the point of view of value, is it better to integrate or to
segregate?
Application of Mental Accounting
 Opening & Closing Accounts
• Paper gain or loss versus realized gain or loss
• One clear intuition is that realized loss is more painful than a paper loss.
• Because closing an account at a loss is painful, a prediction of mental
accounting is that people will be reluctant to sell securities that have declined
in value.
• In particular, suppose an investor needs to raise some cash and must choose
between two stocks to sell, one of which has increased in value and one of
which has decreased.
• Mental accounting favors selling the winner (Shefrin and Statman, 1987)
whereas a rational analysis favors selling the loser.
• Mental account explains disposition effect
Opening & Closing Accounts
• Advance Purchases, Sunk Costs & Payment Depreciation
• Why some people would travel to attend an event even in a blizzard when the
purchase is made well in advance?
• Ex-post evaluations of transactions become more likely when the size of
transaction increases or the situation is unusual in order to close the account
not in a loss.
• Additional hazards like driving in a blizzard is put in a different mental
account.
• Other examples include KT’s experiment of losing a $10 theatre ticket, greater
attendance in health club soon after paying the subscriptions.
• But sunk costs don’t linger indefinitely.
• The gradual reduction in the relevance of prior expenditures is dubbed
'payment depreciation’ by Gourville and Soman (1998)
 An Experiment with Sunk cost
Suppose you bought a case of good Bordeaux in the futures market for $20 a
bottle. The wine now sells at auction for about $75. You have decided to drink a
bottle. Which of the following best captures your feeling of the cost to you of
drinking the bottle? (The percentage of people choosing each option is shown in
brackets.)
(a) $0. I already paid for it. [30%]
(b) $20, what I paid for it. [18%]
(c) $20 plus interest. [7%]
(d) $75, what I could get if I sold the bottle. [20%]
(e) –$55. I get to drink a bottle that is worth $75 that I only paid $20 for so I save
money by drinking this bottle. [25%]
 Sunk Cost & Opportunity Cost
Suppose you buy a case of Bordeaux futures at $400 a case. The wine will retail at
about $500 a case when it is shipped. You do not intend to start drinking this wine for
a decade. At the time that you acquire this wine which statement more accurately
captures your feelings? Indicate your response by circling a number on each of the
scales provided. 1: strongly agree; 5: strongly disagree
(a) I feel like I just spent $400, much as I would feel if I spent $400 on a weekend
getaway.
1 ---- 2 ---- 3 ---- 4 ---- 5 Mean: 3.31
(b) I feel like I made a $400 investment which I will gradually consume after a period
of years.
1 ---- 2 ---- 3 ---- 4 ---- 5 Mean: 1.94
(c) I feel like I just saved $100, the difference between what the futures cost and what
the wine will sell for when delivered.
1 ---- 2 ---- 3 ---- 4 ---- 5 Mean: 2.88
 Payment Decoupling
• In the wine example, the prepayment separates or 'decouples’ the purchase
from the consumption and in so doing seems to reduce the perceived cost of
the activity.
• Decoupling also works through combining or integrating prices, like prices of
individual recreational activities will appear small when combined but large
when segregated reducing transactional utility.
• Piece rate pricing also makes the link between consumption and payment
very salient.
• Consumers prefer flat-rate services called ‘flat-rate bias’ in
telecommunication.
• Flat-rate services, in place of usage-based pricing decouples usage from prices
making the marginal cost of future services zero.
 Exercise 2
• How the use of credit cards is an example of mental accounting?
• Decouples the purchase from the payment
• Delays the payment by a few weeks
• Cash transactions are better remembered.
• In a credit card bill containing several purchases, an individual amount loses its
salience.
• The effect is stronger when the bill doesn’t need to be paid immediately.
• Suppose whenever you purchase something, you have to pay cash on the
spot, but your purchases are not delivered until the end of the month in a
giant box containing everything you bought in the last four weeks.
(a) Would you make more or fewer purchases this way?
(b) Use the language of integration and segregation to explain why.
 Budgeting
• Money is commonly labeled at three levels:
• Expenditures are grouped into budgets (e.g. food, housing, etc.);
• Wealth is allocated into accounts (e.g. checking, pension, 'rainy day'); and
• Income is divided into categories (e.g. regular or windfall).
• Tighter the budget, more explicit are the budgeting rules.
• For proper budgeting, expenses need to be tracked following a 2-stage
process
1. Expenses must first be noticed (equivalent to booking in financial accounting) and,
2. then assigned to their proper accounts (equivalent to posting in financial accounting)
• Not booking an expense is equivalent to “petty cash” expenses in financial
accounting.
• Dividing a large expense into small components to be included in “petty cash”
contradicts the hedonic editing hypothesis.
 Budgeting – Fungibility
• You have already spent ₹5000 this month on entertainment. Would u mind
going for a movie tonight which would cost you just another ₹500?
• You have received ₹5000 from your uncle for your upcoming birthday. Would
you mind going for a movie tonight which would cost you ₹500?
• Economists argue that time is also fungible: A rational person should allocate
time optimally, which implies 'equating at the margin’, i.e. the marginal value
of an extra minute devoted to any activity should be equal.
• Reality: people drive 20 minutes to save $5 on a $15 purchase but not on a
$125 purchase!
• Therefore, the implicit value people put on their time depends on the
financial context.
 Budgeting – Wealth Account
• Shefrin and Thaler (1988) proposed that there is a hierarchy of money locations
arranged by how tempting it is for a household to spend the money in each.
• Starting from the most accessed (or tempting) to the least accessed are
• Current assets' category, for example cash on hand and money market or checking accounts
• Current wealth' category, which includes a range of liquid asset accounts such as savings
accounts, stocks and bonds, mutual funds etc.
