Behavioral Economics

Saba Yifredew
Department of Economics
Addis Ababa University
Time Preferences
Review of basic concepts
Assume a bank pays 8% interest on a
$100 deposit made today. How much
will the $100 be worth in one year?

Fn = P(1 + r) n

F = the balance at the end of the period n.

P = the amount invested now.
r = the rate of interest per period.
n = the number of periods.
Review of basic concepts
Assume a bank pays 8% interest on a
$100 deposit made today. How much
will the $100 be worth in one year?

Fn = P(1 + r) n

F1 = $100(1 + .08)1

F1 = $108.00
Compound Interest – An Example
What if the $108 was left in the bank
for a second year? How much would
the original $100 be worth at the end
of the second year?

Fn = P(1 + r)n
F = the balance at the end of the period n.
P = the amount invested now.
r = the rate of interest per period.
n = the number of periods.
Compound Interest – An Example

F2 = $100(1 + .08)2

F2 = $116.64
The interest that is paid in the second
year on the interest earned in the first
year is known as compound interest.
Computation of Present Value
An investment can be viewed in two
ways—its future value or its present
value.

Present Future
Value Value
Let’s look at a situation where the
future value is known, and the present
value is the unknown.
Present Value – An Example
If a bond will pay $100 in two years, what is
the present value of the $100 if an investor
can earn a return of 12% on investments?

Fn
P=
(1 + r)n
F = the balance at the end of the period n.
P = the amount invested now.
r = the rate of interest per period.
n = the number of periods.
Present Value – An Example
$100
P=
(1 + .12) 2

P = $79.72
This process is called discounting. We have
discounted the $100 to its present value of
$79.72. The interest rate used to find the
present value is called the discount rate.
• Time preference (or time discounting, delay discounting, temporal
discounting, long-term orientation) is the current relative valuation placed
on receiving a good or some cash at an earlier date compared with receiving
it at a later date.
• Most non-trivial economic choices involve trade-offs between costs and
benefts that occur at different points in time.
• A practical example: Jim and Bob go out for lunch, but Jim has no money
so Bob lends Jim $10. The next day Jim visits Bob and says, "Bob, you can
have $10 now, or I will give you $15 when I get paid at the end of the
month." Bob's time preference will change depending on his trust in Jim,
whether he needs the money now, or if he thinks he can wait; or if he’d
prefer to have $15 at the end of the month rather than $10 now. Present and
expected needs, present and expected income affect one’s time
preference.

• Think of Examples
1. Purchasing an expensive software (STATA,EXCEL)

Costs and benefits

• Costly money outlay at the beginning (negative utility)
• Pain and frustration of learning it (negative utility)
• Mastery (positive utility, until it becomes obsolete)
• How do you decide whether to purchase the software?
• Determine value (utility) of costs and benefits
• Weigh these costs and benefits against each other somehow
2. Going to Grad school
Costs and benefits
• Direct cost of education: tuition (negative utility)
• Opportunity costs: foregone wages (negative utility)
• Joy or pain of going to school (positive or negative utility)
• Future wages (positive utility)
• How do you decide whether to go to school?
• Determine value (utility) of costs and benefits
• Weigh these costs and benefits against each other somehow
3.De-activating a social media account
Costs and benefits
• Direct cost of de-activating the account (negative utility)
• Short-run adjustment costs (likely negative utility)
• Long-run impacts on social life, mental health, etc. (positive or
negative utility)
• How do you decide whether to de-activate the account?
• Determine value (utility) of costs and benefits
• Weigh these costs and benefits against each other somehow
Many important choices involve time
• Investment/saving/borrowing
• Education:Human capital accumulation
• Health : Eating patterns, addiction, Exercising, sleep
• Family Life: Marriage, Divorce
Why do time preferences matter?
• Mischel et al. (1989) (Published in Science)
• Delay of gratification in children (the act of resisting an impulse to take an
immediately available reward in the hope of obtaining a more-valued
reward in the future longer)
• Individual differences in self control and self regulation.
35 Stanford students... Stanford preschool.
ρ(seconds, SATV ) = 0.42∗∗∗
ρ(seconds, SATQ) = 0.57∗∗∗ .
300 more seconds → 40 more SATQ points.
Ability to delay gratification (maybe time preference) apparently matters for
life outcomes..
• Marshmellow
Experiment
• Choice between one small but
immediate reward, or two
small rewards if they waited
for a period of time
• Task: Wait 15 minutes watching a
marshmallow(sweet).

