User:MGMT90018 2015S2 Mental Accounting/sandbox

1980
In 1980, Thaler raised the argument that in many situations. Consumers act in a way inconsistent with the economic theory. The orthodox economic theory prescribes what consumers should choose according to the rational maximising model. However, the theory quite often makes systematic errors in predicting what consumers do choose. The prospect theory advanced by Kahneman and Tversky provides a more descriptive model of consumer choice under uncertainty and illustrates instances where consumers’ behaviours can deviate from the normative economic model. Based on the prospect theory, Thaler argued that people tend to underweight the opportunity costs and fail to ignore the sunk costs making financial decisions under different circumstances. In addition, a consumer keeps searching for a purchase until he/she encounters a deal which offers a discount of a certain proportion to the original price. These consumers may voluntarily restrict their choices. Also, people may be inconsistent over time binding themselves to the current preferences.

Kahneman and Tversky use the notion of “psychological account” to discuss the frame and evaluation of compound outcomes which consist a series of gains and losses in 1981. A psychological account facilitates the evaluation of outcomes by setting a reference point which is neither a gain nor a loss but rather neutral and normal. For example, a psychological account is set for a cost of purchasing a car. The cost is neutral and the transaction may be evaluated against the cost as positive if the performance of the car excels or the price of this car is lower than that of the similar car in the market,otherwise, negative.

1984
In 1984 Kahneman and Tversky used the term of “mental accounting” to substitute for “psychological account” and further propose three accounts that outcomes may be framed as minimal account, which includes only differences and disregards features of two options share in common. The topical account where the outcome of a choice is linked to a reference level and a context in which a decision is made, and the comprehensive account is where an outcome may be assessed against the expense. They suggested that individuals may automatically turn to a topical account when making a decision, that is, they tend to evaluate gains and losses against a reference point rather than absolute terms. Later studies provide a closer look at the issue of the topical account and find that sometimes features of topical account could be influenced by evaluation methods. One is separate evaluation and the other is joint evaluation. In joint evaluation, people could have alternative values of the attribute, which gave choice of comparing these values and separate differences. In separate evaluation, people are presented with only one value to the attribute, and different people could bring different values. Therefore, it was not easy to compare it with alternative values. It was suggested that choices and predictions were often produced by joint evaluation because predictors could compare multiple options. Oppositely, an individual might face only one choice in their actual experience at one time using the separate evaluation. The topical account could be easily affected by using an improper mode which resulted in over-predicting difference and fell to make the experiential optimal option for themselves called mischoice and misprediction. Especially, Chatterjee, Heath and Min proposed that joint evaluation could lead people to the rational choice. Through comparison process, people could find out the real nature of the attribute so that choices were able to be rational and most attractive to them. However, in some situations, joint evaluation would result in increasing the sunk cost because people usually consider about sunk costs when determine a future investment.

1985
Employing the concept of mental accounting, Thaler developed a new model of consumer behavior based on cognitive psychology and microeconomics and introduces of the concept of "transaction utility". The measurement of transaction utility illustrates the perceived value of the ‘transaction', which is calculated as the difference between prices paid and the 'quote price' for the commodity. In other words, it is an expected price that consumers are willing to pay for. Transaction utility leads to two different kinds of effects in the market. Firstly, some products are bought from a very good deal like discount primarily. In the contrast, some sellers will avoid using a better offer. To develop this consumer behavior model, Thaler first replaces the utility function from economic theory with a more psychology-based value function from prospect theory to describe the consumer’s behavior, and highlights the concept of mental coding of gains and losses and the concept of reference outcomes. He then proposed a two-stage process of analyzing a transaction, the first stage being measuring the utility of a transaction with concerns to factors such as price while the second stage making a decision on whether or not to approve the transaction. He also incorporate household budgeting process into the concept of mental accounting.

1999
In 1999, Thaler summaried existing studies on mental accounting. He states that the accounting system has the decision of when to open and close the accounts. Recognizing gain or loss will have a bigger influence on people’s feeling than conceptual gain or loss. Therefore, in regarding to close an account, people under mental accounting would close the account which is better than the other because closing the better one would be more painful. Moreover, people are unwilling to close their accounts since they prefer avoid suffering losses. Thaler draw an attention to three components of this concept. The first component is the perception of outcomes and the making and evaluation of the decisions. The second is the way funds are obtained and labelled. The third is the frequency with which each account is balanced and evaluated. He argued that individuals and business entities are subject to mental accounting when making decisions, and they may not perceive one dollar in a certain mental account as exactly the same as one dollar in another account.

