Every rational theory of business and economics works on the premise that the only thing that matters in an economic transaction is the dollar value of the transaction, not the source of the funds or the physical form it is in. Sages and mothers also seem to agree when they write that “a dollar is a dollar” and “a penny saved is a penny earned”. However recent research shows that a penny saved is often not a penny earned.
Consider the following examples:
1. A store offered a $25 discount at their branch 10 kilometers away. Would you drive through bad traffic for the $25? We find that only 14% say they’ll drive if the discount is offered on a big screen TV costing $2,500. But as many as 75% say yes when it is offered on a $75 portable CD player.
2. If you paid $100 to buy a ticket to a basketball game and lost the ticket, would you buy another ticket? Most people say no. But suppose you lost $100 in cash, would you buy a ticket? Most people say yes. Why? In both cases, you have lost $100 due to your carelessness, yet we find a big difference in results.
3. In Hong Kong, people were given $500 to spend. Some people who received a single $500 note held on to it for longer but once they started spending they spent it all quickly. Others were given five $100 notes – they started spending sooner but took a longer time to spend it.
4. In the US, people get income tax refunds after (extra amounts of) taxes are withheld at source throughout the year. This is their own money which the government has kept interest free for a year. Yet mot people who get refunds spend that money on hedonic purchases – vacations, massages, stereo systems – things they would never spend their salaries on. More generally, taking money away from people and giving it back to them makes them spend it more easily.
Judgments about a sum of money are meaningless without comparison (a reference point). We compare our salaries to others around us (or to our previous salary), we compare prices across stores. A $25 discount on a $75 product looks huge – on a $2,500 product it looks tiny. If an outcome is better than the references, then theory calls it a gain, otherwise a loss. And losses hurt us more than gains make us happy – this is called loss aversion and it simply suggests that the value people place o money and objects increases after they possess it. When taxes are withheld at source, we don’t experience a loss because we never see the deducted money. And when we get our money back it seems like a gain and hence spent on indulgences.
Money could also be categorized differently as a function of how it is earned. Salespeople and waiters typically categorize their income into a (steady) salary component; an (unpredictable) commissions / tips component; and a (lump-sum) bonus component. What’s more they spend the money differently – salaries go towards rent and paying necessities, tip towards small indulgences like dinners at restaurants and small vacations, and bonuses on major purchases like cars, and foreign vacation.
One other interesting manner of changing these categories is to change the physical form of a transaction. Back to the season ticket example, the sunk cost effect is very strong if the season ticket is presented as a booklet of five coupons rather than a pass. If there is a coupon for the fifth day’s play, it is more of a reminder of the past expenses and it psychologically forces some people to go. Similarly people spend notes of different denomination differently.
All of this sounds interesting but you’re wondering what importance mental accounting has for business. Research shows that mental accounting has huge implications for investment decisions, for retirement planning for credit card spending in marketing and for helping people make better decisions.