… or How Everyone Debits and Credits Themselves into Irrational Decision Making
by Richard Thaler has a question for you. Imagine that you have purchased a ticket to see a play. You arrive at the theatre, but as you reach into your pocket to find the $25 ticket you discover it’s gone. You now have a dilemma. You can either pay another $25 for a new ticket, or you can leave the theatre without attending the show. What would you do?
Many people would say that if you choose to purchase another ticket, you may now feel that you have paid $50 to attend a $25 play.
Thaler now offers you a different question. You arrive at the theatre to see a play, where you will purchase the ticket at the theatre’s box office. As you open your wallet to pay, you discover that $25 in cash is missing. Here’s the question: Would you still purchase a ticket to attend the play?
If you are like most people, you will pull out some more cash and purchase the ticket. In fact, in experiments conducted on similar situations as above, researchers found that only 46% of people would buy a new ticket in scenario one, while a full 88% would buy a ticket in scenario two.
What accounts for the difference? Mental accounting!
… both scenarios are identical in outcome …
Thaler is a Professor of Behavioral Science and Economics at the University of Chicago, and a proponent of mental accounting theory. Briefly stated, the theory proposes that people have different psychological accounts to tabulate running expenditures. In the first scenario people have already debited the recreation and entertainment account, and so are reluctant to add another charge to this total. However, in the second scenario the misplaced cash has not been allocated to the recreation and entertainment account and so almost twice as many people are willing to spend the additional $25 to see the play. Here’s the takeaway: both scenarios are identical in outcome – your wallet will be $50 lighter!
We must remember that our customers do not have a pool of money to spend from, but rather compartmentalized pockets of money, all of which have different budgets, limits, and resulting pain or joy from “surprises” in these accounts.
Here are some other examples from Thaler on how mental accounting affects situations:
- Imagine you bought some shoes that were comfortable in the store, but now are painful to wear. What do you do? Typically it depends on how much you paid for the shoes. The more you paid for them, the more you will try to live with the discomfort. Eventually you may stop wearing them, but refuse to throw them out. Finally, you throw them out, but only after sufficient time has passed to fully depreciate the original purchase amount.
- A study done on a health club chain that charged its members twice a year for dues discovered that the highest usage of the facilities was in the month the payment was due. It then declined in the following months, until another payment month was due whereupon usage spiked.
- From an income perspective, one perplexing question many New Yorker’s have is why there are so few taxis on the streets on days with inclement weather. It turns out that one of the explanations lies in the mental “income” account of the drivers. Because it is more dangerous to drive in bad weather, when many cabbies hit their mental “income” target for the day they have a stronger tendency to close shop and go home.
Personal Example
My wife and I recently witnessed mental accounting first hand when we purchased a new home. We quickly settled on the purchase price, and were quite happy with the amount we paid. However, when completing the new renovations our original budget ballooned from 1X to 1.5X to 2X. Each additional change we made to the plans resulted in additional angst as we saw the dollars go out the door.
But if we look at this from a mental accounting frame we can quickly see that we had arbitrarily set up two mental accounts for the purchase: 1) Home and 2) Renovations. There was complete certainty in the budget for the Home purchase, but uncertainty in the budget for Renovations.
Here’s our realization: If the seller had offered the home to us for the original purchase price PLUS the 2X dollars in renovations but bundled together in one single price for a newly renovated home, our angst would have been ZERO. Once we re-framed the purchase in this manner we quickly got back to feeling happy about the price we paid.
Understand your customer’s mental accounts and help them to allocate and budget these ledgers.
