Our weekly explainer on economics using lessons from popular culture. In Installment 20, Salman Khan demonstrates Mental Accounting.
If you think the perfect Bollywood movie scene does not exist, then you haven’t seen our friendly neighbourhood hero cum economics professor Salman Khan slap the late Amrish Puri (not related to the author) for running over a child with his car in David Dhawan’s Mujhse Shaadi Karogi.
Despite the irony, Salman, as usual, has some economics lessons for us. In a scene from the movie (see image below), he separates his money into different accounts. He does this by putting his cash in multiple earthen pots which are labeled with a spending objective. You can see that there is one for his sister’s marriage and another for his grandmother’s medical expenses.
According to Richard Thaler, the winner of the Swedish National Bank’s Prize in Economic Sciences in Memory of Alfred Nobel, (commonly referred to as the Nobel Prize in Economics) for his contributions to behavioural economics, Salman Khan just practiced some Mental Accounting.
Let’s take an illustrative example to understand Mental Accounting. You’ve got tickets to a stand-up comedy show featuring your favourite comedian. You’ve paid ₹500. Imagine two future courses of this story.
Course 1: You go to the the venue of the stand-up comedy show. You buy a ticket, realise that there is some time for the show to commence, and go out for a cup of coffee. When you get back to the theatre, you find out that you have lost the ticket. You go to the ticket counter where you’re told that the only way in which you can get to watch the show is by buying a second ticket, because there’s no evidence of the first one. Would you buy a second ticket?
Course 2: You go for a stand-up comedy show to a theatre. You’ve planned to spend ₹500. But before you buy the ticket, you realise that you have lost the ₹500 in cash. So now the question is, would you buy a ticket to the show?
As an economist, these two scenarios are identical. You’ve lost a piece of paper which was ₹500 in value because of your own negligence, and you intended to use it to enter the same stand-up comedy show. Yet, Tversky and Kahneman in their 1981 paper share the results of an experiment which shows us that only half the respondents in the first story are likely to buy another ticket, but almost ninety percent of the respondents will buy a ticket in the second story.
The reason? Mental accounting. Respondents tend to label money with certain names. And the moment the money is labeled differently, it gets spent differently. Basically, all of us behave like accountants.
For example, if you decide to watch a stand-up comedy show priced at ₹500 , what you might end up doing is to create an account in your head. Say it’s called ‘The Comedy-Show’. The account has got a budget of ₹500. And as soon as you’ve bought the ticket, that money is gone. It’s blown. Hence if you lose possession of the ticket, there is nothing left in that fund. On the other hand, in case you lose cash, it’s a completely different mental ball game, because that comes from the general expenses account. The lesson here is that people tend to categorize their money into diversified groups, and as a result, they spend money differently.
Viviana Zelizer, a sociologist at Princeton University, calls this phenomena ‘Tin Can Accounting’, perhaps more akin to Mr Khan’s ways.
Real-World Applications of Mental Accounting
Mental accounting as a concept is key to designing direct benefit transfer programmes. The funds in the direct programme could be labeled and categorised into multiple ‘mental jars’, thus nudging the beneficiaries to shape their spending pattern in a certain way.
Mental accounting can cause irrational use of money. It’s been proven that people treat money differently depending on its source. There is a tendency to spend a lot more of ‘found’ or unexpected or windfall money, such as job bonuses and gifts, in comparison to a similar quantum of money that comes from a regular source, like a salary, which they are more likely to save.
Logically speaking, money should be fungible, regardless of its origin. Spending money according to its source disobeys that premise. If one is aware of the concept of mental accounting, one can reduce frivolous expenditure of ‘found’ money, for ‘found’ money is no different from money that one has earned by working on a daily job.
Thaler gives us an example of a classical situation that can be avoided by being aware of the mental accounting bias.
Mr and Mrs L and Mr and Mrs H went on a fishing trip in the northwest and caught some salmon. They packed the fish and sent it home on an airline, but the fish were lost in transit. They received $300 from the airline. The couples take the money, go out to dinner and spend $225. They had never spent that much at a restaurant before.
Mental Accounting In Investing
The mental accounting bias is also prevalent in investing. Often investors tend to segregate their money differently which results in divergent behaviour while investing. They may divide their investments between a safe investment portfolio and a speculative portfolio in order to prevent the negative returns that speculative investments may have from affecting the entire portfolio. The main problem with this modus operandi is that despite all the work and money that the investor spends to split the portfolio, his net wealth will be no different from if he had held one larger portfolio. For example, investors who receive any unexpected capital gain in their assets or special dividend or any other onetime gain would be more speculative with their money and invest in it aggressively and adventurously. On the other hand, investors might be more cautious in investing their retirement savings as fixed income instruments despite these investments juts giving them returns on such investments which might be less or equal to growth in inflation.
An investors with the knowledge of the mental accounting bias would realise that too many times, the effort and money put in to separate the portfolio is redundant as the his net wealth will be no different from if he had held one larger portfolio.
Mental Accounting being a cognitive bias, the division of the money usually happens in the mind, but we can excuse Mr Khan for using an empty pot as a perfect substitute for his frontal lobe.