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Saturday, November 20, 2010

Mental Accounting

How you combine two financial outcomes depends on the perceived benefits
I have been delivering annual lectures in Europe for quite few years now. At times, I was paid for my efforts before I left the continent, even as the assignment was still on. On other occasions, I didn’t get paid till after my return from the trip. I recall that I have always enjoyed my teaching trips more and spent more lavishly when I was paid before my return rather than after it.
This is because when I wasn’t paid on the spot, I spent more gingerly, though there has never been any risk of default from the university! On the other hand, when I got the payment in the middle of my assignment, I ‘felt richer’ and ended up spending much more!
Clearly, in my mental accounting, spending in Europe and earning in Europe belong to one set of accounts, while the money earned elsewhere belongs to a different set of accounts! So, I feel happier when my European spending is financed by my European earning on the same trip.
Ask yourself a simple question: if you had an advance ticket of Rs 500 for a long-awaited play and, upon reaching the venue, you found you had lost the ticket, would you buy another one on the spot? In contrast, if you did not have an advance ticket and went to the venue with the idea of buying a spot ticket, and found that you had lost a Rs 500 bill from your wallet, would you still buy the ticket for Rs 500?
Most of us might say no in the first case, but yes in the second, since in our mental accounting, the loss of Rs 500 belongs to the ‘ticket account’ in the first case, but to ‘cash account’ in the second, even though in both cases, the loss is of identical value.
Assume again that you go shopping and find tea trays on ‘sale’ in large, medium and small sizes
The mental accounting processes work towards making an individual happier, if not ‘rational’.
. Your tea table is a small one. The normal prices for the trays are Rs 400, Rs 300 and Rs 200, respectively. On the ‘sale’, however, all of them are priced at, say, Rs 150.
Which of the trays are you most likely to buy? Most people faced with the situation are more likely to go for the large ones, even if it was a tad too big for their small table! Clearly, in our mental accounts, there is a larger perceived ‘saving’ in buying the large tray.
Assume yet again that you are out to buy yourself a shirt (or a book). You find the shirt (or the book) you want in a supermarket for Rs 2,000 (or the book for Rs 250). At the supermarket, the shirt (or the book) salesman informs you that in another branch of the same store, some 20 minutes’ walk away, the shirt (or the book) is on sale at Rs 1,960 (or Rs 210).
Will you make a trip to the other store? Most of us may make the trip for the book, but not for the shirt, as if Rs 40 saved on a Rs 250 item is better than the same amount saved on a Rs 2,000 item.
How do consumers combine two or more financial outcomes? The mental accounting processes, perhaps, work towards making the individual happier, if not ‘rational’.
For instance, who is happier? One who wins two little lotteries in the club of Rs 100 and Rs 150, or one who wins a single lottery worth Rs 250? Most of us are likely to rate the double lottery winner as being happier, while finance theory will postulate equal degree of happiness for the two, since value of 100 + 150 must equal 250!
So, now, will you prefer to give a large discount on a single product that you sell or smaller discounts on two different products? Don’t rush into an answer!

The author is a former Professor of Finance, IIM, Ahmedabad. More of his works may be seen at
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