JUDGMENT AND DECISION MAKING
MINORUNDERSTANDING AND INFLUENCING DECISIONS IN BUSINESS &
SOCIETY
Vrije Universiteit AmsterdamFaculty of Economics and Business Administration
Summary of all Texts.
Week 2: Mental Accounting System 1 & System 2; Heuristics & Biases; Availability Bias
Thaler, R. (1999). Mental accounting matters. Journal of Behavioral Decision Making, 12, 183-206.
Mental Accounting: “is the set of cognitive operations used by individuals and households to organize,
evaluate, and keep track of financial activities”.
This paper: summarizes the current state of our knowledge about how people engage in mental accounting
activities.
Of: “The entire process of coding, categorizing, and evaluating events”.
Three components of Mental Accounting are most important here:
1. How outcomes are perceived and experienced, and how decisions are made and subsequently evaluated
The consumer's choice can be understood by incorporating the value of the `deal' (termed
transaction utility) into the purchase decision calculus.
2. The assignment of activities to specific accounts.
3. The frequency with which accounts are evaluated and `choice bracketing'. Accounts can be balanced
daily, weekly, yearly, and so on, and can be defined narrowly or broadly.
Important: Each of these components of mental accounting violoates the economic principle of Fungibility!!!
Money in one mental account is not a perfect substitute for money in another account. Because of the violations
of fungibility, metnal accounting matters.
The framing of gains and losses
The Value Function
- The Mental Accounting Theory is based upon the Value Function of the Prospect Theory (Khaneman &
Tversky’s).
o Value Function: can be thought of as a representation of some central components of the
human perceived pleasure machine.
It has three important features, each of which captures an essential element of mental
accounting:
1. The value function is defined over gains and losses relative to some reference
point. The focus on changes, rather than wealth levels as in expected utility
theory, reflects the piecemeal nature of mental accounting. Transactions are often
evaluated one at a time, rather than in conjunction with everything else.
2. Both the gain and loss functions display diminishing sensitivity. That is, the gain
function is concave and the loss function is convex. This feature that the
difference between $10 and $20 seems bigger than the difference between $1000
and $1010, irrespective of the sign.
3. Loss aversion. Losing $100 hurts more than gaining $100 yields pleasure: v(x)< -
v(-x).
Decision Frames
Role of Value Function in Mental Accounting is very important.
The way a decision is framed will not alter choices if the decision maker is using a comprehensive, wealth-
based analysis. Framing does alter choices in the real world because people make decisions piecemeal, in uenced
by the context of the choice.
,Mental Account: “An outcome frame which specifies (i) the set of elementary outcomes that are evaluated
jointly and the manner in which they are combined and (ii) a reference outcome that is considered neutral or
normal”.
Is een Topical Account: “Relates the consequences of possible choices to a reference level that is
determined by the context within which the decision arises” (zie verder aantekeningen p.6).
Reference Point: “status quo”.
Hedonic Framing
Why are we more willing to drive across town to save money on a small purchase than a large one?
That the utility of the saving must be associated with the differences in values rather than the value of
the difference.
Hedonic Framing: the way of evaluating joint outcomes to maximize utility:
1. Segregate gains (because the gain function is concave).
2. Integrate losses (because the loss function is convex).
3. Integrate smaller losses with larger gains (to offset loss aversion).
4. Segregate small gains (silver linings) from larger losses (because the gain function is steepest at the
origin, the utility of a small gain can exceed the utility of slightly reducing a large loss).
If one wants to describe the advantages and disadvantages of a particular product in a way that will
maximize the perceived attractiveness of the product to consumers, the principles of hedonic framing
are a helpful guide.
To summarize, the evidence suggests that the rules of hedonic framing are good descriptions of the way people
would like to have the world organized (many small gains including silver linings; losses avoided if possible but
otherwise combined). People will also actively parse outcomes consistent with these rules, with the exception of
multiple losses.
Implications
There are two important implications of these results for mental accounting.
