Mental Accounting: Is A Dollar Always A Dollar?

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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:

Relative Value
Consider these two hypothetical scenarios:

  1. 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?
  2. 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?

Advance Purchases
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?

a) $0
b) $20
c) $20 plus accrued interest
d) $75
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.

Choice Bracketing
When trying to help someone with a pack-a-day habit quit smoking, you could tell the addict one of these reasons:

  1. Each day, you can either save yourself $4, or keep smoking.
  2. Stop smoking, and you could save nearly $1,500 over a year.
  3. 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? ๐Ÿ™‚

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.

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  1. This is a very well done post. I know for sure I am guilty of some of these. For example, I cannot be bothered to drive a bit further for cheaper gas. I now I am giving up some money (even with the further distance) but I haven’t changed my behavior.

  2. I resist the drive five miles to save five dollars – mainly because of the the added time this savings search entails and the likelihood that I’ll end up spending the $5 savings on something else BECAUSE I just saved $5 so I can afford it.

    Also, I think another factor (which may be accounted for elsewhere in the study) is the “fear” many people have of seeing the product 1-2 months later for 20-30% less — buyer’s remorse can become buyer’s paralysis. I delayed for two years to buy a LCD TV for these reasons.

  3. Thanks for all the great articles….just a tip regarding driving across town most places will price match on the spot and will even look up the price online in store for you.

  4. Deltablues82 says

    Good Post about a very powerful concept.

    I have found that people often use mental accounting with their securities investments which prevents them from making sound decisions.

    Example: Bought the stock @ $20 a share. Increases in value to $40 a share (the current peak) and then declines to $25. Most people make a mental “mark” at $40 and are disppointed with their $15 “loss”, when of course they actually made $5 a share. They then hold onto this stock waiting for it to “recover” so they can eliminate the loss. “I’m in it for the long term, right?”

    If that bottle of wine in your post had declined from $75 to $25, most people would lament their $50 (or $600 for the case) “loss”, insteading of savoring their $5 (or $60) profit.

  5. Great post. I often think about the psychology of money. I am guilty of many illogical things…

    Barry, I am with you, I haven’t bought an iPhone exactly for that reason… but sometimes it pays off when the price goes from $599 to $399 in two months.

    My favorite illogical thing is driving 80mph on the highway when not only do you risk getting a ticket (which that probability equates to additional cost), but you also get far worse gas mileage at 80mph vs 55mph. But then I say that my TIME is worth it to get to where I’m going faster and use the extra gas, I can’t go 5mph UNDER the speed limit… well then what about when I’m sitting on the couch and watching TV, what is my time worth then? Same reason why 10 minutes before I go to bed isn’t worth near as much as 10 minutes of extra sleep when I wake up in the morning.

    I have also recently conceded that I am a victim of the 1% back on credit card ploy. When it comes to purely discretionary things like eating out, I tend to spend more on a credit card than if it were a debit card. So in the end I end up spending more even after the 1% savings with a credit card. I like to think I’m totally disciplined because I do watch it closely, but when you are tightening up your budget it’s a little bit easier said than done. To solve this I resolved to setting up a separate B of A checking account (which I got $75 for signing up for under promotion) and will have my employer deposit a % of my income into that account, then use a debit card to spend it on food, groceries, drinks, etc. I’ll still use the credit card for the bulk of my expenses, but this should help me come out ahead in the end.

  6. Very nice post. For anyone interested, check out “Why Smart People Make Big Money Mistakes And How To Correct Them: Lessons From The New Science Of Behavioral Economics” by Belsky and Gilovich for more stuff like this. It was a quick and interesting read.

  7. I’ve noticed that regular gambling helps a person get a better handle on money. There’s a saying in poker that “money in the pot isn’t yours any more.” There is an irrational desire to stay in a pot because you have contributed many dollars to it, even when you really know you aren’t going to win.

    If the pot were just “there” and you were asked to bet, you would feel differently. Part of playing regularly is training yourself out of these irrationalities. It isn’t unlike investing in a stock and having it go down (think trader here). People want to hold on to make their money back , but the reasonable thing to ask is “would I invest at this level.” It is a good trade if it is still a good trade, not because you have your own money already buried into the stock. Just like poker.

    In many home games, the dealer antes for everyone at the table. It all averages out in the end, and it is simpler than asking for a chip from anyone since you don’t have to worry about who is “light.” But players (especially beginners) feel differently about winning and losing the pots that they have anted for, even though that makes no sense.

