Mental Accounting

Richard Thaler (1985): people treat money differently based on where it came from or what it's for. Lottery winnings are "house money" — spent more freely. Tax refunds feel like "free money." $100 found in a pocket vs $100 earned — we spend differently. Classical economics assumes fungibility: a dollar is a dollar. Thaler showed we violate this systematically. We maintain separate mental accounts — vacation fund, retirement fund, rainy-day fund, "fun money" — and apply different rules to each. Money in the vacation fund gets spent freely. Money in the retirement fund feels untouchable. A person who refuses to dip into savings to buy a $200 jacket will happily charge the same jacket on a credit card — because the credit card draws from a different mental account.

The sunk cost fallacy is mental accounting. Money spent on a project is "sunk" — unrecoverable regardless of future decisions. Rational analysis ignores it. Mental accounting keeps the account open; we continue investing to avoid closing it at a loss. Amazon's "free" shipping — we have a separate mental account for shipping. Prime members prepay; each delivery feels free because the cost was debited to a closed account. The strategy: frame prices to exploit or combat mental accounting. Annual subscription vs monthly — different mental accounts, different scrutiny, different decisions. Thaler won the Nobel Prize in 2017; mental accounting was central to the citation.