Get another marshmallow.

• Study replicated and challenged

in replication studies
• Nevertheless, relevant
prediction
• Children who delayed gratification in certain laboratory situations
developed into :
• more cognitively and socially competent adolescents, achieving higher
scholastic performance and coping better with frustration and stress.
• More confident
• More organized
• Likely to have better economic outcomes
• But self control can be learnt!!!
Implications

• It was found that self-control during the first decade of life predicts
income, savings behaviour, financial security, physical and mental
health, substance use, and (lack of) criminal convictions, among other
outcomes, in adulthood.
• People are not internally consistent decision-makers
• Internal conflicts can be modeled and measured
• Early understanding of the neural foundations
• Perhaps teaching our children to delay gratification is one of the
best skills we can teach them
• Scalable, inexpensive policies can transform behavior
Choices over time: A quick history
Choices over time: A quick history
• Böohm-Bawerk (1889): The interest rate is just a price. Intertemporal
choices are just like any other economic tradeoff.
• In the neoclassical : Irving Fisher theory of interest due to , the rate
of time preference is usually taken as a parameter in an
individual's utility function which captures the trade off between
consumption today and consumption in the future.

• Paul Samuelson: Exponential Discounted model (Samuelson,1937)

The intertemporal Budget Constraint
The Budget Constraint and Utility Maximization
• We live in a scarce world; we face constraints on what and how much
goods and services we can have.
• Economics assumes that people maximize their utility functions
subject to their constraints.
• Let us review utility maximization in traditional economic theory
• Behavioral economics considers whether these models are realistic
and, if not, how they can be extended to be more realistic
Two goods and a budget constraint
• Assume the following utility function:
• 𝒖 𝒐, 𝒑 = 𝐥𝐧(𝒐) + 𝟐𝐥𝐧(𝒑)………for oranges and potatoes

• Accordingly, the budget constraint is:

• o+𝒑 ≤ 𝟒
• o, 𝒑 ∈ [0,4]

The problem is:

max 𝒖 𝒐, 𝒑 = 𝐥 𝐧 𝒐 + 𝟐𝐥 𝐧 𝒑
s.t
o+𝒑 ≤ 𝟒
Solution
• If (o*,p*) is an interior solution to the problem on the budget
constriant, we get:
𝜕𝑢ൗ 𝜕𝑢ൗ
𝑀𝑈𝑜 𝑀𝑈𝑝 𝜕𝑜 𝜕𝑝
= i.e., =
𝑝𝑜 𝑝𝑝 𝑝𝑜 𝑝𝑝
o+𝒑 = 𝟒
Equating the ratios of marginal utilities to prices gives
1 2
=
𝑜∗ 𝑝∗
Also
𝑜 ∗ + 𝑝∗ = 𝟒
Utility Maximization
∗ 4 ∗ 8
We get 𝑜 = and 𝑝 = …. And will be at point E.
3 3

