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ECO674: Behavioral Economics

Punarjit Roychowdhury
Shiv Nadar University, Delhi NCR
 © Punarjit Roychowdhury
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without permission is a punishable offence.

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 Suppose you get an coupon for an ice cream cone. After
redeeming the coupon, you drop it but figure, no big loss. It was
free anyway!

 Or suppose you want a new video game system. You had

contemplated saving for the system, but knew you really
needed to save your money for a new pair of eyeglasses. You
get a cheque in the mail from your grandmother that will cover
the cost of either the video game or glasses. You use it to buy
the video game – what kind of gift would glasses make!

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 The previous two stories indicate that the source of
earnings/income influences your economic decision and
satisfaction
 This is puzzling, because rational model suggests that total
income is just what matters – source of income has no role in
influencing economic decision of consumers (see next slide)

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• Consumer Problem:

max U  x1 , x2 
x1 , x2

• Subject to:

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p1 x1  p2 x2  y1  y2

• where y1 represents income from source 1 and y2 represents

income from source 2

• Let k = y1+y2

• X1* = (k, p1, p2); x2* = (k, p1, p2)

• If k changes, x1*, x2* changes – source of k change does not matter
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 Consumers have to deal with new income from varied sources
and new expenses on a variety of items on a regular basis
 Given the sheer volume of decisions one must make can lead
people to use simple rules of thumb to make decisions rather
than to “optimize” (as rational economic theory suggests)
 Specifically, people can use a system called mental
accounting to make decisions as well as to rationalize
previous decisions

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 Mental Accounting describes how people simplify the
decisions they need to make in life by separating choices into
different “accounts” in one’s head

Mental Accounts can explain:

1.How income sources affect spending
2.How individuals rationalize bad investments
3.How individuals group events to “balance” accounts

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 Since 1939 the US Supplemental Nutrition Assistance Program
(SNAP) has provided food stamps to low income families that
can only be spent on food
 Historically, most food stamp recipients spent their entire
allotment on food (plus some additional cash)
 If they had not spent some of their own money, this might have
indicated that people were just over-consuming under food stamps
 Do people spend similarly if they were given cash instead of
coupon?
 Experiment conducted by USDA
 Surprisingly people spend less on food!
 Thus income as cash was treated differently than income that
was earmarked for food
 Policy implication for India?

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Experiment (Heath and Soll):
Design: Would you buy a $25 theater ticket if….
 1) You had already spent $50 on a sports ticket.
 2) You had been “given” the same sports ticket.
 3) You had already spent $50 on a flu vaccine

Prediction:What you have done before should not affect your

future decision? It should be forward thinking that would compare
costs and benefits
Results: People were most likely to reject the theater ticket if they
had purchased a sports ticket than if they had purchased a vaccine
Thus spending on entertainment activities in the recent past leads
you to spend less on entertainment activities in the future!
Questions:
What might explain their results? 9
 Definition: Mental Accounting is a theory
of grouping and categorizing money and
transactions so that the individual may
systematically evaluate the potential
tradeoffs. Spending is categorized into
separate budgets for various types of items

 This is just in a company compartmentalizes

decision making into different departments
 Or how people put money into different
accounts like checking or savings
 They key is that people make decisions as if
the accounts were unrelated

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 The principle of double-entry accounting is that for every credit
to an account, there must be a corresponding debit
 Expenses on buying a computer enters the ledger detailing
acquisitions as debit; it is also recorded in the ledger detailing
inventory as credit
 Similarly in mental accounting, for every credit (to say the food
account in the case of food stamps) there must be a
corresponding debit (from the food account only)

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1. Decisions are made as if the budget for different mental
accounts are not fungible
2. Losses and Gains relative to a reference point in each
account are treated differently according to a value
function
3. Individuals receive transaction utility as well as
consumption utility

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 In public finance, we call money fungible when it can be
moved between different accounts
 For example, giving a autocratic country food aid, often allows that
country to spend more money on weapons because the money is
fungible

 The behavioral bias that characterizes models of mental

accounting stems from the fact that a person fails to treat
separate accounts or income sources as fungible