Non-fungibility
According to the traditional microeconomics theory, money will not be tagged, it has fungibility. However in fact, people would never put all their money into the same account to do the management. They will separate their accounts based on the nature of sources of wealth and put them into different multiple sub-account instead. Each account has a separate budget and the rules governing money and cannot be easily transferred from one account to another account. In other word, mental accounting obeys fungibility factors of money. The funding source is one of factors to consider when people start building mental accounts.For example, when people win some money by accident (e.g.gambling), they probably will run out their money in a short time like purchasing expensive stuffs without hesitation. Nevertheless, if they working for a long time gaining the same amount of money, they would thinking much more carefully before they make any financial decisions. The consumption purpose also influences mental accounting. For instance, the husband thinks spending $200 on a shirt is expensive, but his wife gives the $200 shirt to her husband as a birthday gift. Her husband will feels happy because the point of purchasing a shirt comes from the gift account instead of the clothing account, which brings a different emotional feeling but with the same financial behavior. It is argued by Kivetz and Simonson that people always keep themselves away from spending money on their enjoyment needs such as traveling. Most of people prefer spending money on essential life necessaries instead of their personal needs on enjoyment. However, once they acquire a chance, they will try their best to satisfy their enjoyment needs. Furthermore, people usually have self-control about their mental cash accounting, which results in the appearance of pre-commitment account to compel people have the enjoyment consumption. The relevant research shows that providing same value of prices, people are more willing to choose traveling price rather than cash even though theoretically the latter one has higher utility. This means that once people have chances, they will escape from their mental self-control about accounts administration and proceed to luxuries and non-essential consumption for their enjoyment.

The framing of gains and losses
The value function: The value function is established by the Kahneman and Tversky to explain how people make an economic decision. This theory has three significant features. (1)Focus on changes. This theory consider gains or losses on basis of reference points, which reflects some features of mental accounting.In the value function,it only analyses events based on themselves, rather than analyses the relationship between events and surroundings. (2)The sensitivity of the value function, regardless of gain or loss, is diminishing. Because the function of gain is concave, meanwhile the function of loss is convex. (3)Loss aversion. It presents people averse lost. That is for the same amount of money,the hurt person receiving is greater than the pleasure people feeling.In the mental accounting, effects of loss aversion are sustainable.

Decision frames: Kahneman and Tversky allocates decisions into three different decision frames: a minimal frame, a topical frame and a comprehensive frame. A minimal frame evaluates different options by researching the difference between them and ignoring their common aspects. A topical frame analyses decisions through separately comparing the different consequences to a reference points to conclude an optimal choice, and mental accounting is actually a topical frame. A comprehensive frame assesses all relevant factors that have influences on decision made to determine the best option, and the factors include not only current wealth but also future cash flow.

Hedonic Framing: This theory is stated by Thaler to explain how people code combination of events,because Thaler assume people will choose option to maximize their happiness.There are four principles of hedonic framing.(1)Segregate gains (because based on value function,the gain function is concave);(2)Integrate losses(because based on value function,the loss function is convex);(3)Combine little losses with big gains(represent human don't like loss);(4)separate little gains from big losses(considering the pleasure from gaining small gains is larger than the slightly reducing of large losses).Mental accounting is regarded as hedonically as possible.the rule of hedonic framing can help the researchers to analyse what actions that people will do in the real life when they meet these situation. Hedonic framing is affected by two factors. One is condition framing. The mental accounting principles proposed by Thaler illustrates that the value of the multiple events is determined by whether they are integrated or separated mentally before they are estimated individually. The theory of Hedonic framing, one of its three features of principles show that people could usually be happier if they segregate gains or integrate losses. However, Kim indicated that this theory did not apply to all situations. He gave an example of segregation and integration: (1) $120.95 for a stroller plus $19.95 for shipping (2) $140.90 for a stroller including shipping. This example resulted in multiple losses as at this moment people preferred segregated payment which is choice 2. Therefore, when surcharge is easily calculated and people are perceived timely at the price, segregated prices may bring a higher perceived payment than integrated prices. . The other is relative pricing. It was found by Health, Chatterjee and France that different expressions given to prices affected the perception of accounts by people. This theory was embodied by the situation that at the same level of incomes, the prices illustrated by relative pricing could strengthen the preference of separating incomes by people. Meanwhile, at the same level of losses, prices illustrated by relative pricing, which might also support people’s preference of integrating losses. Under this situations of large gains and small losses (large losses and small gains), people will make a choice as same as the Hedonic framing of mental accounting when using absolute pricing, which is integrating large gains and small losses and separating large losses and small gains. However, when the price is suggested by relative values, people will make an opposite choice. It is separating large gains and small losses and integrating large losses and small gains. Therefore, people are not always following the Hedonic framing from mental accounting and they are influenced by the price framing.