Potatoes
K

E
8/3

U3
Q

U1 U2

4/3
Oranges

Need to check for second order conditions to ensure that the objective function is
maximised.
Now consider two periods
• Now suppose there are two periods and no oranges.
• You begin period 1 with 4 units of potatoes.
• You cannot grow any more and you have no other source of food for
the two periods.
• This means that in period 1 you must save food for period 2.
• You can store the potatoes in a basket between the periods, but in
period 2, only 80% of the saved potatoes will remain.(They go rotten,
and maybe mice are around!!!)
Discounting future consumption
• Two goods become consumption in period 1 (c1) and consumption in
period 2 (c2)
• Now the utility function will include temporal discounting. Why?
• Because people may not value current and future consumption the
same.
• Utility becomes
• 𝒖 𝒄𝟏 , 𝒄𝟐 = 𝐥𝐧(𝒄𝟏 ) + 𝜹𝐥𝐧(𝒄𝟐 )
δ is called the “discount factor” and captures intertemporal
preferences
• Generally, we assume δ ≤ 1.
• Larger δ ⇒ more patient
• Now the constraints are :
• 𝒄𝟏 + 𝒄𝟐 ≤ 𝟒
• 𝒄𝟐 ≤ 𝟎. 𝟖(𝟒 − 𝒄𝟏 )
• 𝒄𝟏 ∈ [0,4]
• 𝒄𝟐 ∈ [0,3.2]
Re-writing the constraint
• 𝟎. 𝟖𝒄𝟏 + 𝒄𝟐 ≤ 𝟑. 𝟐
• A typical budget constraint with prices 𝒑𝟏 ,𝒑𝟐 = 𝟎. 𝟖,𝟏
• Equating the ratios of marginal utilities to prices gives
𝜕𝑢 𝜕𝑢
ൗ𝜕𝒄 ൗ𝜕𝒄
𝟏 𝟐
= accordingly
𝑝1 𝑝2

1 0.8𝜹
=
𝒄𝟏 ∗ 𝒄𝟐 ∗
On the budget constraints: 0.8 𝒄𝟏 ∗ + 𝒄𝟐 ∗ = 𝟑. 𝟐
We get:
∗ 𝟒 𝟏
𝒄𝟏 = ….. A fraction of what is available
(𝟏+𝜹) (𝟏+𝜹)

∗ 𝟑.𝟐𝜹
𝒄𝟐 =
(𝟏+𝜹)
More patient (i.e., higher δ) =⇒ more 𝒄𝟐 , less 𝒄𝟏
Exponential Discounting (𝜹 Model)

• Samuelson (1937): discounted utility model

• The standard model of intertemporal choice in economics is time-
separable utility with exponential discounting
• Non-graphical, mathematical version of Fisher’s view of intertemporal
choice: just like any other tradeoff in economics.
• Paul Samuelson proposed using the same discount factor on future utility
from each period to the next
At time t, maximize discounted utility:
u 𝒄𝟏 , 𝒄𝟐, 𝒄𝟑, … . . , 𝒄𝑻, = 𝐮 𝒄𝟏 + 𝜹 𝐮 𝒄𝟐 + 𝛿 2 𝐮(𝒄𝟑 )+……+ 𝛿 𝑇−1 𝐮(𝒄𝑻 )
Here u(ct) is the per-period utility, and U(·) specifies how people value
consumption into the future at t = 1
Exponential Discounting (𝜹 Model)

• U≡ σ𝑇𝜏=𝑡 𝛿 𝜏−𝑡 𝑢𝜏 = 𝒖𝒕 + 𝜹𝒖𝒕+𝟏 + 𝛿 2 𝑢𝑡+2 + 𝛿 3 𝑢𝑡+3 ……+

• Discount factor 𝜹 : (usually < 1)
• Measures how utility in later periods is discounted relative to earlier
periods.
• Instantaneous utility in period t (𝑢𝑡 ) is always worth 𝜹 times
instantaneous utility in the previous period (𝑢𝑡−1 ).
• Where δ (0 < δ ≤ 1) is the discount factor which captures time preference
(patience = values close to 1, whereas impatience = values close to 0)
• Replaces complex psychology of how people think about the future.
• Samuelson chose this functional form for mathematical convenience
Intution
• Utility streams for different choice options (viz. A, B, C, D) can be
represented in table form:
• We can determine which option you should choose using the delta
model.
T=0 T=1 T=2
A 1 0 0
B 0 3 0
C 0 0 4
D 1 3 4