    I, as a rule, try to get the best price on everything because saving a dollar or two or ten in lots of different places adds up to a lot. Ten dollars saved is like having to earn $15 or more because of the taxes you would have to pay on that income.

    I try to be aware of the costs in that effort. It costs $0.10/mile in gas so if I have to go out of my way 5 miles for cheaper groceries I need to save at least $0.50 to break even on gas and more for wear on the car. If I’m picking up one or two things that I can expect to be similarly priced, I don’t drive. If it is a whole load of groceries, I do.

  8. Grad Student says

    Is it just me, or is anyone else thinking – I would compare the price of the TV/calculator online before even leaving the house, taking into account any fatwallet rebates, use my 5% back Cash Returns card to pay for it, and if free shipping wasn’t available, then go to the store to pick it up?

    I guess I’ve been hanging around this blog for too long… (but that might not be a bad thing ๐Ÿ˜‰ )

  9. For those of you that liked this post, you might be interested in this book:

    Discover Your Inner Economist by Tyler Cowen

  10. Good post – the calculator/TV example totally describes me but you are right there is a lot of bad logic at play there.

  11. I can understand why someone winning $300 in a slot machine thinks it’s okay to gamble this money — because it was never in their budget in the first place. So there you are, in a foreign place (a casino), with some extra money that was not pre-allocated into your budget for any other use. When you came to the casino (like a lot of people do) — you come with a certain amount to spend. You leave everything else at home (or in your bank account) and just have fun. If you end up with extra moola, you can do what you please with it. Personally, I wouldn’t gamble it all away — probably I’d get some more souvenirs or something. Also, just because you won $300 when you are there doesn’t mean you are ready to run out the door. Logically, yes, that might make sense — but what if it’s only 4:00 p.m. or something? What are you going to do — sit in your hotel room and not spend it? I wonder if casinos ever gear the payouts to coincide with the hours that you are least likely to leave? That would make sense from their point of view.

    Yes, the way we think of money has so much to do with the context of what’s going on. When you are single and spend $100+ a night having fun – you think that’s normal. When you get married you look to save bucks on everything. Why go out for drinks — get a bottle of wine and save $50. I’ll count my change at Wendy’s drive through for lunch for $3.25 and then spend $80 going to Benihana for dinner. Mmmm, come to think of it — Benihana sounds soooo good right now ..

  12. This has a lot to do with human beings’ irrationality. I’ve always known the best investors to think about finances using zero emotion. Always the facts, and always the logical choices. of course knowing that other investors use emotions gives you the one-up esp. when playing the stock market ๐Ÿ˜›

  13. Wow, this could not be more right on. I go ten minutes out of my way to save $0.10/gallon sometimes but wouldn’t even consider going to another store to save a dollar on a $25 item…

  14. This is sort of along the same lines as mental accounting…..when you receive the free “Thank You” points and other rewards from the credit cards, how do you classify that money? If I am getting $100 back in cash at the end of the year, personally I spend that $100 as if I found it on the sidewalk and I don’t think about it as money that I could use to pay a bill or do something non-fun. I justify it as a free gift I give myself for being smart with my finances ๐Ÿ™‚

    I was wondering how other people thought?

  15. Jonathan, very interesting.

    I have this concept that I created called the ‘diminishing dollar’. At what point does the value of money dissapear/reduce.

    For example, if something that u buy that used to be $1 is now $2, that would make u mad. but if the item was $100 and it is now $101, ur less likely to get mad.

    another thing in this same theory i coined is that……when purchasing a $20K car…..the accessories which are WAY overpriced dont seem much to many people…….$500 for GPS, $80 car mats….sure throw them in! But in reality, if u purchased ur car without car mats, u could save a bundle.

  16. This is one of the reasons casino’s use chips instead of actual cash. I have played $400 on 1 hand using chips but would be EXTREMELY reluctant if it was actual cash.

  17. PTam,

    cash back on credit cards are the best thing that has happened this century. I treat credit card just as I would cash, but now, I get money back.

    I guess this works best for people who pay off their cards every month. Credit card is a convenience for me to carry less cash. That’s it.

  18. I know I’m ruining the study, but one reason I might drive somewhere else for the calculator is because I hate paying for things that are 100% overprice. $10 overpriced (too lazy to calculate the percentage) on $850 won’t phase me as much. In other words, it’s not always about my savings, it’s about “punishing” someone who overcharges.

