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Mental Accounting

The terms mental account and mental accounting were coined in the 1980s by Richard Thaler to refer to certain mental representations (accounts) and cognitive processes (accounting) related to decision outcomes and events, particularly transactions involving money. It is useful to distinguish core mental accounts, which are relatively stable structures, from specific mental accounts constructed to represent a new economic decision.

Core Mental Accounts

Behavioral life cycle theory aims to explain how people deal with the economic transactions they encounter in everyday life across the lifespan. It is a formal economic model incorporating assumptions of bounded rationality theory, notably that people construct simplified mental representations of their economic world. One assumed simplification is that people mentally partition their income and expenditure transactions over time into discrete budget periods, often weekly or monthly, to coincide with significant recurring events such as payday, or utility or housing payments. Another is that economic resources are allocated to one of three core mental accounts: current income, current assets, or future income. The way that these accounts relate to expenditure decisions varies. Each has a different budget constraint, with the current income account having the lowest resistance to spending and the future income account the highest. In addition, different categories of expenditure may relate to these broad accounts differently: For example, low-cost, frequently occurring purchases such as a newspaper are more likely to be allocated to the current income account. Finally, subaccounts for specific purposes may also be constructed, such as “holiday money.” All this implies that money is mentally categorized or labeled.

Behavioral life cycle theory predicts that people will violate a principle of rational economic behavior known as fungibility—in essence, the principle that money from all sources should be interchangeable. It can explain certain anomalies of economic behavior (violations of fungibility) such as holding savings attracting a lower rate of interest while borrowing money at a higher rate (more common than some readers might think). The notion of core mental accounts as simplified representations of long-term resources has mainly been applied to consumer behavior and to basic financial decisions such as saving versus spending unexpected (windfall) income. However, it is also clearly relevant to personal healthcare decisions, including health insurance, which involves uncertain future benefits but ongoing costs, that is, monthly premium payments that would normally be allocated to a current income account.

Specific Mental Accounts

A second use of the term mental account derives from prospect theory and is related to the framing effect. In contrast to the ongoing representation discussed above, Amos Tversky and Daniel Kahneman defined a mental account as an outcome frame set up for a specific consumer choice or transaction (initially these authors used the term psychological account). They distinguished three levels of account, differing in the extent to which contextual information might be included, that were investigated in the Jacket and Calculator decision problem. In one version of the problem, participants were asked to imagine they were about to purchase a jacket for $125 and a calculator for $15 and had been informed that the calculator was on sale for $10 at another branch, a 20 minutes' drive away. Only 29% of participants responded that they would drive to the other store, but when the problem was rephrased so that the prices of jacket and calculator were reversed, with the calculator being $125 in one store and $120 in the other, 68% were prepared to do so. Although the difference in the price of the calculator and the cost of the whole shopping trip are the same in both forms of the problem, respondents tended to represent it differently, which can be understood in terms of the specific mental account primed for the transaction. For example, the calculator price difference could be framed in terms of a minimal, topical, or more comprehensive mental account. For a minimal account, it would be evaluated relative to the status quo (a saving of $5). For a topical account, a reference point from which to evaluate the price difference would be derived from the “topic” of the decision: in this case the actual price of one of the calculators (e.g., $5 less than $15). For a more comprehensive account, the reference point would be based on a wider context, for example, the whole shopping bill ($5 less than $140). The change in majority preference across versions of the problem is explained by a tendency to construct topical accounts that incorporate the most relevant, but not all, aspects of the transaction.

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