Mental Accounting: Our Cognitive Filters

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.