Summary of the ‘Mental Accounting Matters’
Richard H. Thaler (1999) in his article ‘Mental Accounting Matters’ discussed the procedure followed during mental accounting. Mental accounting can be defined as the cognitive operations that individuals and households use to organize, evaluate and keep track of their finances. The decision is arrived at by inferences to certain points and aspects, and observance of behavior. There are three components of mental accounting system. First is the perception of the outcomes, making decision and evaluation. The second is the assignment of activities of the specific accounts to be performed, and thirdly, the frequency of the evaluation of the activities; weekly, monthly, etc. the analysis entails a consideration of the psychological choices.
People make decisions by consideration of the value of the function as well as use of the prospect theory. The value function has three components that are the attributes of the human pleasure machine. First is the value function that is defined over gains and losses as referred from a certain point. Secondly, the gains and loses function that has a diminishing sensitivity. The third is the loss aversion; the inherent desires to avert all foreseeable losses. The value function describes events that influence the perception and hence decision making. This can be done by considering the minimal account, topical account, or comprehensive account. The differences in value influence the hedonic choices that lead one to save. A save of $ 5 is huge for a commodity whole price is $ 15 while this may be very little for a commodity whose price is $ 125. The mental accounting does not involve a single event in most cases. Therefore, there is need to combine all the events into one using a model that outlines all the gains and losses to maximize utility.
The procedures and rules of hedonic framing describe the way people think and how they would want the world to be organized. The decision making in mental accounting may view the costs as losses. This can be overcome by consideration of the overall good of the commodity or service. This influence ones decision. Therefore, one wonders whether mental accounting is of any benefit. The mental accounting procedures and models help one to economize time, think of the costs and control one self. However, this is not always the case all the time. People buy things they do not want simply because the deal is too good.
As it concerns opening and closing accounts, paper losses are less painful than actual losses. The opening and closing has an influence on the advance purchases, sunk costs and payment depreciations. Therefore, right decisions have to be made at the opportune time. Prepayment and use of credit cards also influence the decision on whether to make purchases or not. This may make prices look much smaller if paid bit by bit other than a cumulative single payment. Labeling that categorize ones finances as expenditure, windfall, wealth is considered in the decision making especially when one is drawing the budgets.
Consumption categories need to be established should and endure that the budget remains fungible to avoid distortions in the expenditure. The lack fungibility in the budget may lead to problems of self-control in purchases and consequently spending outside the actual budget limits. Self-control can be improved by placing funds in accounts that are not accessible easily. Fund in savings account is difficult to access than funds in the recurrent expenditure account. Therefore, the limits in these accounts need to be checked and make proper decisions. Choices need to be bracketed by prior outcomes and risks involved, aversion of losses and heuristic considerations. The effect of been trapped into sunk cost can be reduced by teaching people on how to fix it.This may include the processed of modification of the mental procedures to archive certain goals.
Richard H. Thaler (1999). Mental Accounting matters. Journal of behavioral decision making; Sep. 1999;12, 3.