Perceptions of Cost

Imagine you’re on your way to see a play. As you approach the ticket booth you realize that the ticket that you purchased in advance for $10 is no longer in your wallet.

To get into the event, you will have to buy another one. Take a moment to decide if you would cough up the money to see the play regardless. If you’re like more than half of individuals who were asked about their reaction to this scenario in a study described by Khaneman and Tversky (1983), you wouldn’t buy the ticket. After all, it would feel as though you’re paying $20 for something that you had initially only budgeted $10 for.

Now, imagine an alternative scenario where you hadn’t pre-purchased the ticket. But, as you approach the ticket booth, you realize that you’ve lost $10 from your wallet. How likely are you to continue to the ticket counter and make the purchase? As you might suspect, when people predicted their behavior in this alternative scenario, they were far more likely to purchase the ticket and see the play regardless of the lost funds (84% believed they would).

From a rational perspective, you may recognize that this makes very little sense. In both situations, you will be entering the theater with $20 fewer dollars than you had before. Whether you lost a $10 bill or a $10 ticket should have no impact on your decision. So why does it?

Humans tend to compartmentalize money based on factors like where it comes from or what it is intended for. You can see this most clearly when people stash money in jars with labels indicating where it should be spent. What’s interesting from a behavioral perspective, and valuable for anyone selling or designing products in the financial services industry, is how we think of that money once it’s been allocated.

Researchers find that our conceptualization of our money depends greatly on which “mental bucket” we’ve stored it in. Most importantly, our spending behaviors are largely influenced by these categories. So rather than seeing the $10 ticket and the $10 bill as equal, we label the ticket according to what it was intended for (i.e. theatre money) and treat it very differently.

Often, a mental accounting approach is a helpful for money management – it can facilitate savings behaviors and encourage better budgeting. However, there are times when it can cause us to make irrational decisions (such as the example above) or worse, develop damaging habits. For example, it’s very common for people to spend unexpected funds (i.e. bonuses or tax rebates) on frivolous items even if they are carrying a large debt on their credit card. Unlike the portion of their paycheck that they may dedicate to paying off a credit card bill, the windfall hasn’t been allocated to a category and it’s far easier to justify spending it on something more immediately gratifying.

Mental accounting is just one psychological phenomenon that can spur irrational decision-making when it comes to finances.

Reference: Kahneman, D., & Tversky, A. (1984). Choices, values, and frames. American psychologist, 39(4), 341.