    As for the wine, I’m drinking it. Wine is much too speculative for me to treat it as a true investment. And I wouldn’t have any idea how to sell wine at an auction (or really anywhere that it would reach market price). Really, I just increased my enjoyment factor by waiting until it was mature and worth $75, rather than drinking at the $20 stage.

    A great post. Fun mental exercise.

  19. Really enjoyed this post!

  20. Penny wise, pound foolish.

    Happens to me all the time. I spend time researching credit cards which sometimes only amount to a savings of maybe $20 a year.

    It is worst for me with sodas… I’ll spend a $1.50 for a cold soda, when a 2 liter in the same store probably costs less.

  21. Katie has it right on. It is worth driving farther to save on gas not only because it saves you money immediately—but also because we know that the joint actions of people doing this will maintain competition, saving much more money in the long run. Capitalism only works if everyone works to maintain competition.

    The same argument works for the calculator versus TV example. Yes, you are only saving $10 in each case, but in the calculator case the store is less competitive and more deserving of punishment. Next time you shop there they are more likely to have lower prices.

  22. This thinking can be applied to the snowball method of paying off credit card debt and the approach that a person takes.

    The way to pay off credit card debt using the snowball method, the cheapest way, is to pay the minimum on each card you have and then apply any extra money you have to the credit card balance which has the highest interest rate. However, many financial advisors reccemend that a person apply the extra money towards the card witht the lowest balance, because mentall it feels better to watch credit card balances dissapear.

    I am extremely guilty going out of my way to save 10 cents a gallon, but if I had to drive to the store next door to save $5 off an electronics purchase, I say “eh, not worth my time”. It’s really fascinating, and I am going to try to teach myself to treat each savings equally.

  23. Great post. I know a lot of people who live by the motto “easy come, easy go.” If they get money they weren’t accounting for they convince themselves it’s OK to blow it on anything because they weren’t counting on having that money anyway.

  24. just wanted to add a minor point for PT to consider….. any defensive driving class worth its salt will allow you to come to an obvious conclusion: The time saved speeding is so negligible that your time has to be pretty dang important to warrant doing so. Even driving longer distances (let us say 130 miles), if the speed limit is 65mph and you stick right to that, you make it there in 2 hours. If you go 75mph instead, you save a whopping 15 minutes. Considering the high cost of a ticket, the average time spent during a traffic stop, and the wear and tear to your vehicle… it’s hardly worth it. Now, when you crunch the numbers for smaller distances (like commuting to and from work in a major city), especially given that most traffic lights are timed for traffic flow that goes the speed limit… by zooming around, you probably save yourself a handful of minutes, the benefit of which is lost as soon as you take into account a $200+ traffic ticket (and the time spent working to pay for it) and 20+ minutes spent with a cop as they write you a ticket. I love people who, stopped at the light, floor it… only to slam on their brakes at the next light (while I come creeping/coasting it behind them, having accelerated quite slowly). I save considerable gas, don’t have to shell out my hard earned money for traffic tickets and constant brake jobs, and get home just about the same time as all of you speed racers do. I would suggest many of you zoom-zoomers really do a cost/benefit analysis and you’ll see that speeding is futile in most circumstances. That’s not to say I won’t speed up if I see a green light that is about to go red (and know I can make it), but I’m always looking up far ahead of me, hitting the brakes long before other drivers have even caught on that we’re going to be stopped at the light anyways.

  25. Thanks to those who said they enjoyed this post ๐Ÿ™‚ This week, I’m trying to write down every time I catch myself doing mental accounting.

  26. Great post, reminded me of a class I took in college regarding decision making theory that covered these sorts of ‘thinking errors’, especially in relation to things like gambling, purchasing insurance, etc.

    If you’re interested, here was the textbook we used, pretty good reading as well:

  27. I have also written about this topic a number of months back:

    Note that a mental accounting can be viewed in a positive or negative light depending on how the comparison is made. Most of your readers are no doubt aware of the debt reduction concept of paying off the credit card with the smallest balance first. Clearly this is mental accounting. The money one owes in one credit card account is (generally) no different than the money in any of the other accounts. Mathematics would dictate that you pay off the highest interest rate debt first, irrespective of what the balances are on the individual credit cards. Thus, to the extent that it is materially different (e.g. paying off $8,000 at 9% before $20,000 at 19%), I would say it is a mental accounting error. That is because I compare the results with the financially best case, which I can clearly imagine that I could and would do.

