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Evaluation of the Mental Accounting theory in Relation to the Prospect of Gains and Losses
Name
Institution
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Evaluation of the Mental Accounting theory in Relation to the Prospect of Gains and
Losses
Introduction (Name year, page)
The mental Accounting Theory is an economic concept developed by an economist called
Richard Thaler. It asserts that individuals possess a tendency to divide their existing and future
properties into distinct, non-transferable segments. It further states that individuals allocate
various levels of value to each asset segment and this in turn affects their behaviors and
consumption patterns. One of the most common definitions of the theory pertains to its
comparison with managerial and financial accounting as is commonly practiced by organizations
all over the world. Mental accounting gives a description of how individuals and organizations
can trace the origin and destination of their financial resources and to regulate spending. The
Prospect Theory on the other hand is a behavioral economic supposition that describes how
individuals are able to arrive at decisions in situations of uncertainty or where risk is involved.
This essay seeks to discuss the mental Accounting Theory and the Prospect Theory and critically
evaluate the two in relation to each other (Thaler 2004, 10).
Mental Accounting Theory
The mental accounting theory has three components through which it operates. The first
component expresses how various outcomes are arrived at and the manner in which decisions are
chosen and ultimately evaluated. Through accounting systems, both ex ante and ex post cost
benefit evaluation can be achieved. To best illustrate this component, consider a scenario where
an individual seeks to purchase a flat screen television. Though the televisions comes in various
sizes with varying prices, the individual finds a clearance sale in which the prices of the
television sets are standard. The individual opt for the largest size flat but later discovers that it

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does not fit into his wall unit. Here, the individuals choice can be rationalized through the
incorporation of the transaction utility into the purchase decision calculus.
The second component revolves around the allocation of activities to certain accounts. In
this component, the sources and intended usage of funds are earmarked in reality and mentally.
Intended usage of funds is categorized and planned and as a result, spending is controlled by the
budget lines and unforeseen costs are catered for. Through planning, any unforeseen losses are
minimized to ensure that their effects have a lesser impact. For instance, an individual sets a
target amount to be contributed to a local charity account each year. In the event that any
unforeseen expenses are incurred during the course of the year, the individual can simply deduct
the unforeseen expense from the charity account to compensate for this expense. Through this
charity account, the losses incurred by the individual are relatively less painful.
The third component of this theory concerns the rate at which accounts are appraised.
Accounts can be balanced at periodic intervals such as weeks, months or years to determine the
financial value or worth at that time. Poker players are often reminded to not count their money
while playing since in such cases, as it is in other forms of investment where decisions are made
under uncertainty, since this can be misleading. The mental accounting theory empowers us to
comprehend the psychological process of choice since the accounting decisions can alter the
perception behind the appeal of any choices (Davies, Easaw and Ghoshray 2006, 6-15).
The Prospect Theory
According to the prospect theory, individuals go through two distinct phases when
choosing between options that involve risk or uncertainty. During the first phase, individuals
seek to simplify complex scenarios into more conversant situations mostly in terms of gains and
losses. For instance, buying a $25,000 vehicle may be seen as losing the $ 25,000 or attaining a

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vehicle while purchasing a 1$ ticket to enter into a $1,000,000 draw may be seen as losing the
value of the ticket in exchange of gaining the chance to win the prize of the draw. A distinct
feature of this phase is that the manners in which individuals translate such scenarios vary with
time and the surrounding conditions. As with the case of the lottery draw, an individual may
consider it to be a 0.001% opportunity to win the million dollars or a 99.999% chance to lose the
dollar (Wakker 2010, 2-5).
The second phase involves the process of choosing between the identified options that are
available to them. This choice arrived at depends on two aspects; the perceptible worth of each
option and the significance assigned to the option. These two aspects are then utilized by the
decision maker in the process of arriving at a choice. The most riveting aspect of the Prospect
Theory is that it gives a rationale for why and when people opt for controversial decisions that
differ from conventional decisions and as such tries to explain why individuals make
transparently poor life decisions on a daily basis (Wakker 2010, 2-5).
Evaluation of Mental Accounting Theory in Relation to the Prospect of Gains and Losses
Under the Mental Accounting theory, the value function adopted by Kahneman and
Tversky's Prospect Theory is substituted in place of the utility function from the economic
theory. The Prospect Theory predicts that choices made in uncertain scenarios depend on a
combination of the end products apparent worth, dictated by the value function. The value
function has three fundamental aspects that capture the key essential element of mental
accounting. Firstly, the value function is expounded over both gains and losses in consideration
to a reference point. The focus given to changes as opposed to wealth levels demonstrates
gradual nature of mental accounting. Here, transactions are evaluated individually rather than as
a group. The second aspect assumes that the gain and loss functions are concave and convex in

