When gasoline prices spike, do you go in search of the station with the lowest price or wait in a long line to save 5 cents a gallon? When prices fall, do you splurge and pay 10 cents more for brand-name gasoline that promises to make your engine run more smoothly?
You are like most people if you answered yes to either question. Jesse Shapiro and I have researched how consumers buy products, from gasoline to groceries. It turns out that people typically overreact to price or income changes within an expenditure category like gasoline. They work to save or splurge more than they would in response to a change in overall income of similar size.
Why do people react this way? Balancing a budget is difficult. Prices fluctuate and unforeseen expenditures occur. It would require a sophisticated optimization routine to rebalance a budget smoothly across all expenses each time prices or personal income changed. To make this problem tractable, people divide and conquer by breaking down overall budgets into easy-to-remember categories and targets, such as gas money, rent money, grocery money and fun money. By remembering a few targets and sticking to them, people may win the overall budget battle and avoid spending or saving too much. Behavioral economists refer to this as "mental accounting."
Mental accounting recommendations can be found in many self-help guides for budgeting. But mental accounting can cause us to behave in irrational ways, as we compartmentalize our decisions and lose sight of the larger picture.
Economists are often irrational consumers too. Personally, I am tempted to buy a cheaper coffee bean than my favorite brand when prices rise. I often consider waiting in line for a cheaper brand of gasoline when gas prices rise, and I stop doing this when prices begin to fall. But waiting in line is not necessarily a good use of my time or a good way to save a couple of dollars out of all the ways I could save in my overall budget. Splurging on name-brand gasoline is also probably not a great way to spend the windfall created by low gas prices. Maybe I should spend that savings somewhere else—perhaps on a better glass of wine.
In the broader economy, mental accounting can be harnessed for good. Governments could nudge consumer behavior by targeting stimulus packages for durable goods in recessions, or by earmarking supplemental nutrition funds for fresh foods. Certainly companies recognize that a dollar is not always a dollar, as they try to win customers with gasoline rewards on their credit cards when prices are high and their mental accounting "gas envelope" is running on empty.
My research has encouraged me to be less sensitive to categorical income and price changes. Instead of thinking that my coffee is 20 percent more expensive during a price peak and that I should try to save money on coffee, I remember that my overall income is now $4 less a month (or so). I remind myself to save a little extra money when an opportunity arises in any category, while still enjoying my favorite cup of coffee. I use credit cards that offer the cash-back bonus, remembering that an actual dollar returned in cash can be spent on gasoline or coffee, or in any other budget category I choose.