"Examinations are formidable even to the best prepared, for the greatest fool may ask more than the wisest man can answer." - Charles Caleb Colton

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"A former colleague of mine, a professor of Finance, prides himself on being a thoroughly rational man. Long ago he adopted a clever strategy to deal with life's misfortunes. At the beginning of each year he establishes a target donation to the local United Way charity. Then, if anything untoward happens to him during the year, for example an undeserved speeding ticket, he simply deducts this loss from the United Way account. He thinks of it as an insurance policy against small annoyances.*

* This strategy need not reduce his annual contribution to the United Way. If he makes his intended contribution too low he risks having `uninsured' losses. So far he has not been `charitable' enough to have this fund cover large losses, such as when a hurricane blew the roof off his beach house...

A friend of mine was once shopping for a quilted bedspread. She went to a department store and was pleased to find a model she liked on sale. The spreads came in three sizes: double, queen and king. The usual prices for these quilts were $200, $250 and $300 respectively, but during the sale they were all priced at only $150. My friend bought the king-size quilt and was quite pleased with her purchase, though the quilt did hang a bit over the sides of her double bed...

The following example illustrates that mental accounting is topical:

Imagine that you are about to purchase a jacket for ($125)[$15] and a calculator for ($15)[$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? (Tversky and Kahneman, 1981, p. 459)

When two versions of this problem are given (one with the figures in parentheses, the other with the figures in brackets), most people say that they will travel to save the $5 when the item costs $15 but not when it costs $125. If people were using a minimal account frame they would be just asking themselves whether they are willing to drive 20 minutes to save $5, and would give the same answer in either version...

The following example ( from Thaler, 1985) illustrates the role of transaction utility.

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 (a fancy resort hotel) [a small, run-down grocery store]. He says that the beer might be expensive and so asks how much you are willing to pay for the beer. He says that he will buy the beer if it costs as much or less than the price 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 the (bartender) [store owner]. What price do you tell him?

Two versions of the question were administered, one using the phrases in parentheses, the other the phrases in brackets. The median responses for the two versions were $2.65 (resort) and $1.50 [store] in 1984 dollars. People are willing to pay more for the beer from the resort because the reference price in that context is higher. Note that this effect cannot be accommodated in a standard economic model because the consumption experience is the same in either case; the place of purchase should be irrelevant.

The addition of transaction utility to the purchase calculus leads to two kinds of effects in the marketplace. First, some goods are purchased primarily because they are especially good deals. Most of us have some rarely worn items in our closets that are testimony to this phenomenon. Sellers make use of this penchant by emphasizing the savings relative to the regular retail price (which serves as the suggested reference price). In contrast, some purchases that would seemingly make the consumer better off may be avoided because of substantial negative transaction utility. The thirsty beer drinker who would pay $4 for a beer from a resort but only $2 from a grocery store will miss out on some pleasant drinking when faced with a grocery store charging $2.50...

Although sunk costs influence subsequent decisions, they do not linger indefinitely. A thought experiment illustrates this point nicely. Suppose you buy a pair of shoes. They feel perfectly comfortable in the store, but the first day you wear them they hurt. A few days later you try them again, but they hurt even more than the first time. What happens now? My predictions are:

(1) The more you paid for the shoes, the more times you will try to wear them. (This choice may be rational, especially if they have to be replaced with another expensive pair.)
(2) Eventually you stop wearing the shoes, but you do not throw them away. The more you paid for the shoes, the longer they sit in the back of your closet before you throw them away. (This behavior cannot be rational unless expensive shoes take up less space.)
(3) At some point, you throw the shoes away, regardless of what they cost, the payment having been fully 'depreciated'.

Evidence about the persistence of sunk costs effects is reported by Arkes and Blumer (1985). They ran an experiment in which people who were ready to buy season tickets to a campus theater group were randomly placed into three groups: one group paid full price, one group got a small (13%) discount, and one group received a large (47%) discount. The experimenters then monitored how often the subjects attended plays during the season. In the first half of the season, those who paid full price attended significantly more plays than those who received discounts, but in the second half of the season there was no difference among the groups. People do ignore sunk costs, eventually.

The gradual reduction in the relevance of prior expenditures is dubbed 'payment depreciation' by Gourville and Soman (1998) who have conducted a clever field experiment to illustrate the idea. They obtained usage data from the members of a health club that charges the dues to its members twice a year. Gourville and Soman find that attendance at the health club is highest in the month in which the dues are paid and then declines over the next five months, only to jump again when the next bill comes out.

Similar issues are involved in the mental accounting of wine collectors who often buy wine with the intention of storing it for ten years or more while it matures. When a bottle is later consumed, what happens? Eldar Shafir and I (1998) have investigated this pressing issue by surveying the subscribers to a wine newsletter aimed at serious wine consumers/collectors. We asked the following question:

Suppose you bought a case of a good 1982 Bordeaux in the futures market for $20 a bottle. The wine now sells at auction for about $75 a bottle. You have decided to drink a bottle. Which of the following best captures your feeling of the cost to you of drinking this bottle?

We gave the respondents five answers to choose from: $0, $20, $20 plus interest, $75, and -$55 (`I drink a $75 bottle for which I paid only $20'). The percentages of respondents choosing each answer were 30, 18, 7, 20 and 25. Most of the respondents who selected the economically correct answer ($75) were in fact economists. (The newsletter, Liquid Assets, is published by economist Orley Ashenfelter and has many economist subscribers). More than half the respondents report that drinking the bottle either costs nothing or actually saves them money!