• We can determine which option you should choose using the delta
model
• Assume that δ = 0.9 and each utility stream is evaluated from t = 0
• The expected utilities are:
• U0(A) = u0 = 1
• U0(B) = δu1 = 0.9 × 3 = 2.7
• U0(C) = δ 2u2 = 0.81 × 4 = 3.24
• U0(D) = u0 + δu1 + δ 2u2 = 1 + 2.7 + 3.24 = 6.94
• If given the choice between all four alternatives, you should choose
option D
• If given the choice between A, B, and C, you should choose C
• What happens if we repeat this process, but this time assume that δ =
0.1?
• The expected utilities are: •
• U0(A) = u0 = 1
• U0(B) = δu1 = 0.1 × 3 = 0.3
• U0(C) = δ 2u2 = 0.12 × 4 = 0.04
• U0(D) = u0 + δu1 + δ 2u2 = 1 + 0.3 + 0.04 = 1.34

If given the choice between all four alternatives, you should still choose
option D • But now, if given the choice between A, B, and C, you should
choose A
As this example shows, your discount factor can have a dramatic
impact on your choices
❖ If your discount factor is high—viz. close to one—you exhibit
patience and do not discount the future much.
❖ If your discount factor is low—viz. close to zero—you exhibit
impatience and discount the future heavily . You can see how δ
captures time preferences
❖Economists believe that discount factors can be used to explain a
great deal of human behavior
❖ If your discount factor is low, you are more likely to spend money,
procrastinate, do drugs.
❖ If your discount factor is high, you are more likely to save money,
plan for the future, say no to drugs.
Example in a three-period model
In a three-period model:
• Max 𝒖 𝒄𝟏 , 𝒄𝟐, 𝒄𝟑, = 𝐥 𝐧 𝒄𝟏 + 𝜹𝐥 𝐧 𝒄𝟐 + 𝛿 2 𝐥 𝐧 𝒄𝟑 …….. 𝒄𝟏 , 𝒄𝟐 &
𝒄𝟑 ≥ 𝟎
Such that
i. 𝒄𝟐 ≤ 𝟎. 𝟖(𝟒 − 𝒄𝟏 )
ii. 𝒄𝟑 ≤ 𝟎. 𝟖[𝟎. 𝟖(𝟒 − 𝒄𝟏 )- 𝒄𝟐 ]
And 𝒄𝒕 ∈ [0, 0.8𝑡−1 ∗ 4]

Re-writing this Budget constraint

𝟎. 𝟔𝟒𝒄𝟏 + 𝟎. 𝟖𝒄𝟐 +𝒄𝟑 ≤ 𝟐. 𝟓𝟔
Sloving this for an interior solution
𝜕𝑢(𝑐1,𝑐2,𝑐3) 𝜕𝑢(𝑐1,𝑐2,𝑐3) 𝜕𝑢(𝑐1,𝑐2,𝑐3)
ൗ𝜕𝒄 ൗ𝜕𝒄 ൗ𝜕𝒄
• 𝟏
= 𝟐
= 𝟑
0.64 0.8 1

1 𝜹 𝛿2ൗ
ൗ𝒄𝟏 ∗ ൗ𝒄 ∗ 𝒄𝟑 ∗
• = 𝟐
=
0.64 0.8 1

Re-arranging this

𝟏 𝟎.𝟖𝜹 𝟎.𝟔𝟒𝛿 2
• = =
𝒄𝟏 ∗ 𝒄𝟐 ∗ 𝒄𝟑 ∗
Now use the budget constraint and solve for
the optimal values
• Use 𝟎. 𝟔𝟒𝒄𝟏 + 𝟎. 𝟖𝒄𝟐 +𝒄𝟐 ≤ 𝟐. 𝟓𝟔 and get