1. e We would expect mental accounting to be as hedonically ecient as possible. For example, we should
expect that opportunities to combine losses with larger gains will be exploited wherever feasible.
2. Loss aversion is even more important than the prospect theory value function would suggest, as it is
idicult to combine losses to diminish their impact.
Mental Accounting Decision Making
Transaction Utility
Khaneman & Thaler: “Reject the idea that costs are generally viewed as losses.”
Consumers get two kinds of utility from a purchase:
1. Acquisition Utility: Is a measure of the value of the good obtained relative to its price (similar to the
economic concept of consumer surplus).
2. Transaction Utility: Measures the perceived value of the ‘Deal’. It is defined as the difference between
the amount paid and the ‘reference price’ for the good, that is, the regular price that the consumer
expects to pay for this product.
This leads to two kind of effects in the marketplace:
1. Some goods are purchased primarily because they are especially good deals.
2. Some purchases that would seemingly make the consumer better off may be avoided because
of substantial negative transaction utility.
Opening & Closing Accounts
One of the discretionary components of an accounting system is the decision of when to leave accounts `open'
and when to `close' them.
The mental accounting of paper gains and losses is tricky (and depends on timing Ð see below), but one
clear intuition is that a realized loss is more painful than a paper loss. When a stock is sold, the gain or
, loss has to be `declared' both to the tax authorities and to the investor (and spouse). Because closing an
account at a loss is painful, a prediction of mental accounting is that people will be reluctant to sell
securities that have declined in value.
Payement Decoupling: The (pre)payement is decoupled from the purchase.
Consequences:
- The costs seem to be very small because you have made them on before hand
- The link between the payement and the specific consumption is not salient anymore.
You get the: Flat Rate Bias: in telecom: People don’t like the feeling of having the meter running. So they pay
on beforehand an amount of money (which is more than if they pay per thing).
So examplesof Payement Decoupling by organizations: Telecom, Insurence, Credit Card.
Budgeting
Money is commonly labeled at three levels: expenditures are grouped into budgets (e.g. food, housing, etc.);
wealth is allocated into accounts (e.g. checking, pension, `rainy day'); and income is divided into categories (e.g.
regular or windfall). Such accounts would be inconsequential if they were perfectly fungible (i.e. substitutable)
as assumed in economics. But, they are not fungible, and so they `matter'.
Consumption Categories
Deviding spending into Budget Categories serves two purposes:
1. The budgeting proces scan facilitate making rational trade-offs between competing uses for funds
2. The system can act as a self-control device
There is considerable variation among households in how explicit the budgeting process is.* As a rule, the tighter
the budget, the more explicit are the budgeting rules, both in households and organizations.
Implications of Violtations of Fungibility
Violation of fungibility by: Budgeting Process
Whenever budgets are not fungible their existence can in uence consumption in various ways.
1. One example is the case in which one budget has been spent up to its limit while other accounts have
unspent funds remaining.
Implication: This situation is common in organizations. It can create extreme distortions especially if funds
cannot be carried over from one year to the next. In this case one department can be severely constrained while
another is desperately looking for ways to spend down this year's budget to make sure next year's is not cut.
This is also for “Time”.
2. Another violation of fungibility introduced by the budgeting system occurs because some budgets are
intentionally set `too low' in order to help deal with particularly insidious self-control problems.
3. The mental accounting analysis suggests that the best gifts are somewhat more luxurious than the
recipient normally buys, consistent with the conventional advice (of non-economists), which is to buy
people something they wouldn't buy for themselves.
The analysis of gift giving illustrates how self-control problems can in uence choices. Because
expensive bottles of wine are `tempting', the couple rules them `olimits' to help control spending. For
o
other tempting products, consumers may regulate their consumption in part by buying small quantities
at a time, thus keeping inventories low. This practice creates the odd situation wherein consumers may
be willing to pay a premium for a smaller quantity.
To control their consumption, consumers pay more for less of what they like too much'.
Wealth Accounts
Violation of fungibility by: Location of Funds
Another way of dealing with self-control problems is to place funds in accounts that are off-limits.
