Many of the modern economic theories are predicated on the assumption that people are self-interested, i.e. they only take courses of action that elicit pecuniary benefit. Accordingly, one would expect individuals to behave so as to maximise their benefits. Yet, there is a strong body of research evidence indicating that people are strongly motivated by other regarding preferences in their decisions, such as fairness and inequality. Think about the illustrated economic game:

A certain amount of money , say $20, are given to Person A. Person A (giver) can then share any amount at his/her discretion with person B (recipient), who has to accept the given amount. If you were in the place of Person A, would you share your money and, if so, how much?

The assumptions of conventional economics predict the answer to be zero, i.e. the giver keeps $20 for himself/herself. However, in reality, 64% of the participants, on average, shared one-fifth of their endowment. Remarkably, some participants gave away their entire amount. These results highlight that human behaviour is not solely dictated by monetary considerations.

Explaining the Phenomenon: Other-Regarding Preferences

The founding father of economics, Adam Smith, has long formulated the following idea – one who seeks happiness for oneself will not find it; one who helps others will. Individuals gain internal reward in the forms of pleasure, happiness and moral satisfaction from the act of giving, even in cases, in which monetary costs are incurred. In the given example, many people have chosen to give, since the perceived internal reward from giving surpassed the monetary amount given.

Evolutionary biology takes a different standpoint to explain the phenomenon of people’s willingness to give others when they are not obliged to do so. Through the process of natural selection, it may be that evolution favoured people who were co-operative and equitable in exchanges, as the fitness of the group, not the individual, was the essential requirement of survival in nomadic communities. Hence, there is a hard-wired tendency to co-operate, disguised as sharing in the economic game.

Incentivizing Giving: Implications for Non-Profit Organizations

As illustrated in the flow-chart below, in order to arrive to the decision to donate: ( 1 ) people need to recognize the need; ( 2 ) consider the possible impacts of the donation; and ( 3 ) act, if internal reward from giving surpasses monetary costs. Following this model, charity organizations can increase the amount of donations received through addressing the three broad stages of the decision-making process.

The first stage in this process is the recognition stage, in which attention and focus on those in need are imperative for eliciting empathy in potential donators. Hence, organizations need to continuously communicate the need for donation to the public. However, whereas many organizations are successful in the public outreach, only few are successful in increasing the effectiveness of the second stage in our model – consideration stage. Many make the mistake of providing holistic information about the impact of donations, e.g. total number of impoverished students helped. This results in individuals thinking that their donation would not have a substantial impact and perceiving it as a drop in the bucket. It has been consistently shown that willingness to donate is highest, when donations are made to a single person; it is often referred to as singularity effect. Christopher Hsee has found a creative solution to increase group donations by leveraging the singularity effect. A simple, yet powerful, trick consisted of requiring donors to specify how much one would want to give to a single person in need and then asking how many people he/she would like to help. This has significantly increased the size of donations.

Regarding the action stage, it is the step that non-profit organizations should consider with due attention. The fundamental importance of this stage stems from the availability of feedback – as a result of the donation itself – that could be fed back to the donor. In particular, this means providing concrete details about the usage and impact of the donated funds, which proved to substantially increase the tendency of people to donate again. In doing so, a virtuous circle can be established, in which the recognition of the need is re-communicated, and impact considerations are elucidated – simply by increasing the awareness about particular details of the donation outcome.

Altruism highlights that human beings are not purely self-interested, solely focusing on maximizing monetary gains. Instead, we are co-operative, helpful, and prosocial beings, from which we derive intrinsic reward through helping others. However, it is a different question whether true altruism exists, i.e. doing good without expecting anything in return (even in the form of intrinsic reward). The argument of whether pure altruism really exists will be addressed through a philosophical view in our upcoming blog.

Consider the following situations:

1. Imagine that you have decided to see a play where admission is $20 per ticket. As you enter the theatre, you discover that you have lost a $20 bill. Would you still pay $20 for a ticket to the play?

2. Imagine that you are going to the same play in the preceding example and you have paid the admission price of $20. However, as you enter the theatre, you realize that you have lost the ticket. The seat was not marked, and the ticket cannot be recovered. Would you pay $20 for another ticket?

From an economic standpoint, the two situations are identical; a certain amount of money ($20) has been irretrievably lost, and the only decision that needs to be made is whether the play is worth $20. The incurrence of loss in the form of a bill or a ticket is extraneous to the decision. Do people perceive the situations this way? As it turns out, many do not. 88% of the respondents presented with the first situation – loss of a $20 bill – said that they would still purchase the ticket, whereas 55% of the respondents presented with the second situation – loss of the admission ticket – said that they would not repurchase the ticket.

How can this phenomenon be explained?

In many instances, a theory cannot delineate the occurrence of an event, it is the assumptions of the theory that should be revisited.

