In economics, there is a concept called fungibility. A good is fungible if one example of the good is indistinguishable from another example of the same good. A common example is money. A dollar is a dollar, no matter where it came from, where it is located, or what you plan on buying with it. And so it should be treated as such… supposedly. The problem is humans do something called mental accounting, which violates this principle and leads to often-confusing decisions.
A popular example happens while gambling. Let’s say you go to Vegas. You hate the slots, but mindlessly drop a quarter into a slot machine while waiting for a friend and win $300 on your first pull. Are you more less likely to keep gambling? Most people are likely to keep on playing as long as they are playing with “house money”. Once they lose that $300, they’ll stop. But really, that quick $300 is no different than if you had to work 10 hours of overtime to get it. Why do people spend money more easily if it came without much effort? “Easy come, easy go”?
An academic paper by Dr. Thaler titled “Mental Accounting Matters” [pdf] explores this concept further and tries to categorize the types of mental accounting that we do. It was a very intriguing read; here are just a few examples:
Consider these two hypothetical scenarios:
- You are at Best Buy buying a new TV. It costs $860 there, but another store 15 minutes away has the same model for $850. Do you bother driving to the other store to get the savings?
- You are at Office Max buying a calculator. It cost $20 there, but another store 15 minutes away has it for half-off ($10). Do you drive to the other store now?
If presented separately, significantly more people will go out of their way for the calculator than the TV. But both involve saving $10 with the same action. The only difference is that $10 is only ~1% of $860, but is 50% of $20.
The same thing happens at the movie theater. A medium drink costs $4, a large costs $4.50, and a Super Jumbo drink costs $4.75. You might as well go for the $4.75 drink, right?
Here’s a quiz from another study:
Suppose you bought a case of a good 1982 Bordeaux in the futures market for $20 a bottle. The wine now sells at auction for about $75 a bottle. You have decided to drink a bottle. Which of the following best captures your feeling of the cost to you of drinking this bottle?
c) $20 plus accrued interest
e) -$55 (I drink a $75 bottle for which I paid only $20)
Got your answer? You sure? In economic terms, you could have sold that bottle for $75. That’s $75 that could have paid for a nice dinner and a movie for two, an iPod Shuffle, or two months of cell phone service. By drinking it, you just gave up $75.
When trying to help someone with a pack-a-day habit quit smoking, you could tell the addict one of these reasons:
- Each day, you can either save yourself $4, or keep smoking.
- Stop smoking, and you could save nearly $1,500 over a year.
- Stop smoking, and in a year you could save enough money for a cruise vacation for your entire family. Think about that every day.
It may all be the same mathematically, but using different ways of grouping or visualizing your goals you can create a wide gap in reactions. Of course advertisers use this as well, why do you think everyone keeps giving away iPods?
I know I’m guilty of many similar decisions. But by being cognizant of these tendencies, hopefully we can use it both to spend less and also to better motivate (trick?) ourselves to work harder to achieve our financial goals.