This Christmas, I bought my partner a gift card. At first glance this seems like an irrational thing to do. The cash equivalent could have been spent on anything, including the items covered by the card; this interchangeable use of money is a central principle in classical economics known as the fungibility of money. Did I willingly reduce the value of my gift, or does this economic principle fail in the gift giving environment?
To answer this question, we need to examine how our minds evaluate and organize financial activities and whether extra value can be gained in ways contradictory to classical economic theory. This concept, known as mental accounting, was explored in detail by Richard Thaler in his 1999 paper Mental Accounting Matters.
Mental accounting – the set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities.
Thaler describes three components to his mental accounting framework, where psychology interacts with economics leading to behaviors that contradict the fungibility of money principle.
- Assessing the value of items, services, events or outcomes
- Organizing activities into separate mental accounts
- Balancing individual mental accounts
1. Assessing value: what’s it worth?
When we assess the value of something, context matters. Imagine you are out shopping; would you consider spending an hour travelling across town to visit a different store if:
- You find out the$100 pair of sneakers you are buying are on sale for $50?
- You find out the $2,000 laptop you are buying is on sale for $1,950?
If money is truly fungible, these events should have the same value assessment. Essentially, is $50 a fair exchange for the action of travelling across town to the other store. However, people are more likely to travel when the discount is a larger proportion of the overall spend, seeming to assign some kind of mental value to ‘the deal’ itself. The value of the deal is also why a $10 bottle of wine seems much more appealing if we think it has been reduced from $20.
Our natural tendency to avoid losses creates another inconsistency, known as the endowment effect, where we place more value on objects we already own compared to ones we do not. A few years ago, I bought tickets to see Beyoncé at Wembley. Thanks to a nudge from my colleague Noosha, I logged on the hour the tickets were released and secured mine at face value of around £100. As the event drew closer, the resale value shot up to a ridiculous £1000. I would never have considered buying a ticket for that much, so if money was truly fungible I would have sold up and been happy with my profit. But the endowment effect meant I hung on to my ticket and without it I would never have seen that live performance of Survivor!
We also make different value assessments depending on the baseline to which we are comparing. Arsène Wenger, the legendary Arsenal football manager, once said that when spending money on player transfers, he treated the club’s money as he would his own. This mental accounting probably led to the many years of cautious investing that are often blamed for Arsenal’s gradual demise on the pitch. If only Arsène had treated the money like it belonged to the billionaire owner, who seemed to take a $0.5bn lawsuit from the city of St Louis in his stride, rather than himself!
2. Organizing activities: never the twain shall meet
The second key component of mental accounting is the way in which we mentally organize our finances. We tend to group spending into a set of core categories, such as living expenses, investments, leisure, health. These separate mental accounts often end up with completely different budgets and baseline expectations. For example, a $100 spend in my ‘leisure’ account seems extravagant, but in my ‘investments’ account it feels reasonable. The characteristics of different mental accounts can lead people to value money assigned to one specific account very differently to money assigned to another.
What’s more, money held in different accounts does not seem to be fungible. This is highlighted by a phenomenon known as the credit card debt puzzle, where people hold expensive, high interest credit card debt at the same time as easily accessible savings. A 2019 survey of US consumers identified 42% of the sample as “borrower-savers”: people that hold more than $100 in credit card debt and more than $100 in liquid assets. If money was fungible, the liquid assets would be used to pay down the debt reducing interest costs.
3. Balancing the books
How often you ‘clear’ your mental accounts and how you group certain gains and losses will also affect your happiness and satisfaction. Loss aversion again plays a crucial role: as losses are felt more than gains, if you take mental note of your account balance after a loss and then again after a gain, you will feel less satisfaction than if you had checked the balance only once, after both transactions.
This, and the frequent fluctuations in stock prices, is why investors in the stock market who check their balances more often are less satisfied with their portfolio performance, seek to avoid risk and on average earn less interest. This mindset is also used to increase satisfaction with saving into occupational pensions, where payments are taken before they reach an employee’s bank account thus avoiding the separate coding as a gain followed by a loss.
With a contrasting effect on my savings account, it is also this mindset that allowed me to see a great many shows during my busking days at the Edinburgh festival. Regularly, after performing a street show, I would stay in town and buy show tickets directly from the cash I’d collected. Without this money ‘clearing’ into my other finances I ended up seeing far more shows than I would have otherwise justified.
What does this mean for gift giving?
A famous economic analysis of gift giving at Christmas by Joel Waldfogel focuses on the loss of value of gifts, known as deadweight loss, between the amount the giver pays and the value assigned by the receiver. Waldfogel estimates a loss of as much as 33% in value of the gifts given in the holiday season. However, the value assessment in his analysis focuses entirely on the replacement values of the gifts and ignores other sources of value arising from mental accounting.
Thinking back to the gift card, I am confident that the amount of happiness my partner gained from the gift is actually in excess of what she would have felt with the cash equivalent, arising from:
- Extra value from the context: the sentimental value of the place the card can be redeemed, the feeling of being seen (my partner has previously mentioned her desire for a return visit), and the endowment effect of receiving a gift in the first place should all add extra value.
- Extra value from the assigned mental account: the gift can only be redeemed in the “leisure/luxury” mental account, freeing my partner from any pressure or guilt to use the money for something sensible and unlocking extra happiness.
- Extra value from the grouping of mental transactions: my partner will not have to balance her mental accounts after receiving the gift and then again after spending the gift, avoiding the detrimental effects of loss aversion and increasing overall happiness.
I think the true measure of deadweight loss at Christmas may well be much lower than that suggested by Waldfogel.
What do you think?
Does mental accounting assign extra value to gifts? Was it a good idea to buy the gift card? Or did I unwittingly create deadweight loss during the holidays?