 In other words, all mental accounts should be fungible but we treat

them as separate

 Thus, even though we can easily spend money just as easily from
our savings account as from our checking account since these funds
are fungible, we may treat the savings account as off limits

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 Like business accounts, all transactions are characterized as
either a gain or a loss

 Properties of a prospect theory curve

 Diminishing sensitivity
i.e. diminishing marginal utility in gains, but also diminishing
marginal pain from losses
 Loss aversion
i.e. the kink at the origin means marginal losses are more painful
than marginal gains
 Pain from losing x is greater than pleasure from gaining x

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 Utility Value

ug

(losses) (gains)
Dollar Value

ul

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 Suppose someone has a $70,000 / year salary – this can be
thought as the reference point
 Suppose they get a bonus of $5,000 – this would be considered as a
gain
 Or suppose they get a deduction of their annual pay of $5,000 – this
would be considered as a loss

 But it can be more complicated when there are several events

that need to be evaluated at once
 Different outcomes may be suggested depending on how the items
are grouped
 Example:
 Suppose you get a $10 gain and a $20 loss
 This could be coded either as ug(10)+ul(-20) or ul(10-20) depending
on whether the events are integrated or segregated

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 Define reference point as k
 Algebraically:
u  x  k  if xk
vx | k   g
 ul  x  k  if x  k.

 We often normalize the reference point k=0, then we can write:

v  z   v  x  k | 0
 In this case, any negative (positive) value is a loss (gain)

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Example: suppose you find that dinner is $30 more than you
expected and that parking is $4 more than you expected

If these expenses are segregated, then you would experience

v(-30)+v(-4)
If these expenses are integrated, then you would experience
v(-34)

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Questions:
•Why might you think of them as segregated?
•These might be treated as separate experiences because they
occurred at different times and different places
•Why might you think of them as integrated?
•“I had to pay way too much to go out tonight”

Claim:
•Person who integrates the two losses is better off than someone
who segregates the two losses
•See next figure

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Utility Value

v  34 
v  30 

v  4
34 30 4
4 30 34 Dollar Value

v  4 

v  30 
v  34 

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 What if these were gains instead of losses?
 A person was charged $30 less than what she had expected for
dinner and $4 less than what she had expected for parking
 What if there was some gain and some loss (of equal
magnitude)?
 A person paid $30 less than she expected for dinner but found a
$30 parking ticket on her car when she leaves the restaurant

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 In each transaction within an account, people receive both
consumption utility in terms of gains and losses to the value
function but also transaction utility for that particular deal
 Thus people use a value function for transaction utility as well
 Question: Whether a person will integrate or segregate
transaction and consumption events
 Generally modeled as the person maximizing the sum of
consumption and transaction value functions

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 Consumer Problem with (mental) budgeting by categories of
goods:
max 𝑣 𝑥1 , … , 𝑥𝑛 𝑘)
𝑥1 ,…,𝑥𝑛

 Subject to:
𝑝1 𝑥1 + ⋯ + 𝑝𝑖 𝑥𝑖 < 𝑦1
𝑝𝑖+1 𝑥𝑖+1 + ⋯ + 𝑝𝑗 𝑥𝑗 < 𝑦2
⋮
𝑝𝑘 𝑥𝑘 + ⋯ + 𝑝𝑛 𝑥𝑛 < 𝑦𝑙

 Where ym represents the income allocated to each budget

category m
 The consumer here reduces the giant consumption optimization
problem into various budgets by category

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 x2
v  x1 , x2 | k 
 v  x1 *  ym , p1 , p2 | k  , x2 *  ym , p1 , p2 | k  | k 

x2 *  ym , p1 , p2 | k 

x2   ym  p1 x1  p2

x1 *  ym , p1 , p2 | k  x1 24
 Suppose we choose to plot good 1 from budget 1 and good 3
from budget 2 then
 With the same level of expenditure between these two goods,
𝑝1 𝑥1∗ 𝑦1 𝑘 + 𝑝3 𝑥3∗ (𝑦2 |𝑘)

the individual could purchase any bundle such that ,

p1 x1  p3 x3  p1 x1 *  y1 | k   p3 x3 *  y2 | k 

 The consumer did not compare these possible bundles because of

the artificial budget category
 Instead, the consumer found the tangency of the indifference curve to
budget 1 for all items in budget 1 and then found the tangency of the
indifference curve for all items in budget 2