∗ 𝟒 ∗ 𝟑.𝟐𝜹 ∗ 2.56𝛿 2
• 𝒄𝟏 = , 𝒄𝟐 = & 𝒄𝟑 =
(𝟏+𝜹+𝛿 2 ) (𝟏+𝜹+𝛿 2 ) (𝟏+𝜹+𝛿 2 )
• Note that the ratio of consumption across periods is the same! This is
the essence of exponential discounting
𝒄𝟐 ∗ 𝒄𝟑 ∗
• = = 𝟏. 𝟐𝟓 𝜹
𝒄𝟏 ∗ 𝒄𝟐 ∗
Time Consistency
• Suppose you follow the optimal allocation plan and consume 𝒄𝟏 ∗ =
𝟒
2 in period 1.
(𝟏+𝜹+𝛿 )
∗ 𝟑.𝟐𝜹
• Then in period 2, will you deviate from consuming 𝒄𝟐 = ?
(𝟏+𝜹+𝛿 2 )
• Let us see. In period 2…you will function like you are in a two period
model (thinking about period 3)
∗ 𝟒
• In period 2, there remains 𝟎. 𝟖(𝟒 − 𝒄𝟏 ). Substitute 𝒄𝟏 =
(𝟏+𝜹+𝛿 2 )
•
 𝟒
• In period 2, there remains 0.8[4 − 2 ] potatoes
(𝟏+𝜹+𝛿 )
𝟎.𝟖∗𝟒(𝜹+𝛿 2 )
•
(𝟏+𝜹+𝛿 2 )
Now essential you are in a two-period problem. In a 2-period problem,
𝟏
you will consume fraction of the total in the first period and leave
(𝟏+𝜹)
the rest for the second period(i.e third period).
∗ 𝟏 𝟎.𝟖∗𝟒(𝜹+𝛿 2 ) 𝟑.𝟐𝜹
This is hence in period 2, 𝒄𝟐 = * =
(𝟏+𝜹) (𝟏+𝜹+𝛿 2 ) (𝟏+𝜹+𝛿 2 )
• Note that the ratio of consumption across periods is the same!
• Key assumption of the model: Amount of patience between any two
periods the same
Time consistency
• Because Exponential discounting assumes the same discount factor
between every future period to the next.
• Preferences do not change with the passage of time unless new
information is presented
• The marginal rate of substitution between consumption at any pair of
points in time depends only on how far apart those two points are
• With exponential discounting, your trade-offs between receiving utils today
and receiving them with delay are independent of when that delay occurs:
• If you prefer 10 utils now to 15 next week, then you must also prefer 10
utils in 25 weeks to 15 in 26 weeks.
• Discounting is “time-consistent” (or “dynamically consistent”) Preferences
Exponential discounting implies same level of impatience for
any delay of the same length.
Exponential discounting: discount rates do not change with horizon.
The discount rate is constant .

Although exponential discounting has been widely used in

economics, a large body of evidence suggests that it does not
explain people’s choices.
A major shortcoming of this model is that it assumes that people have
time consistent preferences:
It implies that your preferences over two options should not change
simply because times passes.
if you feel (today) that a is better than b, then you felt the same way about
a and b yesterday and will feel the same way tomorrow .
The bad news is that people violate this assumption all the time:
• Planning to do your homework on time
• Saying will give up alcohol
• Promising to stop smoking
• Purchasing that gym membership
Psychologist George Ainslie
Identical choices but different
behaviour.

Scenario 1-High discount rate

Scenario 2- Low discount rate

time-inconsistent
 Pieces of evidence against exponential discounting
Are discount rates constant over time?
(I) Would you like to. . .
(A) eat one chocolate now, or Note: Patience being constant over time
(B) eat two chocolates in an hour? means you’d either choose (A) for both or
(B) for all three situations.
(II) Would you like to. . .
(A) eat one chocolate in a week, or
(B) eat two chocolates in a week and an hour?
(III) Would you like to. . .
(A) eat one chocolate in a year, or
(B) eat two chocolates in a year and an hour?
In reality people impatient and present biased

• Next month, I’ll quit smoking.

