Let’s say you budget Rs1,000 for entertainment and another Rs1,000 for clothing for your family per month. Imagine you are nearing the end of the month and have already exhausted your entertainment budget for the month. You come across a new movie released in theatres that you really want to see with your family. How difficult would it be for you to go over your monthly entertainment budget?
Now imagine that you had only seen one movie that month and still had roughly Rs500 in your entertainment budget. However, you have overspent your clothing budget by about Rs500 because of the expensive dresses you bought that month for your kids. Now, this new movie comes along. Will it be difficult for you to spend Rs500 on the new movie? If you are like most people, it would be much easier for you to justify going to the movie in the second case than in the first. However, from a purely economic perspective, your financial layout is exactly the same in the two situations. Why should you be more likely to spend additional money in one situation than in another?
This anomaly is explained using a concept called “mental accounting”. We create separate “mental accounts” for different pots of money. Income and expenditure are grouped into categories and the associated money is viewed differently depending on the category in which it is placed. Money received as part of your salary is treated differently from money received as a bonus. Similarly, money spent to buy a fixed asset is viewed differently from the same amount of money spent to treat yourself to a dinner at a luxury hotel. From an economic perspective, these mental accounting rules violate the economic principle of “fungibility”, which basically means that all money is equal. A rupee is still a rupee whether you get it as a gift from a friend or as payment for a product you sell. When the principle of fungibility is violated, people act in economically irrational ways.
Generally speaking, people group their expenditures into separate mental “budgets” that are not easily combined. Income is also generally grouped into “regular” income and “windfall” income and consequently treated differently. For individuals, these categories serve as ways to control their impulses. So, if you exceed your “entertainment budget” by Rs500 in one particular month, you still feel bad even though you may have spent Rs500 less than usual out of your monthly clothing budget. You feel worse in this situation than if you had spent the exact budgeted amount on both entertainment and clothing even though both situations leave you with exactly the same amount of money at the end of the month. On the other hand, if you receive a salary raise of Rs500 a month, you are less likely to go on a spending spree at the end of the year than if you win a prize that gives you Rs6,000. In one case, the money becomes part of your “regular income” and is treated the same way as your other regular income, whereas in the second case, it is treated as “windfall income” that you can use to treat yourself to something you’ve been wanting. In both cases, however, your income at the end of the year has increased by the same amount.
Marketers often use the concept of mental accounting to influence buyers’ behaviour. For example, most people budget for larger expense categories (rent, clothing, entertainment, savings, etc.), but always include a smaller “miscellaneous” category for expenses that are not tracked as carefully. Say, a company wants to sell you a service costing Rs1,000 per year. Instead of making it a Rs1,000 a year proposition, it may tell you that the service costs “less than Rs3 per day”. Framing it this way may result in your classifying the expense in the untracked “miscellaneous” category, instead of a major category into which the Rs1,000 would fall. On the other hand, if they were trying to convince you how expensive some activity is, it makes more sense to combine the expenses into a larger amount to show you its impact on your budget. Instead of just asking you how much you spend on cigarettes every day, a campaign trying to reduce smoking would not focus on the Rs30 a day you are spending on cigarettes, but ask you to think about how the Rs10,000 a year you could save by not smoking could be used for a relaxing vacation.
So, the next time you are thinking of splurging your year-end bonus on an exotic vacation, think about the fungibility of money. There are no labels attached to the money you have in your savings account. And by the same token, you shouldn’t worry too much if you overspend in one account as long as your overall budget is balanced. The labels you attach to your income and expenditure are all in your mind!
Praveen Aggarwal is an associate professor of marketing at the Labowitz School of Business & Economics at the University of Minnesota Duluth and Rajiv Vaidyanathan is a professor of marketing and director of MBA programmes at the University of Minnesota Duluth. Send your comments to firstname.lastname@example.org