April 13, 2019 tedplayer4

An approach towards mental Accounting

Illustration by Felicia Gulda

Illustration by Felicia Gulda

My friend Alexander was shopping for a nice spring jacket recently. He went to the store and found one he liked and that was on sale. The regular prices were €450 for a winter jacket, €350 for a spring jacket, and €300 for a summer one. This week only, all models were priced at €180. Alexander could not resist: he bought the winter jacket.

Before we get started, on the topic of mental accounting: it helps to understand the basic economic theory of the consumer. Based on the so-called endowment effect (people ascribe more value to things merely because they own them) we can argue, that all economic decisions are made through the lens of opportunity costs. These costs describe the revenue that could be earned by their alternative use. In other words, opportunity cost is the cost of “what else could I do/get with the money”.

If you understand opportunity costs and you have a TedxTuWien Ticket to the event in May that you could sell for €1000, the initial price of the ticket becomes irrelevant. From now on, the ticket is valued at €1000 and you should only go see the event if that is the best possible way you could use that money. Most people will think of a few alternatives on how to use it, however it is impossible to constantly evaluate the best use of your money this way simply because the problem is too complex. Your decision-making would stagger if you´d apply this logic to every problem you have.

What do people do instead?

If we have a quick look at the “value function” graph from the prospect theory (outdated theory) it suggests that a loss hurts double as much as a gain of the same magnitude makes us feel good. But if that should be true (and it does have its relevance) what on earth was Alexander thinking when he bought that winter jacket? The €450 he paid for it should be seen as a loss and thus make him very unhappy. Which obviously was not the case.

This mixup brings us to two new terms which tackle this dilemma elegantly. Acquisition utility and transaction utility. Acquisition utility is equivalent to the “consumer surplus”. It is the surplus which remains after we asses the usefulness of the object and subtract the opportunity costs. A purchase will produce an abundance of acquisition utility only if the consumer values the object much more than the market does.

e.g. If you are very hungry, then a €0.3 apple is a utility jackpot. And for Alexander the acquisition utility of buying a spring jacket would be higher than that of a winter jacket in spring. So, acquisition utility is the value which is ascribed to the object by the person buying it at the time minus the price they paid for it.

On the other hand, we also tend to weigh in another aspect of the purchase. The perceived quality of the deal. It is defined as the price actually paid for the object and the price one would normally expect to pay, the reference price.

Suppose you usually buy an apple for €0.3 at the shop and then buy an identical apple at the gas station for €2. The more expensive apple is fine but the deal stinks. It produces negative transaction utility, a “rip-off”. If it produces a positive transaction utility, a price below the reference price, it´s a “bargain”, like Alexander´s winter coat he bought in spring.

Let´s take a look at the following scenario.

You´ve been lying on the beach on a hot day and really craving a cold beer for a while. A friend of yours is on his way to join you and offers to stop by the fancy hotel/ the little grocery store and buy you a bottle. However, he will only buy it for you if it costs less or exactly the amount that you guess it will cost. He can´t bargain with the vendors. What prices will you tell him for the two different places?

Keep in mind, the beers are identical in both places, you never enter or even see the establishments from where they are bought, and thus can´t take in the ambience, positive or negative. And by not being able to bargain you have no reason to disguise your true preference.

This is an actual thought experiment that was carried out with US students in the mid 2000´s and resulted in the following prices for one bottle of beer. On an average, the students would pay a maximum of €6 at the fancy hotel and €4 at the store for the beverage. Although they were consuming the same beer on the same beach, people were willing to pay different prices for the bottles. The reason for this behavior is “expectations.” People expect prices at the hotel to be higher than those at the shop. Paying six euros for a beer at the fancy hotel is annoying but expected. Pay the same price for the beer at a store and it´s an outrage! This is the essence of transaction utility.

Suppose you would only pay €4 for the beer at the store, but €6 for the beer from the hotel. Your friend could make you happier if he bought the beer at the store for €5 but told you he had bought it at the hotel rather than at the shop for that price. You´d get to drink your beer under the impression that the deal was fine. It´s only your distaste of overpaying that stops you from agreeing to this transaction in the first place.

So in essence bad deals can prevent us from consuming experiences which could have given us unforgettable memories even if the price by which we would have overpaid would be irrelevant shortly after paying. On contrary, good deals can lead us to buy useless stuff we don´t need just because the deal was “too good” to pass it on. And ofcourse somewhere in the closet everyone has their own version of Alexander´s winter coat he bought in spring.

By Alexander Drechsel

Illustration by Felicia Gulda