... the typical wine connoisseur thinks of his initial purchase as an investment and later thinks of the wine as free when he drinks it. We have therefore titled our paper 'Invest Now, Drink Later, Spend Never'. Note that this mental accounting transforms a very expensive hobby into one that is 'free'. The same mental accounting applies to time-share vacation properties. The initial purchase of a week every year at some resort feels like an investment, and the subsequent visits feel free...

More generally, consumers don't like the experience of `having the meter running'. This contributes to what has been called the 'flat rate bias' in telecommunications. Most telephone customers elect a flat rate service even though paying by the call would cost them less. [Ed: You can also explain this by risk aversion]

... Perhaps the best decoupling device is the credit card. We know that credit cards facilitate spending simply by the fact that stores are willing to pay 3% or more of their revenues to the card companies... A credit card decouples the purchase from the payment in several ways. First, it postpones the payment by a few weeks... (a) the payment is later than the purchase; (b) the payment is separated from the purchase... the simple separation of purchase and payment appears to make the payment less salient. Along these lines, Soman (1997) finds that students leaving the campus bookstore were much more accurate in remembering the amount of their purchases if they paid by cash rather than by credit card. As he says, `Payment by credit card thus reduces the salience and vividness of the outflows, making them harder to recall than payments by cash or check which leave a stronger memory trace' (p. 9)...

In many situations sellers and fund raisers elect to frame an annual fee as 'pennies-a-day'. Thus a $100 membership for the local public radio station might be described as a `mere 27 cents a day'. Given the convex shape of the loss function, why should this strategy be effective? One possibility is that 27 cents is clearly in the petty cash category, so when the expense is framed this way it tends to be compared to other items that are not booked. In contrast, a $100 membership is large enough that it will surely be booked and posted, possibly running into binding budget constraints in the charitable giving category. The same idea works in the opposite direction. A firm that markets a drug to help people quit smoking urges smokers to aggregate their annual smoking expenditures and think of the vacation they could take with these funds. Again, $2 a day might be ignored but $730 pays for a nice getaway.

Whenever budgets are not fungible their existence can influence consumption in various ways... Heath and Soll (1996) provide several experiments to illustrate this effect. In a typical study two groups of subjects were asked whether they would be willing to buy a ticket to a play. One group was told that they had spent $50 earlier in the week going to a basketball game (same budget); the other group was told that they had received a $50 parking ticket (different budget) earlier in the week. Those who had already gone to the basketball game were significantly less likely to go to the play than those who had gotten the parking ticket.*

* One might think this result could be attributed to satiation (one night out is enough in a week). However, another group was asked their willingness to buy the theater ticket after going to the basketball game for free, and they showed no effect.

... Another violation of fungibility introduced by the budgeting system occurs because some budgets are intentionally set 'too low' in order to help deal with particularly insidious self-control problems... the usual economic advice (which says that a gift in kind can be at best as good as a gift of cash, and then only if it were something that the recipient would have bought anyway). Instead the mental accounting analysis suggests that the best gifts are somewhat more luxurious than the recipient normally buys, consistent with the conventional advice (of non-economists), which is to buy people something they wouldn't buy for themselves.

The idea that luxurious gifts can be better than cash is well known to those who design sales compensation schemes. When sales contests are run, the prize is typically a trip or luxury durable rather than cash. Perhaps the most vivid example of this practice is the experience of the National Football League in getting players to show up at the annual Pro Bowl. This all-star game is held the week after the Super Bowl and for years the league had trouble getting all of the superstar players to come. Monetary incentives were little inducement to players with seven-figure salaries. This problem was largely solved by moving the game to Hawaii and including two first-class tickets (one for the player's wife or girlfriend) and accommodations for all the players.

... For other tempting products, consumers may regulate their consumption in part by buying small quantities at a time, thus keeping inventories low. This practice creates the odd situation wherein consumers may be willing to pay a premium for a smaller quantity... [Wertenbroch's] one-sentence abstract succinctly sums up his paper: 'To control their consumption, consumers pay more for less of what they like too much'...

Another example of income non-fungibility is provided by Kooreman (1997). He studies the spending behavior of families that receive child allowance payments from the Dutch government. He finds that spending on children's clothing is much more sensitive to changes in the designated child allowance than to other income sources...

The choice of how to bracket the gambles influences the attractiveness of the individual bets. An illustration is provided by a famous problem first posed by Paul Samuelson. Samuelson, it seems, was having lunch with an economist colleague and offered his colleague an attractive bet. They would flip a coin, and if the colleague won he would get $200; if he lost he would have to pay only $100. The colleague turned this bet down, but said that if Samuelson would be willing to play the bet 100 times he would be game. Samuelson (1963) declined to offer this parlay, but went home and proved that this pair of choices is irrational. [Ed: ... economists]

The diversification bias is not limited to young people choosing among snacks. Benartzi and I (1998) have found evidence of the same phenomenon by studying how people allocate their retirement funds across various investment vehicles. In particular, we find some evidence for an extreme version of this bias that we call the 1/n heuristic. The idea is that when an employee is offered n funds to choose from in her retirement plan, she divides the money evenly among the funds offered... We find evidence supporting just this behavior. In a sample of pension plans we regress the percentage of the plan assets in stocks on the percentage of the funds that are stock funds and find a very strong relationship...

A question that has not received much attention is whether mental accounting is good for us... It is not possible to say that the system is flawed without knowing how to fix it. Given that optimization is not feasible (too costly) repairing one problem may create another. For example, if we teach people to ignore sunk costs, do they stop abiding by the principle: 'waste not, want not'? If we stop being lured by good deals, do we stop paying attention to price altogether? There are no easy answers."

--- Mental Accounting Matters / Richard H. Thaler, Journal of Behavioral Decision Making (1999)