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A concept first named by Richard Thaler, mental accounting (or psychological accounting) attempts to describe the process whereby people code, categorize and evaluate economic outcomes. People may have multiple mental accounts for the same kind of resource. A person may use different monthly budgets for grocery shopping and eating out at restaurants, for example, and constrain one kind of purchase when its budget has run out while not constraining the other kind of purchase, even though both expenditures draw on the same fungible resource (income).
One detailed application of mental accounting, the behavioral life cycle hypothesis (Shefrin & Thaler 1988), posits that people mentally frame assets as belonging to either current income, current wealth or future income and this has implications for their behavior as the accounts are largely non-fungible and marginal propensity to consume out of each account is different.
In mental accounting theory, framing means that the way a person subjectively frames a transaction in their mind will determine the utility they receive or expect. This concept is similarly used in prospect theory, and many mental accounting theorists adopt that theory as the value function in their analysis.
Another very important concept used to understand mental accounting is that of modified utility function. There are two values attached to any transaction - acquisition value and transaction value. Acquisition value is the money that one is ready to part with for physically acquiring some good. Transaction value is the value one attaches to having a good deal. If the price that one is paying is equal to the mental reference price for the good, the transaction value is zero. If the price is lower than the reference price, the transaction utility is positive.
Another example of mental accounting is the greater willingness to pay for goods when using credit cards than cash, and buy more goods when paying with a debit or credit card than with cash. If people use credit card to pay for tickets to a sporting event, they will tend to be willing to pay more than if they make their bid with cash. This phenomenon is also related to transaction decoupling, the separation of when a good is acquired and when it is actually paid for.