Imagine you enter a shoe store that is having a sale – buy any pair of shoes, get a second pair for free. Sounds like a great deal, right? Now imagine that same store had an offer to take 50% off any two pairs of shoes. Even though you are spending the exact same amount for the same two products, perhaps you react differently to the two offers. Perhaps there is something about removing “free” from the offer that might make you feel like you’re not getting as good of a deal. And how would you pay for these shoes – with cash? Credit card? Mobile wallet balance? Does it even matter? Research shows that people perceive $1 in stored electronic value differently than $1 in cash, and that these different perceptions DO influence spending habits.
The process of mentally separating different forms of money and assigning value to them, keeping track of potential costs and benefits to transactions, and categorizing expenses into buckets like “food” and “healthcare” is called mental accounting. Economist Richard Thaler first introduced the concept of mental accounting and demonstrated its consequences in everyday life. He explained why Mental Accounting Matters in a paper of that same name:
In general, understanding mental accounting processes helps us understand choice because mental accounting rules are not neutral. That is, accounting decisions such as to which category to assign a purchase, whether to combine an outcome with others in that category, and how often to balance the ‘books’ can affect the attractiveness of choices. They do so because mental accounting violates the economic notion of fungibility. Money in one mental account is not a perfect substitute for money in another account. Because of violations of fungibilty, mental accounting matters.
For the world’s poor, who make complex financial decisions under conditions of extreme scarcity on a daily basis, we know that mental accounting influences their household money management but don’t yet know how and to what extent. Understanding mental accounting in these contexts could allow the creation of financial tools that take advantage of these “irrational” cognitive processes to achieve certain goals, like increasing savings or business investment.
FAI’s Tim Ogden sat down with David McKenzie, Lead Economist in the Development Research Group at the World Bank, to discuss the importance of mental accounting in his work and the development research agenda:
There have been a number of recent studies with somewhat puzzling findings that can be attributed to the possibility that mental accounting influences how households make financial decisions – but that’s a hard thing to measure. Can you talk a bit about these studies?
What are some additional strategies to better design studies to explore the impact of mental accounting?
For additional information on the impact of mental accounting from the field, please see the following links to the research David mentions in the above clips:
- Collins, D., Morduch, J., Rutherford, S., Ruthven, O., Portfolios of the Poor: How the World's Poor Live on $2 a Day, 2010
- de Mel, Suresh, McKenzie, David, and Woodruff, Chris, Business Training and Female Enterprise Start-up, Growth, and Dynamics: Experimental evidence from Sri Lanka Journal of Development Economics, 106: 199-210, 2014
- Drexler, Alejandro and Fischer, Greg and Schoar, Antoinette, Keeping it Simple: Financial Literacy and Rules of Thumb, January 2011
- Dupas, Pascaline and Robinson, John. Savings Constraints and Microenterprise Development: Evidence from a Field Experiment in Kenya, American Economic Journal: Applied Economics 2013, 5(1): 163–192
- Schaner, Simone, The Persistent Power of Behavioral Change: Long-Run Impacts of Temporary Savings Subsidies for the Poor, May 2013