Concerning the given example, economists have traditionally assumed that funds, regardless of mental representations and intended use, are fungible – dollars of money are substitutable – and irrecoverable costs should not affect future decisions. However, these assumptions certainly do not hold. Richard Thaler sheds light on this issue through introducing the concept of mental accounting – “the set of cognitive operations used by individuals and households to organise, evaluate, and keep track of financial activities.”

As depicted in the diagram above, funds are represented in mental accounts that, through the cognitive filter, are dictated by the funds’ mental representation, source, and intended use. This phenomenon occurs due to the tendency of individuals to categorise money and decision outcomes. In turn, it allows them to simplify aspects of the complex economic world along with imposing budget constraints, which helps individuals to keep control over their expenses. Hence, mental accounting arises as a coping function that sets budgets and facilitates spending for a specific purpose, which is analogous to tin-can household accounting, differing in the aspect that it occurs in the mind.

Revisiting the ticket problem, when the ticket was originally purchased, a “ticket purchase account” was set up through the source filter. In the first case, the lost $20 bill is not directly linked to the ticket, therefore, the majority of the respondents were willing to repurchase. In the latter case, the cost of an additional ticket is introduced to the still open “ticket purchase account”; hence, the price of a ticket was now perceived to be $40, leading to the decision of not repurchasing.

From Theory to Practice: Business Implications

The implications of mental accounting with regard to businesses are substantial, as it is the concept by which households and individuals’ saving and spending decisions are made. For instance, since individuals set budgets for their different needs, such as appliances and electronics, positioning a product that covers both accounts would increase budget reserved for the product, leading to a potential rise in sales. Another case where mental accounting plays an essential role is bonuses, often treated as “special money” by the receivers. Employees are commonly seen spending their bonuses on “irregular” expenses, such as an extravagant holiday or an expensive watch that has been on the wishlist for a long time. Potency of mental accounting further arises in the luxury business. It has been found that given gift vouchers, people’s tendency to buy luxury items substantially increases even if the gifted amount is relatively low. The implications also include non-profit businesses; for example, framing charitable donations as exceptional expenses can lead to the creation of a “new mental account”, considerably increasing collected funds.

The benefit of understanding mental accounting stems from its feature of reflecting the actual way of consumer thinking. Therefore, the identification of existing accounts along with shifting and creating new ones would prove to be of seminal importance in any context involving consumer behaviour.

For centuries, economists referred to the normative models when judging whether a decision is rational or not. Although the definition of rationality has been largely debated, there is a general agreement that rational choices should, among others, satisfy an invariance requirement. According to the invariance principle, regardless of the various framing options presented, people’s preference among certain options should not be influenced. However, an extensive body of evidence indicates that people do not conform with this principle, and they are, in fact, predisposed to persistent decisional biases. This phenomenon is referred to as loss framing effect in which, through loss-aversion, choice reversals or shifts occur when the expected outcome of a situation is communicated as either negative or positive.

Think about the illustrated study, taken from the work of Economics Nobel laureates Daniel Kahneman and Amos Tversky. In their study, Kahneman and Tversky asked participants to decide between two treatments concerning 600 people who contracted a fatal disease. The treatments were framed either positively, highlighting the number of lives that would be saved, or negatively, focusing on the loss of lives. If you are like most people (72%), in the positive frame case, you have chosen treatment A that saves 200 people with exact certainty. The interesting fact is that when the problem is communicated accentuating negative sides, the number of people choosing the certain treatment option significantly declines to 22%, leading to 50% choice reversal.

What explains this contradictory phenomenon?

The framing effect is a natural consequence of human cognitive psychology that ensured survival in the past. Through experience, we have learned to select the positive events that are certain, and take caution and try to avoid events with negative outcomes. Loss-framing has been extensively  discussed in Behavioural Economics, and it has been found that the weight given to the outcomes considerably differ depending on whether they are seen under positive or negative light – effects of equal amount of losses being two times greater than effects of gains. Accordingly, in valence framing effects, the way through which critical information is presented (framed) – in either positive or negative semantics – would lead to different decisions. In other words, by changing how it’s said, framing alters the perception of what is said.

What are some of the implications?

Implications of loss framing with respect to businesses are virtually boundless, with promising effects on behavior at no cost. For instance, many companies make the mistake of highlighting how much people would save (7%) by buying their products in their marketing campaigns. However, a more effective way to frame their campaign would be “buy now, do not lose 7%“, which includes both a call for action and loss framing technique, eliciting the common fear of missing out. Regarding non-profit organizations, particularly charitable ones, converting common positive messages of “save lives of children” to “do not miss the opportunity to save others” would have substantial impact. In addition, other types of framing, such as attribute framing, can alter perceptions for a particular product. A typical example is applied by meat producers via telling 95% lean beef instead of 5% fat beef.

The power of framing arises from the fact that it is extremely easy to apply, generating quick and effective results (eg. there was a 50% choice shift in the aforementioned study). It is usually the small things, with a cascading effect, that bring drastic changes. Hence, through changing how the information is presented, framing can be a potent tool to achieve the desired goals in numerous contexts, including consumer choices, perceptual judgments, and medical decisions.