This irrationality is predictable and, fortunately, can be used to positively influence our motivations, decision making and behaviors.
It starts with mental accounting. Mental accounting is what we use to differentiate our life’s accounts. We have a mental account for vacation time. We have a mental account for effort at work. Birthday money, paychecks, commissions and small gifts of money end up in the checking account. When we go to spend from an account, we don’t differentiate the sources. Our brains don’t calculate that “this slow cooker was 20% paid for with birthday money from Auntie Marguerite, 70% paid for with my regular salary and 10% with money from my parents.” Our brains don’t process transactions that way in part because our brains are somewhat lazy.
Mental accounting also informs us that we perceive $20 off the $50 item as a richer percentage (40%) than $20 off the $5,000 item (4/10ths of 1 percent). A 40% discount is much more attractive even though the cash value is the same. It’s a fact: $20 is still $20 no matter how you slice it.
Modest cash values don’t get differentiated into separate mental accounts. However, when the values are large – say a $20,000 bonus – it’s easier for the brain to allocate those funds for an upgrade to the kitchen, an exotic vacation or a means to pay down the mortgage. For most of us, however, those situations are far and few between.
Using Behavioral Economic Superpowers for Good
Mental Accounting can be used to improve our subjective wellbeing, or happiness. In many corporations today, employees can earn points for completing major projects, participating in health and wellness activities, achieving sales objectives, and a variety of other circumstances. Normally, points make up a small percentage of salary – usually between 1% and 5% of total earnings.
Consider for a moment that you earn $50,000 at your job. You’re given an opportunity to earn $500 in a year-end bonus – contingent on completing a massive project during the year. Your mental accounting says that a $500 bonus on $50,000 in salary is a measly 1%. (Small percentages leave us cold.)
Now consider the situation with help from behavioral economists applying a mental accounting tool.
Imagine that you still earn $50,000 salary and you can also earn $500 in points (that cannot be combined with cash) from a variety of small payouts throughout the year. Because different sized achievements warrant different sized awards, you were able to earn $100 in points for one project. Your mental accounting says that’s 25% of your total point-earning opportunity – a rich payout percentage. (We like larger percentages.)
The money account is a $50,000 account while the point account is only a $500 account. Mental accounting informs us that when payouts occupy a larger percentage of the mental account, we enjoy them more.
Guilt and the Joy of Being Human
There’s another important factor that influences what we do with the $500: guilt.
If you were fortunate enough to earn the $500 cash bonus at the end of the year, what would you do with it? Would you indulge? Would you pamper yourself with an off-the-hinges spa day? Splurge on a shopping spree? Buy a couple of new golf clubs you’ve been coveting (even though you don’t need them)?
No way. That $500 would be used more pragmatically. Our rational selves would take over and divvy up the $500 between the Visa bill, the kid’s braces or this month’s gas and electric bill. Why? Guilt.
Now consider the alternative. Let’s say you earned all $500 in points throughout the year. Would you indulge? Would you pamper yourself? Would you grab those new golf clubs? Of course you would – especially if you couldn’t combine your own cash with the points. You would consume them guilt-free. Imagine the conversation at home walking in the door with the new clubs:
“Hi, I’m home.”
“Are those new golf clubs in your hands?”
“Yes – this is the new Z1000 mega driver. It’s going to improve my long game!”
“And just how much did THAT cost? Did you recall we have two kids in braces?”
“I only used points from my company. I didn’t spend a dime.”
This is a guilt-free exchange. Everybody wins.
Our research indicates that given the same payout in points or in cash equivalents, people are six times more likely to splurge on luxury items with points.
Motivation and Counter-Intuition
As lazy as our brains are, we are remarkably quick to calculate percentages and assign motivations. We know from the very start of the year that if we earn the $500 cash bonus, we’re going to spend it on bills (research indicates that 86% of all cash bonuses go to pay bills or are unmemorable). Those facts work against our motivation to earn. The brain quickly decides we’re not willing to go through all the effort just for 1% of our salary.
The points story is just as quick to play out. When we calculate what we can take home guilt-free with our points, it effects our motivation in a positive way. We get emotionally engaged in the golf clubs in a way that is nearly impossible to be engaged with our kids’ orthodontic bills.
Research in the area of awards is clear. While people indicate their preference for cash awards, they work significantly harder and achieve significantly more when they are striving toward guilt-free awards (such as points that cannot be combined with cash).
Mental Accounting Matters
Human beings are robust and frail, courageous and cautious. We can enumerate examples of both strengths and weaknesses. Behavioral Economists help us understand how our decision-making succumbs to psychological frailties and mental accounting helps us overcome them.
The good news is that we naturally split up different currencies (cash and points) into different mental accounts. We can spend from each of those mental accounts using different rules. We will still rationalize that the price we pay for the beer from the 5-star resort offsets the cost of the beautiful surroundings…but it’s still the same beer we could get for half the price at the dive bar down the street. Cheers.