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nature, a feature that reflects the Weber-Fecher Law which dictates that the difference between
$50 and $100 seems larger than that between $1050 and $1100, regardless of the sign. The third
aspect centers on loss aversion which dictates that losing $500 is considered more painful than
gaining $500 is considered pleasurable.
With regards to the mental accounting, the value function serves to describe the manner
in which events are discerned and coded in the decision making process. According to
Kahneman and Tversky, outcomes in decision making can be framed in three ways with regards
to a minimal account, a comprehensive account and a topical account. The minimal account
enables for the comparison of two choices through the examination of the differences that exist
between the choices while disregarding all other aspects. A topical account links all the
consequences of the available choices to a referral level that is dictated by the context from
which the need of the decision arises. A comprehensive account takes into account all the other
factors such as the possible outcomes of impending activities, wealth and projected earnings
among others (Wilkinson & Klaes 2014, 254).
Consider a situation where an individual seeking to buy a laptop worth $450 learns that
he can get the same laptop for $10 less at a store located half an hours drive away. Consider the
same situation for a book worth $25 in the first store and $15 in the second store. When these
two scenarios are given to an individual, most individuals under the topical account would take
the drive to save the $10 for the book rather than the laptop. However, under the minimal
account, individuals would question the need to cover the thirty minute drive to save the $10 in
either scenario. Interestingly, the manner in which a decision is conceived bears little alteration
to the choices in the case that the decision maker is using the comprehensive account mentality.
However, in the real world framing affects the choices made since people arrive at decisions

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gradually under the influence of the context of the existing scenario (Grinblatt & Han 2005, 311339).
Suppose that a gambler at the casino wins $500 at the tables on his first try but then goes
on to lose $100 on his second try. The outcome of the second bet may be seen as either a loss of
$100 from his recent $500 gain or simply as a loss of $100. In such a choice context, the decision
maker has the ability and flexibility to think about the issue at hand. The process by which such
problems are formulated differs slightly in the mental accounting and the prospect theory since
the proposed value function is non-linear. One critical feature in mental accounting is narrow
framing; in which the gambler treats each gamble individually. When placing a bet, most people
will evaluate it separately from other pre-existing bets to determine whether the new bet will be a
worthwhile investment (Grinblatt & Han 2005, 311-339).
The nature of the value function dictates that minor changes witnessed near the reference
point are likely to yield a greater dramatic influence on decisions made rather than those further
away from the reference point. Secondly, the asymmetry between gains and losses on the value
function dictate that people will generally be loss aversive and this explains the reluctance of
individuals to gamble with funds that they have an equal probability of losing and winning.
Third, the asymmetry also means that people are more likely to be more risk seeking in the
domain of losses and risk averse when it comes to the domain of gains.
Conclusion
Kahneman and Tverskys (1979) prospect theory give a description of how losses
incurred by individuals bear more pain than the equivalent pleasure brought about by gain. The
disposition effect explains how individuals would rather sell an investment to attain a gain than
they would at a loss. Through averting an individuals attention from the losses they wouldl

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encounter in an investment, they are able to feel better about themselves and the decisions they
make and thereby derive greater utility in the short-term. Many theorists and academic persons
recommend against the use of mental accounting in economic reasoning since avoiding regret by
mental accounting creates greater discrimination in resource allocation and consequently to more
unavoidable regret in the long-term.

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References
Davies, S, Easaw, J, and Ghoshray, A, 2006, Mental Accounting and Remittances: A Study of
Malawian Households, Proceedings of the seminar in Chancellor College, University of
Malawi, Zomba, September 2006, University of Bath, Bath, United Kingdom
Grinblatt, M., and Han, B. 2005, Prospect Theory, Mental Accounting and Momentum, Journal
of Financial Economics, 78, 311-339
Thaler, R. 2004, Mental Accounting Matters, in Advances in Behavioral Economics, eds. C.
Camerer, G. Loewenstein and M. Rabin, Princeton: Princeton University Press.
Wakker, PP 2010, Prospect Theory: For Risk and Ambiguity. 1st Edition. Cambridge: Cambridge
University Press
Wilkinson, N & Klaes, M. 2014, An introduction to Behavioral Economics. 2nd Edition. London:
Palgrave Macmillan.