• Next week, I’ll catch up on the required reading.
• Tomorrow morning, I’ll wake up early and exercise.
• After the wedding, I’ll start eating better(healthy).
• Next month, I’ll start saving for retirement.
These quotations all involve a pattern of deviations from time
consistent exponential discounting called “present bias”
The bias is systematically in favor of the present
Future Bias statements would be
• Future bias would yield quotations you seldom (never?) hear
• I plan to watch more TV next year.
• I plan to eat more cookies and doughnuts next year.
• I plan to smoke more cigarettes next year.
• I plan to borrow more on my credit card next year.
• I plan to exercise less next year.
• I plan to wake up later next year.
 Present bias
• Cognitive biases, like present biases,
are mental shortcuts we use, which
generally help us make quick
decisions, but don’t always work out
for the best.
• Present bias is the tendency to focus
more on the present situation than the
future when making decisions.
• This can lead us to prioritize
immediate rewards over future
payoffs, even if that decision benefits
us less overall.
Evidence of Prefernce Reversal
• Imagine you are asked to make a choice for today
i. Salad or burger for lunch
ii. 10-minute game today or 11-minute game tomorrow
And a choice for next Wednesday
i. Salad or burger for lunch 2
ii. 10-minute game on the 30th(wed) or 11-minute game on the
1St(Thursday)
Choice {burger(b), salad(s)} or {10,11} is a preference reversal
Interpretation: you are tempted by the burger, but would prefer to choose
the salad
Read and van Leeuwen (1998)

Choosing Today Eating Next Week

Time

If you were
deciding today,
would you choose
fruit or chocolate
for next week?
Patient choices for the future:

Choosing Today Eating Next Week

Time

Today, subjects 74%

typically choose choose
fruit for next week. fruit
Impatient choices for today:

Choosing and Eating

Simultaneously
Time

If you were
deciding today,
would you choose
fruit or chocolate
for today?
Time Inconsistent Preferences:

Choosing and Eating

Simultaneously
Time

70%
choose
chocolate
• This is inconsistent with standard intertemporal choice theory
Utility given by
U≡ σ𝑇𝜏=𝑡 𝛿 𝜏−𝑡 𝑢𝜏

• If u(s) > u(b) then salad should be chosen over burger both today and
next Wednesday.
• If u(s) < u(b) then burger should be chosen over salad both today and
next Wednesday
• If u(10) > δu(11) then 10-minute earlier game should be chosen over
11 minute later game both today and next week
• If u(10) < δu(11) then 11 minute later game should be chosen over
10-minute earlier game both today and next week
How can we measure or estimate 𝜹 ?
• We need data.
• Want several choices over time.
• Need to know the costs and benefits associated with each choice.
• Each choice gives us an inequality involving present and future
outcomes
Pieces of evidence against exponential discounting
• Efforts have been made to identify time preferences from naturally
occurring field data
• The majority of research has relied on laboratory samples using
variation in monetary payments
• Experimental community lacks a clear consensus on how best to
measure time preferences
• Thaler (1981 Economics Letters) asked subjects to choose between
money now versus more money later hypothetically (but many similar
experiments have now used real rewards, with similar results):

• What amount makes you indifferent between $15 today and $X in 1

month? Typical response: X = 20.
Eliciting Discount rates
• The basic question used to elicit individual discount rates is extremely simple:
do you prefer $100 today or $100+x tomorrow, where x is some positive
amount?
• If the subject prefers the $100 today then we can infer that the discount rate is
higher than x% per day; otherwise, we can infer that it is x% per day or less.
• When x is zero we would obviously expect the individual to reject the option of
waiting for no rate of return.
• As we increase x we would expect more individuals to take the future income
option
• The point at which they switch from choosing the current income option to
taking the future income option provides a bound on their discount rate.
• That is, if an individual takes the current income option for all x from 0 to 10,
then takes the future income option for all x from 11 up to 100, we can infer
that their discount rate lies between 10% and 11% for this time interval.
Many studies and strong evidence of
Short-run impatience vs. long-run patience
Quasi-Hyperbolic Discounting (Laibson, 1997)
• In exponential discounting, the individual maximizes
• U= 𝑢𝑡 + 𝛿𝑢𝑡+1 + 𝛿 2 𝑢𝑡+2 + 𝛿 3 𝑢𝑡+3 ……+

