Financial and Monetary Systems

This classic thought experiment explains the strange decisions you make with money

An employee counts Indian rupee currency notes inside a private money exchange office in New Delhi July 5, 2013. India's central bank was seen selling dollars via state-run banks on Friday as the rupee approached its record low of 60.76 seen on June 26, four dealers said.

We assign our money to different timeframes in our minds, says Claudia Hammond. Image: REUTERS/Adnan Abidi

Claudia Hammond
Broadcaster, BBC Radio 4
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Financial and Monetary Systems

Some years ago, I interviewed the Nobel prize­-winning psychologist and best­selling author Daniel Kahneman. He told me one of his all­-time favorite thought experiments, which is something of a classic in behavioral economics.

It involves a woman who has spent $160 on two theatre tickets. She is looking forward to the show, but when she arrives at the theatre she can’t find the tickets. She empties out her bag. She goes through her pockets. No sign of them. She feels slightly sick as she thinks of the large sum of money she’s wasted. But what about the show? Will she spend another $160 on replacement tickets, or will she just give up and go home?

When Kahneman tested this scenario with a sample of people back in the 1980s, nearly nine out of 10 assumed that having lost the tickets, the woman would forgo seeing the play. But what if the scenario was slightly different?

This time, the woman hasn’t booked in advance. Instead she has brought $160 in cash with her, ready to buy tickets at the box office. But when she gets to the theater, she opens her purse and sees that the money is somehow missing. Does she use her credit card instead?

With this scenario, more than half of the people Kahneman questioned changed their answer and said yes. So why is it okay to in effect pay twice for the tickets in the second scenario, but not in the first?

The theory advanced by the economist Richard Thaler, famous for the behavioral theory “nudge,” is that we have different “mental accounts.” We assign different characteristics and purposes to different portions of our money. “Spending money” is different from savings. Money you win in a bet is different from money you earn. Even as an adult, the £10 note sent by a great­ aunt in a Christmas card is more exciting than the £20 note I’ve just collected from a cash machine.

These mental accounts aren’t generally organized like real bank accounts. We don’t make precise, conscious deposits into them or monitor the balances to avoid over­ drafts. Indeed, most of the time, most of us are barely conscious of them. But they can nonetheless exert a powerful influence over the way we use our money.

Mental accounting

For Thaler, the explanation for the different attitudes above would run as follows. The theater tickets come from a mental account devoted to entertainment and making a double purchase out of that account after the tickets have been lost feels unduly extravagant. But lost cash is different: it sits in a “general” mental account, and there’s still money left in there to spend. For Thaler, this explains why so many more people said the woman would still buy tickets if she’d lost the cash than if she’d lost the tickets.

Thaler first coined the term “mental accounts” in the 1990s. But other researchers also described similar ideas. In 1982, researchers in Japan found that even within the single category of “spending money,” women divided their cash into nine mental accounts or “psychological moneybags,” as the researchers termed them: daily necessities, small luxuries, culture and education, personal fortune, security, clothes and make­up, going out, pocket money and raising the standard of living.

The women judged the value of an item not by comparing it with all the items they might wish to purchase, but by making a comparison with other items in the relevant moneybag. For example, oranges sold on the train on a family day trip were more expensive than oranges in the local store, but the women were happy to pay the higher price because the money was coming from the “going out” moneybag, which was used for special and therefore pricier items, rather than from the mental account for the daily necessities, so a different judgement about the cost was made.

It’s pretty intuitive when you think about it. Maybe a bottle of gin is something you always have in the house, in case visitors ask for a gin and tonic. When it runs out, you get some more from the supermarket and it goes on the food and drink bill. You pay £20 for it at the very most. Yet on holiday, you might agree to pay almost half that for a single gin and tonic in a bar with a great view, but you don’t resent it. Why? Because the money is coming out of a different mental account.

Now you might think having these accounts would make us careless with money. But in fact we are not. We don’t throw all our money into the high­-end and “fun ­stuff” accounts. We assign it quite carefully, putting larger amounts of money into the more serious mental accounts, from which we spend more, but with a keener eye on the price.

