Category Archives: Deciding

Mental accounting at the pump

Mental Accounting and Gasoline Consumption, by Justine Hastings and Jesse M. Shapiro

“When the price of gasoline increases … the market share of regular gasoline increases while the market share of higher quality gasoline falls.”

While conventional economic theory suggests that decision makers treat a dollar as a dollar no matter how it was earned or is to be spent, in practice some households may engage in “mental accounting” — setting aside special budgets for certain purposes, like food, clothing, or transportation. Households that budget this way may respond to a given income gain, or loss, differently depending upon how it arrives. For example… a household may reduce spending on vehicle-related luxuries more in response to an increase in fuel prices than in response to a comparable loss in financial wealth.

In Mental Accounting and Consumer Choice: Evidence from Commodity Price Shocks (NBER Working Paper No. 18248), Justine Hastings and Jesse Shapiro consider this type of mental accounting with data on purchases of gasoline. Using aggregate data covering 1990 to 2009 and data on purchases at a retailer for 2006 to 2009, the authors find a clear and positive effect of gasoline prices on the market share of regular gasoline, the lowest quality gasoline available. When the price of gasoline increases — typically by similar amounts at all quality levels — the market share of regular gasoline increases while the market share of higher quality gasoline falls.

The extent of this substitution from higher quality gasoline to regular gasoline cannot be explained by income effects alone. During the 2008 financial crisis, for example, the income effect would have predicted an increase in the purchases of regular gasoline and a decrease in the purchases of premium gasoline. In practice, the opposite occurred.

Moreover, the income effects necessary to explain the relationship between gasoline prices and quality choices are extremely high. Households adjusted their mix of gasoline purchases almost 20 times more to a reduction in their buying power because of an increase in gasoline prices than to an equivalent reduction in income from other sources.

Psychological models of decisionmaking may be able to help explain the buying patterns observed in the data. These findings also have interesting implications for retailer behavior — they indicate that consumers will put a higher premium on saving money on gas in high-gas-price times than in low-gas-price times. This implies that retailers will face more intense competition during high-price times. That prediction is borne out in data that shows lower retail margins on gasoline in periods when oil prices are high.