The failure of the hedonic editing hypothesis: Hedonic editing is that people can be told to edit or parse the multiple outcomes they consider or experience in a way that could be considered optimal. The symbol '&' is used to denote the cognitive combination of two outcomes, then hedonic editing is the application of the following rule: I(X & y) = Max[ v(x + y), v(x) + v(y)]. Thaler and Johnson find that for gain the reality follow the principle of hedonic framing, whereas for loss,person prefer to segregate loss which can give them more happiness,because simple combination can't diminish losses'impact.

Implication on decision making
Compounding Rule Implications: Compounding rule implications states that the results from analysis of mental arithmetic have an influence on marketing decisions in the area of design and products, as well as the choice of the distribution of products. There are two principles in the results. (1)Segregate Gains: It is easy to understand the illustration that when a product attracts more than one dimension, it is satisfied to do the separation evaluation for each dimension. This principle can be used in two levels. The first level is that there are many functions in one product. Each function needs to be demonstrated. The second level is bonus items such us “if you buy right now and you can receive a small gift”. (2)Integrate losses: it is possible for consumers to prefer integrate losses. There is a little impact on loss if you add $50 less to $1000 existing loss. This principle means that sellers hold a distinct advantage in sales and the cost can be charged into another larger purchase.

Transaction Utility Implications: (1) Sell outs and scalping: this principle illustrates that the adjustment of prices will be continue until the balance of supply and demand. Although the confidence is well put in the relevant analysis, there are still some consistent failures of distribution in some markets. (2) Methods of raising price: if a seller who holds a monopoly on some popular products may realize that the price being changed is mostly under those of market clearing price. This theory illustrates three different strategies. The first strategy is that Perceived reference price can be increased by step by step. The second strategy is to raise the minimum sales price or make combination to other sales products. The third strategy is to make the product obscure and make the bargain from disutility to salient. (3) Suggested retail price: Many suppliers provide a suggested retail price (SRP) to shops for their products. According to the fair trade laws, SRPs is the only suggestion to retail shops, but there are some differences among products between SRPs and market prices. In some products, SRP often is used as the market price but some products’ prices are more than SRPs.

Budgeting Implications: The budgeting rules can be analysed that there are variety categories and time specific shadow prices. These can be implicated into individual failure of undertaking some internal arbitrage operations, which can increase utility in principle. There are different levels of individual transactions of mental accounting decision making. One of components of mental accounting is categorization or labelling. There are three levels in this principle. The first level is expenses are divided into budgets including apartment or eating. The second level is wealth will be allocated into different accounts like pension and health care. The third level is that there are different categories of incomes like interest and salary. These three levels are perfectly fungible as assumed in economics.

Price discount: People may assess a price reduction with reference to its absolute value, relative value or to other expense. An experiment shows that $5 on a $15 calculator 68% of the respondents whereas the same dollar amount of discount on a $125 calculator. However, when the amount of absolute monetary savings increase beyond a certain threshold, the mental accounting effect become less manifest, that is, more people tend to take extra effort to save that amount.

Payment decoupling: The purchase consumption may reduce the perceived cost. Consumer will 'acquire benefit' from prepayment as the prepayment will decouple the perceived cost from purchasing a commodity. For example, credit card and flat-rate service. (1)Credit card decouples the cost mainly for 2 reasons. First, it defers the payment by several weeks, which makes actual payment becomes later than the purchase also separate from the purchase. Second, once the bill arrives, the purchase will be mixed in the context of other bills. (2)flat-rate service decouples the payment in a different way. After making a prepayment for flat-rate service, the consumer will see the cost of usage from the service being zero.

