12 March 2013

SUV over Dental Work; Belgian Beer over Book and Savings alongside Loans – The Money Jars in Your Head or About Mental Accounting

One major property of money is that it is fungible. To put things simply, any amount of money is perfectly replaceable by another equal amount of money. For example, if you have a 20 Euros bill in your left pocket, that amount can be replaced by the ten 2 Euros coins that you have on your desk.

If you have to go shopping for groceries you can take and spend either the 20 euros bill or the ten 2 euros coins. Each will buy exactly the same things.

The human brain, however, has some shortcomings when it comes to fungible things. Even if we know that any 100 Euros can be replaced by any other 100 Euros, when we make judgments about spending money and judging how much to spend on this or that, somehow money tends to not be fungible any more.

To better understand how in our minds money loses the fungible property, imagine the following scenario. You live on a limited budget and all your income is in cash (coins and bills). In order to not get into trouble, you come up with a really smart and low cost income management system. Your main expenses are: rent, groceries, transport, communications and leisure. Your smart management system consists of 5 jars (like the ones you keep jam in). Each month when you get your income, you fill each jar with the amount for each spending. First, you fill in the rent jar, then the groceries jar, the transport and communications jars. If there is anything left, you put something in the leisure jar.

Your golden rule is to use the money from each jar ONLY for the expenditures they are intended for. You do not use the money from the rent jar to pay your phone bill, nor do you take money from the communications jar to cover expenses on food.

Although rudimentary, this money management system is quite effective in getting you from one month to the other without overspending and without having unpaid bills in each of your main areas of expenditures.

This management system, however, violates the fungible quality of money. In essence if you would pay your groceries from the “rent jar”, then what remains in the “rent jar” plus what is in the “groceries jar” can be used to pay the rent.

However, this opens the door to overspending (assuming that you pay more for rent than for groceries) which in turn may lead to you not being able to pay the entire rent this month.

The role of the “jar based” money management system is to prevent the eventual shortcomings in self-control. In essence the jars are not a money management system as much as they are a self-control enhancement mechanism.      

Nowadays most people don’t have a “jar based” money management system, but one thing we still have, namely our mental jars. Even if we don’t have physical jars for our expenses, we still have our mental accounts for most types of expenses.

Take for example the case of Patrick planning a holiday trip. Patrick is thinking of going to Macedonia and the plane ticket costs 400 Euros (which is quite expensive for a flight within Europe). Patrick’s mental account (“mental jar”) for airplane tickets within Europe has room for about 250 Euros. Patrick might say that the 400 Euros is a high price and subsequently make the decision to not go to Macedonia.

At the same time, in Patrick’s “hotel room” mental account there is space for about 70 Euros per night. Thus, a hotel room that costs 35 Euros per night will be perceived by Patrick as cheap.

When it comes to the mental account of “overall holiday expenses” Patrick has about 1000 Euros. How this amount is divided between airplane ticket and accommodation (hotel) is perfectly irrelevant. However, because the plane ticket costs more than it is reasonable in Patrick’s mental account, he might ignore the fact that because accommodation is cheap (costs less than what he has in his “hotel mental account”) the overall cost is within his “holiday expenses” account. Patrick might decide to not go to Macedonia for his holiday.

Since we are talking about airplane tickets, we should mention the pricing policies of low cost airlines and the extension of these practices to regular airlines.

The low cost airlines gained a lot of market share due to the low prices for flight tickets. However other services such as transportation of luggage, serving food and beverages, using the toilet in the airplane and even using established airports (ones that actually close to the big cities) are not included in the flight ticket.

The marketing communication “trick” in this case is that most travelers did not have mental accounts for services such as “luggage fee” and their focus was on the “plane ticket fee” account. Thus, communicating that the “flight ticket” is below what is one’s “flight ticket mental account” made people perceive low cost airlines as very cheap viable alternatives to regular airlines.

