Why our mental arithmetic does not add up

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Kai Ruggeri works as an associate professor at Columbia University's Mailman School of Public Health.

Suppose you plan to purchase a chocolate bar for $1, but the seller quotes you $6 instead. You would likely argue about the extra $5 and decline to purchase it. On the other hand, if you were to buy a plane ticket worth $250 and it ended up costing $255, you would possibly go ahead with the purchase.

This displays the common and powerful phenomenon of "mental accounting", which clarifies why people, organizations, and communities view the worth of money as proportional to where it came from and how it will be used.

The idea of mental accounting is what made Richard Thaler so famous and earned him a Nobel Prize in economics. However, it is important to note that this concept can also have harmful effects. For example, when we make big purchases using credit instead of cash, we may end up spending more than we intended. This has led to laws like the US Credit Card Accountability Responsibility and Disclosure Act of 2009 being put in place to prevent such negative consequences.

However, besides its dubious use in marketing, it has seldom been utilized to encourage innovation that benefits both the company and its workers. An encouraging method would be to look beyond monetary decisions and contemplate how time, energy, and creativity are allocated most effectively.

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Think about how annoyed you would feel if your regular 10-minute journey by car, subway or bike was extended to 15 minutes due to traffic congestion. On the other hand, you probably wouldn't care much if your return flight from a faraway place was 15 minutes delayed and you arrived late.

Although theories such as the fear of losing, the preference for immediate rewards, and the standard options are regularly validated through research, recent controversies have sparked worries regarding certain elements of behavioral studies. These concerns range from unsatisfactory results seen in major policy initiatives to investigations that reveal insufficient advantages and purported incidents of deceit.

It is crucial to verify and duplicate concepts on a large scale and under various circumstances. A study was conducted in 21 nations under the guidance of Giulia Priolo and the University of Padova in Italy, which I assisted in overseeing. This research emphasized the prevalence of mental accounting across numerous cultures and situations.

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We looked at previous studies and modified them to ensure that the results applied to various regions. For example, we removed any mentions of alcohol and replaced a Bluetooth speaker with a calculator. Our findings indicated that the theory remained valid, and there were no notable disparities based on factors such as age, gender, education, and income.

The article proposes that additional measures could be taken to assist individuals in managing their retirement savings, handling debt effectively, and protecting themselves against financial fraud. It further recommends that advisers be equipped with adequate training while aiding individuals with financial decision-making.

Private banks have the potential to enhance their customers' investment strategies by providing transparent information about the various expenses in their portfolios. By featuring this information in their mobile banking applications or offering education on how resources can be interchanged, private banks can empower their clients to make more effective investments.

Usually, we tend to spend more time and energy on daily, insignificant expenses like buying groceries, while we don't mind being more flexible when it comes to spending a larger amount of money or investing it. For example, we pay close attention to even a tiny difference of 0.1% in mortgage rates.

Likewise, mobile banking applications have the advantage of utilizing the concept of mental accounting to educate users on effective savings management, while pinpointing specific expenditures that hinder long-term savings. These apps can give priority to actual profit margins rather than just relative ones.

In general, our research indicates that even those who are knowledgeable in financial matters should not ignore the impact of mental accounting, thinking it only applies to others. Various studies have proven this notion to be untrue. Additionally, we discovered that such individuals are just as prone to exhibiting the typical behaviors associated with mental accounting.

When I worked as an economic consultant, I created a plan to deal with mental accounting for auditors assigned to detect errors in significant financial transactions. These auditors tended to consider a $1,000 error in a $1 million payment to be insignificant, but they would put more effort into locating a $100 error in a $500 payment.

In order to address this issue, we implemented a system of probability that permitted auditors to rearrange transactions based on two factors - the probability of mistakes (determined by prior data) and the transaction's value. By doing this, we reduced the importance of the overall transaction value during the audit, and instead gave preference to the net profit.

Although mental accounting is often linked with financial transactions, it can also be applied in various aspects of organizations beyond managers and executives. Different areas such as travel, hiring processes, salary evaluations, healthcare, meetings and policies all involve the use or application of mental accounting. These areas can spark innovation for both individuals and the organization.

Airline companies should think about handling delays differently depending on whether it's a short flight or a long flight. Companies should keep in mind the cost of promoting an employee versus hiring a new one when making decisions about employee retention. Hospitals should keep better records of the advantages and value of taking preventative measures instead of just treating illnesses. Decision-makers need to rethink the focus on auditing the tax returns of low-income families as it is unlikely to provide a significant return.

These possible uses present valuable chances for upcoming leaders to grow and thrive.