ECO331: Behavioural & Experimental Economics - Mental Accounting and Myopic Loss Aversion

Flashcards covering key vocabulary and concepts from the lecture on Mental Accounting and Myopic Loss Aversion in Behavioural & Experimental Economics.

Mental Accounting

A set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities, explaining phenomena like the sunk cost fallacy and influencing risk aversion.

Sunk Cost Fallacy

The tendency for individuals to continue an endeavor once an investment in money, effort, or time has been made, often explained by mental accounting.

Hedonic Editing

The process of classifying outcomes and actions to maximize perceived 'utility,' typically by breaking up gains, offsetting small losses with larger gains, segregating big losses from small gains, and aggregating losses, assuming Prospect Theory.

Myopic Loss Aversion

A behavioral phenomenon combining mental accounting and loss aversion, often explaining why individuals reject favorable long-term gambles due to evaluating them over short, isolated horizons.

Homo Economicus (in context of mental accounting)

An economic model of human behavior that assumes individuals make decisions with the broadest framing, considering only their total net benefit and utility over final states rather than changes from a reference point.

Utility over final states

A concept in economic theory where an individual's utility is derived from their absolute wealth or final outcome, rather than from changes relative to an initial reference point.

Change from reference point

A concept in behavioral economics where an individual's utility is derived from gains or losses relative to a specific starting point or reference level, rather than from absolute final wealth.

Mental Accounting (Concert Ticket Anomaly)

An example where losing money on the way to a concert or losing the ticket itself leads to different willingness to pay for a replacement, contrary to the broad framing predicted by homo economicus.

Tax Rebate Cheques (Behavioral Aspect)

A form of Keynesian stimulus largely saved by consumers, suggesting that individuals typically 'mentally account' these as windfalls or savings opportunities rather than spendable income.

Reduced Pay Cheque Withholding (Behavioral Aspect)

A form of tax reduction that often leads to a higher marginal propensity to consume, suggesting individuals 'mentally account' these changes as increases in regular income, stimulating consumption more effectively than rebate cheques.

Supplemental Nutrition Assistance Program (SNAP) (Behavioral Aspect)

A program providing restricted benefits (food stamps) that, contrary to homo economicus predictions, leads to increased food spending even for recipients for whom the benefit is economically equivalent to cash, illustrating mental accounting for specific spending categories.

Narrow Bracketing (Mental Accounting)

The tendency for individuals to place financial inflows and outflows into specific, narrowly defined mental accounts, leading to different marginal propensities to consume for different categories of income or expenses.

Pennies-a-Day Framing

A marketing strategy that frames costs as small, ongoing expenditures to make them seem less significant, by encouraging comparison with other small, frequent expenses within a specific mental account.

Mental Accounts of Income (Thaler's Categories)

Richard Thaler's proposed three mental accounts for income: current income (high mpc), asset account (medium mpc), and future income (mpc near zero), demonstrating differential spending behaviors based on income source categorization.

Loss Realization Aversion

The psychological reluctance to close mental accounts that are currently showing losses, meaning individuals are less willing to sell assets that have decreased in value, hoping to avoid 'locking in' the loss.

Sunk Cost Bias (Mental Accounting Explanation)

The tendency to continue an activity or investment due to previously incurred costs, explained by mental accounting as a desire to combine the benefits of future decisions with these past costs within the same mental account.

Arrow (1971) on Small Gambles

A finding that expected-utility maximizers should ideally be approximately risk neutral for small-stakes gambles, implying that significant risk aversion in such scenarios points towards very narrow framing.

Rabin Paradox (2000)

A theoretical finding demonstrating that if an expected utility maximizer rejects a small-stakes gamble, the degree of diminishing marginal utility implied over plausible ranges of wealth would lead to absurdly high levels of risk aversion for much larger gambles.

Loss Aversion

A core concept of Prospect Theory stating that individuals feel the pain of a loss more intensely than the pleasure of an equivalent gain, contributing to observed risk-averse behavior.

Samuelson's Bet

A classic illustration of myopic loss aversion, where individuals reject a single favorable bet but would accept many independent repetitions of the same bet, due to evaluating each outcome in isolation rather than aggregating risks over time.