• Home equity
• ‘Future income' account
• Life-cycle model says wealth is perfectly fungible.
• The alternative proposed ‘behavioral life-cycle model’ suggests that if money can
be transferred to the least tempting account, savings would increase.
• Similarly, there is income accounting where the source of the additional income
dictates how to spend it – dividend payments vs share repurchase.
 Choice Bracketing – House Money Effect
• Problem 1. You have just won $30. Now choose between:
(a) A 50% chance to gain $9 and a 50% chance to lose $9. [70]
(b) No further gain or loss. [30]
• Problem 2. You have just lost $30. Now choose between:
(a) A 50% chance to gain $9 and a 50% chance to lose $9. [40]
(b) No further gain or loss. [60]
• Problem 3. You have just lost $30. Now choose between:
(a) A 33% chance to gain $30 and a 67% chance to gain nothing. [60]
(b) A sure $10. [40]
• Problem 1 shows the ‘house money’ effect.
• Problems 2 & 3 show that prior losses did not stimulate risk seeking unless the
gamble offered a chance to break even.
 Choice Bracketing

• Loss aversion & one-bet-at-a-time

• Paul Samuelson offered his colleague a game where if the colleague wins he
would get $200 & if he loses, he would pay $100.
• The colleague refused. And instead said that if Samuelson plays the game a
100 times, then he would be game. – why?
• One-bet-at-a-time is unattractive following Prospect Theory.
• Combine 2 bets. The prospect is (400, 0.25; 100, 0.5; -200, 0.25)
• Expected utility for combined bets is positive and grows with number of bets.
 Choice Bracketing - Myopic Loss Aversion
• Equity premium puzzle
• Equity premium – the difference in the rate of return on equities (stocks) and a safe
investment such as treasury bills.
• The puzzle is that this difference has historically been very large. In the USA, a dollar
invested in stocks on 1 January 1926 was worth more than $1800 on 1 January
1998, whereas a dollar invested in treasury bills was worth only about $15 (half of
which was eaten up by inflation).
• The level of risk aversion to explain such large differences in returns is implausible.
• One way to examine is to consider how frequently the investors should evaluate
their investment to make themselves indifferent between the two investments.
• Simulation suggested a period of 13 months.
• Therefore, if investors’ have a narrow frame of evaluation of once in a year, equity
premium puzzle is explained.
• This is termed as myopic loss aversion.
• Kahneman & Lovallo (1993) termed this as narrow framing which also explains the
New York taxi drivers’ decision about how long to drive.
 Diversification Heuristic
• Children were asked to select among six snacks (candy bars, chips, etc.) in one
of two conditions:
1. sequential choice: they picked one of the six snacks at each of three class
meetings held a week apart;
2. simultaneous choice: on the first class meeting they selected three snacks
to be consumed one snack per week over the three class meetings.
• Simonson (1990) observed that in the simultaneous choice condition subjects
displayed much more variety-seeking than in the sequential choice condition.
• This behavior might be explained by variety-seeking serving as a choice
heuristic.
• Alternatively, people tend to diversify when asked to make several choices
simultaneously.
• A failure to account for this kind of behavior may lead to incorrect predictions.
 Diversification Bias
• Read and Loewenstein (1995) called this diversification bias and observed
similar patterns in their experiments with candies picked up by kids on
Halloween night.
• Benartzi and Thaler (1998) have found evidence of the same phenomenon by
studying how people allocate their retirement funds across various
investment vehicles.
• In particular, they found some evidence for an extreme version of this bias
that called the l/n heuristic where if an employee is offered n funds to
choose from, then she evenly divides the money among the funds offered.
• This heuristic can be utilized to increase exposure to any particular type of
funds.
• They also observed that employees seem to put stock in the company they
work for into a separate mental account.
 Exercise 3
• Consider the experiment of Paul Samuelson offering his colleague a game
where if the colleague wins he would get $200 & if he loses, he would pay
$100.
• The colleague refused the bet and agreed to play if only it is played a 100
times.
• Using Prospect theory value functions and decision weights, find out how
many times he should play to break even?
 Exercise 4
• Suppose Akira has two sources of income. Anticipated income, y1 is spent on
healthy food, represented by x1, and clothing, x2. Unanticipated income, y2 is
spent on dessert items, x3. suppose, the value function is given by
𝑣 𝑥1 , 𝑥2 , 𝑥3 = (𝑥1 𝑥2 𝑥3 )1/3 . Suppose, y1 = 8, and y2 = 2, and the prices of
the goods are p1 = 1, p2 = 1, p3 = 2.
• What would be the consumption level following the neo-classical
prescription?
• What would be the consumption level following mental accounting
principles?
• If Akira’s anticipated income increases by 4 units, then how the consumption
changes?
• If Akira’s unanticipated income increases by 4 units, then how the
consumption changes?
 References
• Thaler, Richard H. (1985). Mental Accounting and Consumer Choice,
Marketing Science, 4, 3, pp. 199-214.
• Thaler, Richard H. (1990). Anomalies: Saving, Fungibility, and Mental
Accounts, The Journal of Economic Perspectives , 4, 1, pp. 193-205.
• Thaler, Richard H. (1999). Mental Accounting Matters. Journal of
Behavioral Decision Making, 12, 183 – 206.
• Wilkinson, N. and Kleas, M. An Introduction to Behavioral Economics,
Palgrave McMillan.
• Thaler, Richard. Misbehaving: The Making of Behavioral Economics, Allen
Lane.
• Angner, Erik, A course in Behavioral Economics, Palgrave McMillan.