Mental budgeting

What is mental budgeting?

Mental budgeting is the allocation of resources to categories and the tracking of expenses against those categories. It is one part of the broader concept of mental accounting.

Evidence

Heath and Soll (1996) examined budget setting and expense tracking in three studies. Purchases that clearly fit a category could reduce willingness to make further purchases within that category, beyond income and satiation effects considered in the studies.

An illustration

Suppose a household’s repair budget is empty, but money remains in its vacation budget. A leaking faucet needs attention. The household can afford the repair overall, yet postpones it because the repair category has no money left. The mental budget makes the category balance, rather than only the total available, part of the choice.

If the household considers the repair a higher priority, refusing any transfer between categories can obstruct its own goal. But earmarking vacation money may also serve a deliberate savings plan. The example shows how to identify the tradeoff, not that every separate budget is irrational.

Limits

Separate categories can be useful rules for managing spending. To judge a particular budget, ask whether it serves the person’s goals and constraints. A label alone does not tell us that the decision was a mistake.

The denomination effect instead concerns how the form of money can affect spending.