    On the other hand, people who promote this concept argue that mental accounting actually helps in this case. They argue that the typical person in debt often lacks motivation, and that compartmentalizing the money into accounts (practially a definition of mental accounting!) and paying off one of the mental accounts quickly improves motivation. Compared to the worst case (i.e. not paying off anything), mental accounting does indeed help and is not an “error”.

    So it all comes down to what you perceive as realistically possible or not. This is not unlike the voting condundrum. Suppose there are three political candidates running for office. Candidate A is your ideal choice. Candidate B is OK. You absolutely loathe Candidate C. Further suppose candidate A is (unfortunately for you) the fringe candidate, receiving 10% in pre-election polls. Candidates B and C each poll 45% in pre-election polls. Do you vote for A or B? If you really believe that A has a possibility of winning, then you clearly vote for A. But if A has no chance, and you feel that you could possibly be the deciding vote between B and C, you will vote for B.

    So what is realistically possible and what is not? This is often the question to ask…

  28. cw…
    My point exactly, us speeders think every extra second is so valuable, but if we crunch the numbers, it’s actually additional cost (especially in the long run) with very little additional benefit.

    I agree with you as well, credit card rebates are the best, I never have interest expense there either… another benefit you could mention is the protection you get from fraudulant charges: they are required to refund them by law. I’m admitting though, that sometimes I think I’m saving more money that I wouldn’t otherwise be spending. If I spend an extra $10 a month because my credit card has a large limit that I never hit that’s the same as $1,000 worth of rebate. A bottle of wine at dinner? $3,000 worth of rebate. I’d say that when I constrain myself to only spend what gets put in a checking account, I might be even more mindful. In the end I might go from getting $500 a year in rebates to $250 a year, but I promise you that I can cut my overall spending by at least 0.50%!

  29. Nicolas Wilson says

    good post..tried to argue with the thought with experiences but realized i’m a victim ;P

  30. sorry ptam… didn’t catch the “illogical” in your OP. You make a great post. Sorry to restate it for you…. well said. ::embarrassed::

  31. ps— this was an awesome post, jonathan. I’m sure I’m guilty of many of your examples. Excellent to think about.

  32. I see a lot of people “bragging” about driving a little further to save $.10/gallon on gas. Some have mentioned at least trying to account for the additional gas used to drive further. But what about the additional time to drive further?

    I agree that percentages tend to play heavily in monetary decision making. But an even bigger one that many don’t seem to think about is the value of time.

  33. One reason the calculator/TV example DOES make sense is that it’s the $10 savings on small and frequent purchases that add up more than the $10 savings on a one time large purchase. I try to save money on things I buy often, but for a large purchase, driving to save $10 isn’t as important to me since it is a one time $10. I know this still isn’t as smart, it isn’t completely intellectually honest. But it is a principle that has been ignored in the post.

  34. Depends. If that drinking that 1982 Bordeaux is a $100 benefit to you, in terms of the health and enjoyment, then you gained $100 and lost $75, so you have a $25 net gain ๐Ÿ™‚

  35. Great post man and it seems that a lot of posters have brought up the what ifs and wherefores and the standard rationalization / justification / explanation. So I’ll summarize the confounding factors of Mental Accounting.

    1. People are bad at math: more specifically, people are bad at understanding and appreciating the “holistic” cost of both their goods and their lifestyles. And this isn’t one of my “frugality rants”, I don’t really care how you live your life as long as you really understand the implications of living your lifestyle.

    So this is really what I mean when I say “people are bad at math”, it’s simply that I’ve met very few people who live and spend in calculated, pre-meditated fashion. And really, this is fundamental source of “Mental Accounting Errors.

    Of course, there’s more going on:

    2. People have some foresight: When it comes to the relative value issue (calculator vs. tv), we’ve likely failed to capture the entire picture: people rarely shop for only one thing (especially just a calculator), they rarely shop in a bubble and they rarely have to actually drive 15 minutes out of their way to find whatever they need.

    Some personality profiles really like shopping, it’s actually a pleasant activity to them. So if I’m out on a Saturday afternoon just driving around and I’m just going shopping, then my gas and time are basically sunk costs. If I’m going to drive around anyways, then the $10 saving is a bonus. However, if I’m buying a TV, that’s probably the end of my shop for the day. Driving away is pointless, in fact the sales guy will likely just knock off the $10 if I bring it up.