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 Note, consumers might set budget in ways that the rational
optimum is excluded
 The consumer might allocate less to budget 1 than would be
required to purchase the unconditional optimal bundle (suggested
by the standard choice problem)
 The consumer might allocate more to budget 2 than would be
required to purchase the unconditional optimal bundle
 Thus, if consumer follows mental accounting, she would buy less of
good 1 and more of good 3 than the optimal levels
 In other words, setting artificial budgets imply that rationally
optimal consumption bundles might not always be purchased
 See next figure

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 x3

v  x1 , x3 | k 
 v  x1 *  y1 | k  , x3 *  y2 | k  | k 

x3 *  y2 | k 

x3   p1 x1 *  p2 x2 *  p1 x1  p3

x1 *  y1 | k 
x1 27
 The figure shows that the indifference curve crosses the
budget curve so that there are many points along the budget
curve that lie to the north east of the indifference curve (the
dashed portion of the budget set)
 The consumer would be better off by choosing any of these
consumption points
 Each of these points consists of consuming more of good 1 and
less of good 3

 Thus, budgeting/mental accounting leads to

misallocation of wealth so that the consumer could be
made better off without having access to any more
resources

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Final Notes on Budgeting:
 If particular income sources are connected with particular
budgets, any variability in income leads to further shifting of
funds
 If money that is received as gifts is only budget for entertainment
or for items that are considered fun, a particular large influx of gift
money will lead to over consumption of entertainment and fun,
relative to other items
 The consumer who optimizes unconditionally could instead spend
much of this money on more practical items for which he or she
will receive a higher marginal utility

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Experiment (Eply, Mak and Idsom):
Design: How did you spend your income tax rebate check if…
 It is called “withheld income”
 It is called “bonus income”

Results: 87% had spent the bonus income though only 25%
spent the withheld/refund income
Labeling income as a bonus led to greater spending than labeling
it as a return

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 Experiment (Chambers and Spencer):
•Design: How would you spend your tax return when
• You received it as a lump sum (single cheque)
• You received it as weekly per-pay cheque basis

• Results:
• Students indicate they are more likely when they get the money
on a weekly per-pay cheque basis
• Students would save 80% when it is a lump sum, but 35% when it is a
lower rate
• Perhaps a smaller amount per week is not large enough to
enter on the ledger at all, and thus is more likely to spent
instead of saved

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 People generally think that consumption and payment is
coupled
 Then, the value of buying something is the value minus the price
v(x-p)
 However, if the payment for something is separated by
sufficient time from when it is consumed, this is called payment
decoupling
 Then people would only consider v(x) and ignore the price when
deciding consumption
 Artificially increases the utility

 Might explain why people feel more indulgent while using

credit cards than when using cash for payment

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Payment decoupling implies

 Consumers consider the number and quality of the anticipated future

consumption episodes when considering the number and size of the
future payments
 Thus, a consumer facing future payments on a durable good might
consider the value of the account
  t 
v    x  p  
 t 0 
where x is the value of consumption in any time period, p is the payment on
debt for the good in any period, 𝛿 is the discount factor, and the t
represents time
For one time consumption good (i.e., consumed once but paid over
time), then after consumption has occurred, the account is evaluated as:
  t 
v    p 
 t 0 

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 If the consumer anticipates this future dread of payment when
consumption no longer occurs, then prorating payment can
lead consumers to prefer to prepay for goods that can be
consumed only once but potentially prefer to buy durable
goods on credit
 Prorating  consumers while consuming considers future
payment and future consumption when evaluating the (mental)
account
 Thus, if the future consumption is expected to be at least as good
as the forgone money, consumers evaluate the account as having a
positive balance (even though there is outstanding debt) [durable
goods]
 If there is no future consumption, ignoring/discounting prior
consumption implies the account has a negative balance [non-
durable goods]