Consumer credit decision processes: When people estimate the duration of loans, the accuracy of the estimation varies with different supplementary information. It has been found that when given the Annual Percentage Rate of interest and the monthly interest charges, respondents not only assess the duration with higher level of error, a tendency of underestimate the longer term loans, but also experience difficulty when making the assessment, whereas the information of total interest charge substantially reduced the estimation bias and perceived difficulty.

The pricing of financial options: Rational portfolio investors are supposed to care only about the expected utility of the portfolios rather than that of the individual components in the portfolio, but in practice investors tend to have in mind a safe account for stable wealth level and a risky account for speculation, and to assign bonds to the former and risky assets such as stock and options to the latter. A portfolio therefore can be regarded as a layered pyramid combining a bottom layer to avoid poverty and a top layer for a shot at riches.

Mental accounting of time: People maintain mental accounts for time the way they do for money. First, people tend to value time differently when it is for work-related objective than when it is for leisure-related objective. A delay of a flight on a business trip seems more upsetting than one on a holiday trip. Second, people tend to allocate extra time gained from work to non-work related activities, regardless of the amount of the time. For example, when someone is going to visit a bookstore for work purpose only to find out that he/she has to wait an hour for the bookstore to open, he/she is more likely to spend the hour on non-work related activities such as having coffee with friends than on working on laptop. In addition, people may have larger budget for work-related activities, which may be explained by the inherent work orientation or work ethic.

Advance purchases, sunk costs, and payment depreciation: Sunk costs may affect subsequent decisions, but they may not linger indefinitely. There are several arguments. First of all, the more money spent on the commodity, more frequently the consumer will use them. Second, even though the consumer stops using the commodity that they paid much money for, they will still keep them. That is the more money spent on the commodity, the longer time the consumer will keep them. Third, regardless of how much they spending on the commodity, it will be fully depreciated before the consumer casts off them eventually. However, although theoretically sunk cost may have influence on decision making, people always ignore sunk cost in their daily life.

Mental accounting cost
More generally, a mental accounting cost or mental transaction cost, a kind of transaction cost, is the cost of making an useful decision. Customer's mental transaction costs come from three sources: uncertain cash flows, incomplete and costly observation of product attributes, and incomplete and costly decision making. Shirky explained that mental transaction cost as "the people pushing micro-payments believe that the dollar cost of goods is the thing most responsible for deflecting readers from buying content, and that a reduction in price to micropayment levels will allow creators to begin charging for their work without deflecting readers . This strategy doesn't work, because the act of buying anything, even if the price is very low, which creates what Nick Szabo calls mental transaction costs, the energy required to decide whether something is worth buying or not, regardless of price. The only business model that delivers money from sender to receiver with no mental transaction costs is theft. In many ways, theft is the unspoken inspiration for micropayment systems. For example, the salami slicing exploit in computer crime, micropayment believers imagine that such tiny amounts of money can be extracted from the user that they will not notice, while the overall volume will cause these payments to add up to something significant for the recipient. However, users do notice the situation because they are being asked to buy something. Mental transaction costs create a minimum level of inconvenience that cannot be removed simply by lowering the dollar cost of goods."

Counteract the mental accounting bias
Prelec and Loewenstein propose that the customer will fell painful for the payment immediately after the purchase, which will reduce or will even offset the happiness produced from consumption. The aching feeling act a significant role relating to consumer’s self-control.

Decoupling of payment and consumption: Shafir and Thaler present that decoupling of payment can decrease the harmful impact on feeling painful from purchase, and increase the satisfaction and the probability of hedonic consumption. People will perceive a good purchased for free even though it is able to be traded in the market, this kind of perspective can make consumers become better-off by releasing them from excessively prudent.

Mental accounts and hedonic self-regulation: it is ambiguous for consumers between the term ‘economically losses’ and ‘psychologically gains’.

When purchasing goods, a consumer is more probably to redeem a certain-valued-coupon when the amount can be saved from purchasing any goods in that store instead of only saving the coupon value on specific goods, and the savings on the coupon will be perceived as extra income that people would prefer to spend on purchasing luxuries, as a gift given to themselves.

Consumers perceive the cash to be placed into a “general account” used for regular, essential expenditure and it is hard to correspond with luxurious expenditure. Thus, they tend to pre-designate that reward as a luxury. This prop up the view that mental accounting can help counteract the miserable feeling from consumption and a propensity to under-consume luxuries.