    So the problem with the relative value issue is actually that it’s a really bad question. The question will not generate the apples to apples comparison that it’s looking for, it’s filled with the type of lurking variables I just mentioned.

    3. We not always good at nebulous concepts: I’ve said it elsewhere, but money is just a nebulous concept: it’s numbers on paper or valueless pieces of plastic or worthless slips of paper. The concept behind Choice Bracketing is that we can improve our physical relation with money by improving our ability to convert abstract dollars into into less abstract concepts (a home, a car, hours of my time, etc.)

    But that’s just our nature, we’ve abstracted money so far from reality that we simply lose that connection between bills and time. So the whole Choice Bracketing concept tends to improve mathematical capacities, b/c it reduces the abstraction of money.

    4. Time, effort and desire all cost money: but none of these short questions actually makes these elements into a factor. Take the wine example, the bottle may be worth $75, but nobody’s actually buying it from you. If instead of saying “is worth $75 at auction” you say “and someone is waving the $75 in front of you” then the answer likely changes.

    And it changes, b/c your time/effort is worth something. Doing an auction to sell your wine is high time and high effort for most people, so the bottle really has to be worth it. You see, even if I figure that the bottle is only worth $50, but I know that it’s going to take me more than 1 hour of effort to get it sold (at my rate of $25/hour), then I’m past even anyways. For the extra work I might as well drink it.

    The only key exercise here is the fact that we’re showing off our capacity to value our time and effort, but I won’t go so far as to call these “mental accounting errors” (as some have), b/c the above examples are all pretty confounded. They try to apply good math to bad questions, but bad questions have a habit of giving bad answers.

  36. Most people are not very smart about money. That explains:

    1. Most people have very little or no money saved for retirement. They figure they can live on social security.
    2. Most people buy fancy cars, go on expensive vacations, eat out many times a week. And have thousands of $$$’s in credit card debt.
    3. Many people are obese, and can’t start eating moderately. Then years later they are sticken with diabetes, heart problems, etc.

    We all need to think and contemplate more about retirement, and where the money is going to come from.

    We all need to value our health. And eat healthy foods. Stop eating junk made from high fructose corn syrup. Take care of your body today, and avoid health problems decades later when you are older.

    I’m not saying be a hermit cheapskate, but just be more thoughtful on purchases, and buy things that have value. Don’t just make shopping a hobby.

  37. And sometimes it isn’t about the money at all. I don’t feel I’ve gotten ripped off if I pay an extra ten for the television, but if I pay DOUBLE what I should’ve/could’ve paid for the calculator then I’ll be lying awake at night cursing my misfortune! Saving $10 on the television wou.d make be feel good, but not as good as saving $10 on the calculator. Little victories.

  38. Another thing to consider is how many times are you going to buy an expensive tv as opposed to stuff around $10?
    TV you will probably pay only once. Stuffs around $10 you buy them every day. At the end of the month this makes a bigger difference than just 10 bucks if you never pay attention to those small expenses.

  39. Actually, the calculator/tv thing makes complete sense. the calculator purchase is representative of everyday purchases we make, while the TV isn’t. since you don’t often purchase things for so much money, an extra 10 dollars isn’t important, but when purchasing cheap things, it is since the 10 dollars adds up over multiple purchases.

  40. I think the diff. is if I were spending 800 something on a tv, I wouldn’t care much about 10 dollars since presumably if I’ve got 850 to blow on a TV, I’ve got enough money to not care about the 10 dollar difference. So to me, the two are not the same even if both involve a $10 savings. To me this type of mental accounting does make sense. If I have more money, then I’d rather save time than money. If I have less money, I’d rather save money over time. Money is worth more, to me at least, when I have less of it and need more. When I have more money than time, I choose to pay a bit more in order to save the resource I’m short on, in that case, time.

  41. Josh Raines says

    Just wanted to say that I found this site being inside of an article on and I must say I read this everyday now. I check it at least twice a day for updates.

    I do agree with this posting because its the same for people that are on gameshows (same concept anyway). Games such as who wants to be a millionaire. When they get to a certain part of the show there guaranteed the money they are at and they say “well im already at alot.” But they dont realize that they came with nothing and there going to leave with $32,000 at least. After taxes you drop almost half but still. You didnt have that much before. And i think the 25% chance I have of getting up to that $1 million question is worth gaining only $16,000 for. Just my 2 cents.

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