Behavioural economics is a field of study that combines insights from psychology and economics to understand how people make decisions. It challenges the traditional economic assumption that individuals are rational and always make decisions that maximize their own self-interest. Instead, behavioural economics recognizes that human behaviour is influenced by a variety of factors, including emotions, biases, and social norms.
The Concept of Mental Accounting
One of the key concepts in behavioural economics is mental accounting. This refers to the way individuals categorize and evaluate their financial transactions.In other words, it is the process of assigning different values to money based on how it is spent, earned, or saved. For example, imagine you have $100 in your wallet. You may be more likely to spend this money on a fancy dinner than on groceries because you have mentally categorized it as "disposable income" rather than "necessary expenses". Similarly, you may be more hesitant to spend $100 from your savings account because you have mentally labeled it as "emergency funds".
The Role of Mental Accounting in Decision Making
Mental accounting can have a significant impact on our decision-making process. It can lead us to make irrational choices that go against our best interests.This is because we tend to treat different categories of money differently, even though it is all essentially the same. For instance, imagine you have two credit cards - one with a balance of $500 and another with a balance of $1,000. You also have $1,500 in your savings account. According to traditional economic theory, you should use your savings to pay off the credit card with the highest interest rate. However, most people would choose to pay off the smaller credit card first, even though it may not be the most financially beneficial decision.
This is because we tend to mentally categorize the $1,500 in savings as "untouchable" and the credit card balances as "debts" that need to be paid off. Similarly, mental accounting can also lead us to make impulsive or irrational decisions. For example, if you receive a bonus at work, you may be more likely to splurge on a luxury item rather than save it for a rainy day. This is because we tend to mentally categorize windfall gains as "extra" money that can be spent without guilt.
The Influence of Framing and Anchoring
Mental accounting is closely related to two other behavioural economics concepts - framing and anchoring. Framing refers to the way in which information is presented, while anchoring refers to the tendency to rely too heavily on the first piece of information we receive when making a decision. For example, imagine you are shopping for a new laptop and come across two options - one priced at $1,000 and another at $1,500.You may be more likely to choose the $1,000 laptop because it seems like a better deal compared to the higher-priced option. However, if you had seen a third option priced at $2,000 before seeing the other two, you may have been more likely to choose the $1,500 laptop instead. This is because the initial price of $2,000 acts as an anchor and makes the $1,500 laptop seem like a better deal in comparison. In terms of mental accounting, framing and anchoring can influence how we categorize and evaluate our financial transactions. For instance, if we see a sale for 50% off on a designer handbag, we may be more likely to buy it because we perceive it as a good deal.
However, if we had not seen the original price of the handbag, we may not have been willing to spend that amount of money on it in the first place.
Overcoming Mental Accounting Biases
So, how can we overcome the biases associated with mental accounting? One way is to be aware of our tendency to categorize and evaluate money differently based on how it is spent or saved. By recognizing this bias, we can make more rational decisions that align with our long-term financial goals. Another approach is to consolidate our mental accounts and view all of our money as one pool. This means not differentiating between money in our savings account, checking account, or wallet. By doing so, we can make more informed decisions about how to allocate our resources. Furthermore, it is essential to consider the opportunity cost of our financial decisions.This means thinking about what else we could do with the money we are about to spend. For example, instead of buying a new car, we could invest that money and potentially earn a higher return.