Romancing Greed and Ignorance: Experiments in Time Preference
Updated: Jul 12, 2020
“Money does not buy you happiness, but lack of money certainly buys you misery.”
Daniel Kahneman
How long are you willing to wait to receive a million-dollar lottery if you were asked to stop eating at your favorite pizzeria for a month? How much money received in three years makes you indifferent to get a thousand dollars now? Questions of such indifference between future and present values of a particular stream of dividend payments lead to the Discount Rate, a neoclassical portmanteau that catches all variables that are exogenous to axiomatically independent intertemporal consumption optimization. However, insights from Experimental and Behavioral Economics debunks the classic case of interdependent attitude and a deeper look into how this Rate encompasses a variety of psychological, cultural, and socio-economic backgrounds once considered irrelevant in discourse and theory.
Intertemporal choices, i.e. decisions involving trade-offs between choices over the present and the future have been expressed through various models. The first mention of the importance of intertemporal choices was presented by Adam Smith; he proposed that choices of this nature determine the economic prosperity of nations. Further research was conducted by John Rae who studied the sociological and psychological determinants of these choices in his 1834 paper, The Sociological Theory of Capital. The most widely accepted theory often taught in Consumer Theory is the classic two-good indifference model developed by Irving Fisher, later polished by Paul Samuelson in A Note on Measurement of Utility (1937). There are several characteristics of this model whose soundness demands questioning. It condenses all the disparate factors underlying these choices into a single parameter- the discount rate. The constancy of this rate over all time periods, i.e. Exponential Discounting implies that intertemporal preferences are time consistent, which is debatable.
Empirical evidence has debunked almost all assumptions of the Discounted Utility model, terming the resultant departure as anomalies. These are not to be confused with errors in judgement of the agent as these anomalies show the descriptive invalidity of the model propounded by Samuelson as one of the caveats of using the model in practice. The most famous of such anomalies is Hyperbolic Discounting and Present Bias, supported by a behemoth of experimental evidence. Models that incorporate hyperbolic or quasi-hyperbolic discounting fit well with the observed notion of decreasing patience over time. Moreover, said decrease is accentuated if the temporal landmark is finely partitioned, giving rise to projection biases and partition dependence in estimating future utility. Additionally, gains and small outcomes are discounted at a higher rate than losses and larger outcomes, along with largely observed nonlinearity of the utility function which explains significant overestimation of discount rates in cross-sectional and longitudinal studies. A desire for spreading consumption over time suggests consumption interdependence, often shaped so by framing effects. Contemporary findings conclude striking coherence of such influences with intertemporal choice. One of such widely discussed elements heavily rests upon multiple motives of present consumption and future saving, models of which are at a stage of infancy.
Alternative models proposed in existing literature use various creative notions such as hysteresis effects of past consumption, tenets of the Remembering and Experiencing Self, utility from anticipating future consumption, and Prospect Theory. Instantaneous utility derived from present consumption also include a notion of naivety with asymmetric information and sophistication, where the latter has an efficiently endogenized model of future expectations of income streams, inflation, interest rates, and other factors that predict classical definitions of consumption and leisure. Some contemporary models also include visceral influences, such as hunger and sexual desire that better explain immediate consumption.
Empirics surrounding exponential discounting use a different notion of time. Experiments conducted by Gal Zauberman, et al (2009) examined how consumers value time, i.e. using subjective values placed on time delays as opposed to objective delays usually accepted as months or years. One of such studies included asking respondents to respond on how they perceive the duration between the present day and three months, a year, and three years. Subjectivity of time delays revealed that the value placed on patience is seemingly constant, with no significant differences in discount rates.
Addiction studies in healthcare and preventive medicine are one of the most important examples that involve the use of hyperbolic discounting. A limited rational addiction model presents myopic projection biases in estimating the (dis)utility of ex-post addictive indulgence, where the gamble may have been ex-ante rational, implying a systematic underestimation of the extent of future addiction. The intertemporal conflict is a variant to Prisoner’s Dilemma, where a future self may not be motivated to retaliate against a defecting present self who relapses. But given time inconsistencies, it may be apt to defect as the pattern of cooperation that promised bundled benefits has been broken. Credit cards systems and pricing strategies of “Buy Now, Pay Later” are classic examples of deferred payments where even raising the price of the commodity is of relatively little significance to the buyers as they are not paying for it immediately. Annual subscription fees that do not make mathematical sense are framed in such a way that takes care of temporal substitution. “$10 a month and $90 a year” appears as a discount if the user perceives immediate payment as $120 a year.
Inconsistent and intransitive decision making coupled with dynamic discounting is a major reason why we put off a pile of work due in a few days’ time and browse binge-watching prospects, under a promise to deal with it tomorrow. The implications of such rational tasks are far reaching, from multi-million marketing deals to prudent and prospective policymaking. The need for interdisciplinary research is very crucial to understand conflicts in discourse as well as failures and inadequacies in existing models. The amalgamation of psychology with economics is a promising venture to carry out a postmodernist approach of questioning widely accepted stems of discussion.
References and Additional Readings:
Garrison, Roger W. (1998). The Intertemporal Adam Smith. Quarterly Journal of Austrian Economics vol. 1, no. 1 (Spring). pp. 51-60.
Heilmann, Conrad (2008). A Representation of Time Discounting. CPNSS working paper, vol. 4, no. 6. pp 12-16. The Centre for Philosophy of Natural and Social Science, London School of Economics, London, UK.
Boyarchenko, Svetlana I. and Levendorskii, Sergei Z., A Theory of Endogenous Time Preference, and Discounted Utility Anomalies (February 18, 2005)
P. Diamond, B. Köszegi, Quasi-hyperbolic discounting and retirement, Journal of Public Economics, 2003
Abdellaoui, et al, Intertemporal Tradeoffs for Gains and Losses: An Experimental Measurement of Discounted Utility, The Economic Journal, 2009
Frederick, Loewenstien, et al, Time Discounting and Time Preference: A Critical Review, Journal of Economic Literature Vol. XL (June 2002), pp. 351–401
