How does mental accounting affect economic decision making?

Mental accounting influences economic decision making by causing individuals to categorise and treat money differently based on its source or intended use.

Mental accounting is a concept in behavioural economics, developed by Richard Thaler, which refers to the cognitive process of categorising personal finances into separate accounts. This mental categorisation of money can significantly influence spending, saving, and investment decisions, often leading to irrational economic behaviour.

For instance, people may treat money differently depending on its source. A common example is a tax refund, which many people view as a bonus or windfall, leading them to spend it more freely than they would their regular income. This is known as the windfall gain effect. Similarly, people may be more willing to spend money on a credit card than cash, as the physical detachment from the money makes the spending feel less real, a phenomenon known as the credit card effect.

Mental accounting also affects how people allocate money for different purposes. People often create separate mental 'buckets' for different types of expenses, such as rent, groceries, entertainment, and savings. This can lead to illogical decisions, such as keeping money in a low-interest savings account while carrying high-interest credit card debt, simply because the money in the savings account is mentally categorised as 'savings' and therefore off-limits for paying off debt.

Moreover, mental accounting can lead to the sunk cost fallacy, where individuals continue to invest in a losing proposition because they consider the money they've already spent as a separate mental account. This can lead to poor investment decisions, as the rational choice would be to consider the future prospects of the investment, not the sunk costs.

In conclusion, mental accounting can significantly affect economic decision making by causing individuals to treat money differently based on its source or intended use. Understanding this concept can help individuals make more rational financial decisions and avoid common pitfalls associated with mental accounting.