What has happened in the case of low and regular cost airlines is that learning occurred. People who have used low-cost airlines learned that there are additional prices (and inconveniences) to be paid and subsequently new mental accounts were created for things such as “luggage fee”. Most interestingly, regular airlines such as KLM took advantage of this change in consumer mentality and will start charging a separate fee for luggage. Of course, KLM could have increased the prices for “luggage included” tickets, but then their prices would have not been competitive in the battle fought within the “flight ticket” mental account.

Another implication of mental accounting is related to gift giving. Gift giving is one of the social practices deeply rooted in human nature. Despite this, quite often we are faced with the problem “what gift to get” for someone. A hint on this issue comes from mental accounting.

Each and every one of us has “mental jars” for different purchases. This implies that for some purchases we are not willing to pay over a certain amount. Gifts are a very nice way to bring joy to someone by braking the celling of a certain “mental jar”.

For example, if you know that the person who will receive the gift would never pay more than 100 Euros for a coat, then it is a good idea to give as gift a coat that costs more than 100 Euros. This way the gift receiver will get something that she would never buy on her own, whereas the gift giver would succeed in making a nice gift.

Most interestingly the proposition above is valid even if the gift giver and receiver are sharing financial resources. Putting things a bit simpler, if a husband makes a gift in the form of a coat that costs more than 100 Euros to his wife, by paying from their shared account, she will still be happy because she would have not bought the coat on her own by paying out of the same shared account.

Mental accounting explains also why some products are condemned to remain cheap (at least in some markets) whereas other products have a much wider price range. Take the example of books. If a book costs around 25 Euros it is already considered an expensive one (in the mainstream market). However, people pay more than 25 euros for products that in my opinion are a bit more frivolous than books.

Think about Mark who is a university student. He sees a book that he considers buying and reading, but he is not keen on doing so. It is not mandatory reading for any course, but its topic is related to his field of study. The book costs 25 Euros. After thinking a bit about this purchase he decides that 25 Euros is too much to pay for a book that is not mandatory reading, even if it might be interesting.

The next evening, Mark and some of his colleagues decide that they deserve a treat after a prolonged study session. They go out to a nice pizza place and enjoy the evening spiced with a couple of nice Belgian beers. After all, what can be better than Italian pizza and Belgian Beer? Mark’s share of the bill is 25 Euros. He thinks it is a bit more expensive than the usual pizza and beer, but still within the limits his mental budget of maximum 30 Euros for a nice evening out.

As you can see, Mark was unwilling to pay 25 Euros for a book because the price was a bit above the limit of his mental account of “book purchases”. At the same time he had no problem in paying 25 Euros for Pizza and Belgian Beer because this amount was within the limits of his mental account for “evening out”.

The example of Mark may seem a bit frivolous to some of my readers. To a large extent I agree that missing on a book in exchange for a nice evening out can be overlooked. Most likely the impact of this tradeoff on Mark’s life is minor. At the same time, such tradeoffs between different mental accounts may have significantly larger implications in one’s life.

Take the example of Miriam who is a young woman in her late 20s. She grew up in some difficult times when medical care and healthy food were not largely available. Thankfully things have changed and now she has a nice social and economic status. She is not rich, but for sure she can afford more than most people can. Miriam and her husband are considering having a child and she as a smart young lady knows that during pregnancy medical interventions, including dental works, are not recommended. Also the risks associated with dental problems such as infections during pregnancy are high. She decides to go to the dentist and fix some of her problems caused by the unfavorable conditions during her childhood.

Miriam goes to a dental practice and after the doctors examines her, he proposes a treatment plan and makes a cost-estimate. The estimate is quite high – around 5000 Euros. She thinks that the cost is too high and decides to only get treatment for whatever is urgent and wait on the non-urgent problems. As you may know dental problems do no simply go away by waiting. If anything, they get worse.

At the same time, Miriam and her husband are considering changing their car. They want the best for their future child and even if their current car is spacious enough and in good condition they think that a SUV would offer more protection than their current sedan does. After all, what parent is not concerned with her child’s safety?