Mortgages and fancy mushrooms

Matsutake mushrooms are the caviar of Japan. They grow around the roots of trees such as red pines and have fat stalks that can reach 20 centimeters in height. They have a strong smell and a spicy, some say cinnamon-­tinged taste.

Gathered by hand from September to November, they are hard to come by—and so very expensive. Today, depending on the size of the harvest, they can cost as much as $800 a kilo. The researchers found that back in 1982, they were similarly pricey. To spend $50 on mushrooms was a consid­erable outlay. Spending $50 on big bags of rice was fine because that money came from a general grocery account, but money for matsutake came from the precious and smaller luxury account, so this was not a decision to take lightly.

We also assign our money to different timeframes in our minds: Money for today, money for tomorrow and money for a rainy day. Through the creation of mental accounts, we are able to make quick judgements about when to buy something and what it’s reasonable to spend in different situations. They help us to exert self-­control over our spending.

Some people go as far as to set up separate bank accounts to reflect these mental accounts, even if that means paying interest on the debit in one while others are in credit. It’s irrational in one way—overall you are losing money; but understandable in another—you’ve worked hard to build up that savings nest egg, and it feels wrong to raid it to pay this month’s credit card bill.

Banks do offer mortgage deals where the interest you earn on savings is offset against the interest
on your mortgage, but still 98% of people in the UK in 2014 chose to separate their savings and their debts. We don’t like the idea of one big tally, especially when there’s a mortgage involved, because then we’ll always feel we’re massively in debt.

Our use of mental accounts also helps to explain why we make judgements about the value of discounts within the context of the total price. It all depends on which mental account the money comes from.

When my husband and I bought our house and failed to shop around for a solicitor, it was partly because these fees seemed inconsequential in comparison with the price of the house. But it was also because we were chalking the fees up to a particular mental account, in this case a special one—the “once in a lifetime buying a house” account. In reality, of course, the money we were shelling out to the solicitor was coming from my actual current account, which was rapidly looking very empty.

Irrational accounting

It is very important that we can assign money mentally in this way. If we didn’t do it, we wouldn’t take risks or make long­term investments, and we wouldn’t have the economic activity and the prosperity to show for it. Mental accounts allow us to escape from the crippling financial caution that could otherwise grip us. In this sense, our evolving psychological attitudes to money allow modern economies to function.

But difficulty sometimes arises in trying to force our minds to put money into the appropriate psychological moneybag. Around 15 years ago, my husband and I decided to get rid of our car. Living in London, we found we were using it less and less, not least because parking spaces where we lived at the time were so precious that we were reluctant to surrender the one we had by using the car. It got to the point where, on the rare occasions we did decide to drive, we couldn’t remember where the car was even parked. On one occasion, we wandered around for more than half an hour and then said to ourselves it was probably better that we take the tube after all, because if we drove we would only have had to spend ages later finding another elusive parking space.

It was getting ridiculous. Our Renault 5 was not so much a car as a white elephant. Selling it to someone who would use it regularly was clearly the sensible thing to do. Yet doing that would mean we would always have to take public transport. In London, this is generally reliable, but what about on late nights or if we wanted to travel out of the capital?

No matter, my husband said, just think of the thousands we’ll be saving over the years. With no insurance, road tax, MOT, repairs or petrol to pay for, the money we saved could easily justify paying for a late night taxi home from a friend’s house or a hire car for a weekend away.

His argument was logical and sensible—and we sold the car. But all these years later, I still find it hard to take the fare for a black cab from a mental account for everyday transport. Petrol and garage bills didn’t feel like luxuries, but a taxi still does. So I rarely take one.

Now that we have a garden and want to be able to fill a car boot with plants, we’ve started to wonder about buying a car again. In fact, taking a taxi, and even having it wait for us, would still be cheaper, yet we can’t quite bring ourselves to do it. It feels so extravagant to take taxis to garden centers. Yet a car, although far more expensive, seems reasonable.

The explanation, I suspect, is that I’ve grown up in a culture where a car is considered essential for everyday life. A hundred years ago, things would have been different. A car would have been a luxury and paying cab fares relatively commonplace. In the future that might be true again. Maybe we’ll be summoning driverless cars to come and get us instead of owning a car at all.

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