Mental accounting gave Thaler the Economy Prize

Published: 2017-10-12

Behavior Economist Richard H. Thaler was given the The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2017. His research focuses on how we simplify our financial decisions, why we suffer such difficulties in keeping our New Year’s resolutions—and our weakness for short-term temptations.

How does flowers and chocolates make us so happy? Because our own mental account for this genre is quite strict. At least this is how economists explain the theory of mental accounting of Richard H. Thaler, the Economics Sciences Laureate of 2017.

“Mental accounts or mental accounting is a term Thaler is very famous for. It describes the accounts we create in our minds to categorize our financial transactions: one pleasure account, one savings’ account and so on. One of the reasons we do this, is that it can help us to self-control and be more able to resist temptations,” says Erik Wengström, researcher at the Lund University School of Economics and Management.

“It’s a way for us to curb our consumption. Many people have a maximum amount for themselves when they are to buy a bottle of wine, for example. They can tell themselves: I must not spend more than 10€ on alcohol. Then they leave the store, go out in the street to buy themselves a 4€ coffee without even thinking of it.”

Because the coffee and the liquor do not exist in the same mental account.

Making the process of saving a little less hard

If you have children, you might have accounts in your bank that you named after them. This is also all about mental accounting.

“We do this in order to make it difficult for ourselves to use up the money for other purposes than those that they’re originally ment for,” says Erik Wengström.

Another area where the mechanisms with mental accounts appear very clearly are—gifts:

“What are the perfect things to give away? I’ll tell you: those for which people have narrow accounts—wine, flowers, chocolates. Many of us limit ourselves quite rigorously regarding this, which means that it does not require much to giving the impression that a gift is generous. You will be much happier for chocolates worth 20 €, than being given the same amount in cash, says Erik Wengström.

We have an aversion to losses

We tend to base our financial decisions focusing on the narrow impact of each individual decision rather than its overall effect.

“It would be too cognitive demanding for us to make all the decisions simultaneously. When buying a freezer box, it affects the opportunity to do that holiday trip,” says HJ Holm, professor at the Lund University School of Economics and Management.

We aren’t always as rational as we imagine, about our finances. This fact has been of interests to economists and researchers for a long time. Richard H. Thaler has shown that we often value things we own much higher than if we do not own them—and that means we will not get rid off the things easily, even if offered compensation. HJ Holm explains:

“The Social Democrats in Sweden did not want to remove job tax deduction after the previous election, which is explained by Thaler’s theories of aversion against losses.”

More on behavioral economics

Associate professor Erik Wengström and professor HJ Holm, researchers at Lund University School of Economics and Management, are both experts in behavioral economics.