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One of the primary suppositions of the mental accounting
model is that consumers prefer to close an account when they
have a positive or zero balance

Example: Suppose you bought a house. The initial cost of the

house is a natural reference point

Selling the house will close the account. People become

reluctant to sell the house at a loss
 Thus, people might continue with investments/activities that are
losers in hopes of obtaining a balanced mental account
 Were these sunk costs to persist in one’s memory forever, the
accounts may be at loss at perpetuity, and the person would
continue with bad investments forever (hoping to eventually
balance the account)!
 Luckily this does not happen due to payment depreciation
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 The reluctance to close accounts fades over time through
payment depreciation
 We can represent this symbolically as:
𝑣(𝑥 − 𝑝𝛿 𝑡 )
 Thus, as time passes, the price paid plays less and less of a role in
utility (𝛿 𝑡 gets smaller and smaller as 𝛿 < 1)
 So that accounts may be closed at minimal loss
 May be that is why we hang onto more expensive items as they age
(because original p is high), whereas comparably functional items
that were cheaper would be thrown (because original p is low)

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 Rational choice models have a difficult time explaining the
notion of temptation
 Temptation  consumers want something but don’t think they
should have it (e.g. a slice of chocolate cake)
 Traditional economics generally uses the utility function to
capture what consumers want and what they think they should
have – thereby eliminating role of temptation
 However, efforts have been made to model temptation in a
rational choice setting using an intertemporal utility
framework…

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 Temptation is modeled by differentiating between short-run
and long-run impacts of goods/activities
 A good can generate an immediate positive utility (say, taste
of a desirable dessert) but a negative long-term impact on
utility (extra pounds)
 Let u be the utility of consumption in any period given the
health ht. x is the cake consumption in the first period. z is
future consumption
 Consumer problem:

max u  x | h0    u  z | h1  x  
x

z is taken as given
Presumably, increasing consumption of cake decreases health in
the future, thus decreasing utility in the future

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 In the traditional model the consumer selects x* that
maximizes intertemporal utility
 This represents the notion that the consumer desires the cake
now but dreads the impact it could have on future health
 So, there should be no regret in the rational framework
 The consumer in a rational choice framework, although might
desire better health, must acknowledge that he has made the
correct choice
 But, in reality we do find people eat so much cake that
afterwards they regret their action and believe they should
have shown more restraint!

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 Because budgets are treated as non-fungible, people use
accounts to limit temptation (and hence reduce regret!)
 Shefrin and Thaler propose three types of mental accounts:
 current income
 money kept in this account meant for spending in near term – very
tempting hence
 current wealth
 money in this account less tempting; substantial justification must be
found
 future wealth (e.g. retirement saving)
 untouchable

 People might want a portion of one’s paycheck to be placed in

each of these three accounts

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 Issue: Artificial rules might not always lead to optimal
behavior
 It might save people from over-spending but it might prevent
them from consuming more expensive wine on occasion
when such a purchase might be justified
 For example, if one sets an artificial budget for consumption
of wine to $20, then she will never want to buy more
expensive and more tempting wines (which costs say around
$50) on very special occasions even though that she would
really prefer to
 In such cases, she might be made better off by gifting her a
bottle of wine that costs $50 instead of gifting her cash
 General principal: by giving gifts instead of cash can often
make consumers better off
 Justifies why people gives gifts (because one would think that
giving cash would always make people better off)

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 For marketers…
 Mental accounting suggests that how you categorize your
product and how you frame purchasing decisions does matter
 Segregating gains can induce greater sales
 Use of pre-payment for single consumption items (vacations)
induce greater sales than offering consumers financing alone
 Goods that receive repeated use (durable goods) may be more
easily be sold with financing that amortizes the costs over the life of
the product

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 For consumers…
 Who suffer from self-control problems, using budget mechanism
could be an effective tool
 Who do not suffer from self-control problems, budgets should be
set to maximize the enjoyment from consumption over time
 More generally, people who behave according to mental accounting
heuristics can potentially improve their wellbeing by reevaluating
their spending budgets regularly, cutting budgets for which the
marginal utility is low relative to others

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 People use mental accounts to make decisions

 Mental accounts have three main properties

 People behave as if transactions across accounts are not fungible
 Gains versus losses matter
 Transaction Utility also matters

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1. Consider a high school student who gets lunch money,
money from a part time job, an allowance, and a raise. How
does each source matter?
2. Suppose you manage a factory. What is the best way to
frame incentive pay bonuses?
3. How should you think about buying a video game for your
friends when you know they worry about temptation and
that they have different mental accounts?