They go to a car dealer and find a nice second hand SUV. They ask the dealer how much they would have to pay if they would give their current car as buy-back. The dealer makes some calculations and comes up with the 15.000 Euros sum. Miriam and her husband think that this is a good price to pay for a SUV and decide to make the purchase.

From a “cold thinking” perspective this couple’s decision makes little sense. Miriam decided not to get (all) her dental problems fixed because she believed that 5.000 Euros is too much to pay for the treatment, while at the same time they paid 15.000 Euros for an upgrade of their car which was not necessary. Moreover, their future child is more likely to benefit from having a mother with lower risks during pregnancy than from being driven in a SUV.

From a mental accounting perspective, this couple’s action is easily explainable because the “mental jar” for dental treatment is smaller than 5000 Euros, whereas the “mental jar” for (second hand) SUV is larger than 15.000 Euros.

Mental accounting also explains the co-occurrence of savings and loans. Consider the example of Sophia and Gerri who are a couple with a young daughter. Gerri received a quite large inheritance and since they have a good financial situation, Gerri and Sophia decide that the money from the inheritance should go to their daughter for university education or whatever she will need when she grows up. The parents think that if they will have another child, the money from the inheritance will be split between their children. They go to the bank and place the money inherited by Gerri into a savings account.

A couple of years later, Sophia tells Gerri that she is pregnant. They are both very happy and look forward to having a new member of the family. As you may know, a (new) child brings some administrative issues, such as having a room for the baby. Gerri and Sophia want their daughter to keep her room and decide that they should get some work done in the house to make a room for the new-born by “cutting” some of the space in the large living room.    

Getting construction work done is not exactly cheap and the two parents get some offers from contractors. They realize that the costs are a bit over their budget. They consider taking some money out of the children’s account (the money Gerri inherited a couple of years before), but then they say that they should not “touch” that money because it belongs to their children when they will be adults. Thus they go to the bank and get a loan to finance the construction work needed for the new baby to have a room.

From a rational point of view Sophia and Gerri’s decision is perfectly irrational. It is common knowledge that banks pay interest on savings accounts lower than the ones they charge for loans. After all, that is how banks make money. So, Sophia and Gerri would bear lower costs if they would simply take some money out of their (children’s) savings account and then put it back month by month. By taking a loan, not only they still have to give the money back, but they also have to pay the costs of the loan. By taking money out of their savings account they would forgo the gain in interest from the bank, but what the bank charges them as credit cost is higher than what the bank pays for their savings.

From a mental accounting perspective, Sophia and Gerri’s decision is easily explainable. For them the money in the savings account dedicated to their children is in the “DO NOT TOUCH mental jar”. Subsequently, getting a loan to finance the building of the new child’s room is the natural thing to do.

Before ending, I would like to say once again that mental accounting has a very important function, namely to increase self-control. For example, if Sophia and Gerri would take money out of the savings account dedicated to their children, might later fail to put the money back due to self-control shortcomings. By getting a bank loan, they avoid such a problem because somehow banks manage to get people to pay back their loans. The difference between the amount paid to the bank as loan cost and the amount got from the bank as interest on their savings account is in fact a cost for a self-control mechanism.

At the same time, mental accounting can lead to not so fortunate decisions. If Sophia and Gerri pay the bank to provide them with self-control, Miriam and her husband are paying extra for a SUV and sooner or later Miriam will have to go to the dentist to solve her then acute problems. The bill from the dentist will be higher than it would have been now. By that time, their second hand SUV will be old and will require costly repairs and maintenance.

The downside of mental accounting includes more than just money related issues. Because the cost of the airplane ticket is higher than what Patrick believes it should be, he might not take that holiday in Macedonia, despite the fact that hotels and restaurants are cheaper than he are used to and the overall costs of a holiday would be reasonable. Patrick might miss on a nice holiday experience simply because he uses mental accounts.

Mental accounts are good for increasing self-control, but they can also lead to bad decisions.

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This post is documented from: Thaler, Richard H. (1985), "Mental Accounting and Consumer Choice," Marketing Science, 4 (3), 199-214. 

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