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Shape of value function indicates:

 Case 1: Multiple gains

x>0, y>0
 v(x)+v(y) > v(x+y)
 Individual feels better off segregating

 Case 2: Multiple Losses

x<0, y<0
 v(-x) + v(-y) < v(-x-y)
 Individual feels better off integrating

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 Case 3A: A Loss and a Gain, but the net is positive (under
strong loss aversion)
x>0, y<0, x+y>0
 If there is strong loss aversion, then the individual feels better
off integrating
 A value function conforms to strong loss aversion, if for any two
positive numbers z1 and z2, with z2 > z1, it is always the case that
𝑣𝑔 𝑧2 − 𝑣𝑔 𝑧1 < 𝑣𝑙 𝑧2 − 𝑣𝑙 (𝑧1 )
 This requires that a loss function has a greater slope than the
gain function at a given distance from the reference point
 The slope over losses near the reference point is always assumed to
be steeper than the slope over gains
 Further, the slope over gains is decreasing owing to diminishing
marginal utility over gains

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Utility Value

v  x

v x  y
y
x y x
Dollar Value
v  x  v  y

v  x

v y

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 Explanation of the figure:

• v(x) > 0, v(y) <0, |v(x)|< |v(y)| implies v(x) + v(y) will lie in
the lower vertical axis
• On the other hand, x>0, y<0, and |x|>|y| implies x+(-y)>0
and hence, v(x+(-y)) lies on the upper vertical axis
• Therefore: v(x+(-y)) > v(x) + v(y)

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• Case 3B: A Loss and a Gain, but the net is positive
(without strong loss aversion)
x>0, y<0, x+y>0
• In absence of strong loss aversion, whether an individual feels
better off or worse of by integrating relative to segregating
cannot be unambiguously determined

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Utility Value

v  x
v  x  v  y
v x  y
y
x y x
v y Dollar Value

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 The previous figure shows that in absence of strong loss
aversion [check for any two positive numbers 𝑧1 and 𝑧2 with
𝑧2 > 𝑧1 , we now have 𝑣𝑔 𝑧2 − 𝑣𝑔 𝑧1 > 𝑣𝑙 𝑧2 − 𝑣𝑙 (𝑧1 )], v(x) +
v(y) > v(x+(-y))
 However the reverse can also be true

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 Case 4: A Loss and a Gain, but the net is negative
x>0, y<0, x+y<0
 Indeterminate
 Try!

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 Up until now, prospect theory value function written in terms of
monetary outcomes and a reference point as a monetary
amount
 This type of analysis suffices when considering a single
consumption activity/good
 If we are considering multiple consumption activities, it may be
that the consumer faces a reference point that includes
consumption level of each good (multiple reference points)

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 Someone who consumes 2 eggs and 1 toast for breakfast
every morning, would consider 2 eggs and 2 toasts as a gain
or 3 eggs and 1 toast as a gain, and 1 egg and 1 toast as a loss
 But, what about 1 egg and 2 toasts?
 Loss in one dimension and gain in the other

 For loss averse person, loss in one dimension decreases utility

by much more than gain in other dimension
 Thus to be at the same level of utility, losing 1 egg must be
compensated by a lot more toasts than the consumer would
be willing to give up in order to gain 1 more egg!
 Implies a kink in the indifference curve…

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x2

x2r

v  x1 , x2 | x1r , x2r   k

x2   ym  p1 x1  p2

x1r x1 56
 On the right side of the kink (reference point), loss in good 2
and gain in good 1
 Small losses in good 2 must be compensated with large gains in
good 1
 On the left side of the kink, loss in good 1, and gain in good 2
 Small losses in good 1 must be compensated with large gains in
good 2

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