Where 𝜹 is the short term as well as long term discount factor and lies
between 0 and 1.
In quasi-Hyperbolic discounting, the individual maximizes:
U= 𝒖𝒕 + 𝛽𝜹𝒖𝒕+𝟏 + 𝛽𝛿 2 𝑢𝑡+2 + 𝛽𝛿 3 𝑢𝑡+3 ……+
𝛽 is the short-term discount factor (0 < 𝛽 < 1) and 𝛿 the long-term
discount factor such that 𝛿 is closer to 1.
Quasi-Hyperbolic Discounting: (𝛽- 𝜹) model
• Hyperbolic discounting, also called “present bias,” is a
cognitive bias, where people choose smaller, immediate
rewards rather than larger, later rewards.
• 𝛽 relaxes the assumption that the amount of patience between any two
periods is the same
• It allows for more impatience between today and tomorrow than between
7 and 8 days from now
• Allows for Myopia and Dynamic inconsistency.
• Dynamic consistency: The action a person thinks she should take in the
future always coincides with the action that she actually prefers to take
once the time comes.
Quasi-Hyperbolic Discounting: (𝛽- 𝜹) model
Example
• 𝛽 =2/3 and 𝛿 ≈ 1

𝟐 𝟐 𝟐
U= 𝒖𝒕 + 𝒖𝒕+𝟏 + 𝑢𝑡+2 + 𝑢𝑡+3 ….
𝟑 𝟑 𝟑
• Relative to the current period, all future periods are worth much less
(they get a factor of ).
• Most (here, all) discounting is between the present and the future.
• Little discounting between future periods.
Quasi-Hyperbolic Discounting: (𝛽- 𝜹) model
• All discounting takes place between present and immediate future
• In ‘long-run’, we are relatively patient
• Decisions are sensitive to the timing of benefts and costs.
• Captures Myopia
• Delaying bad things to the future, pulling all good things to the
present
• Compulsive behaviour is captured
• Allows us to mis-predict behaviour
• Allows for procrastination
Exponential vs Hyperbolic Discounting
Strictly speaking, quasi/hyperbolic(Blue
curve)
BE model to capture impulsive behaviour!!
• Hyperbolic discounting can result in poor decision-making, because it
incentivizes impulsivity and immediate gratification.
• Decisions that prioritize short-term gratification often neglect and
detract from our long-term well-being.
• Think of cigarette addicts! smoking: there is a quick rush of dopamine
that is valued over one’s future health.
• Marriage and Divorce
Example
• Learning stata software: Numerical example
• Procrastinations and choices that we regret
• That is only human
• Classical utility model cannot capture time inconsistency and
procrasitnation.
• In the example: using the classical model..people choose to learn in
today.
• But in reality, that often does not happen..procrastination and regret
• Allows people to mispredict their behaviour.
• In reality...they end up nevel learning it, utility is zero and people in
regret
When does she learn STATA?
• Given this conflict, when does she actually learn the software?
• Key question: is the student aware of her time inconsistency?
መ
• Additional parameter: 𝛽(Beta hat) measures beliefs about future 𝛽 .
• Naïveté versus sophistication (O’Donoghue and Rabin, 1999)
• Distinguish between Naifs and Sophisticates
Distinguish between the planner(self) and the doer(self) and We need to
consider three types of individuals
1. Rational: Planner self and doer self have the same behaviour. No
distinction
Planner self does not have much job to do. The doer does everything
rationally. The doer always behaves well.
2. Naif: Irrational(Behavioral).Naïve with human tendencies and he is
unaware. The planner assumes the doer self:
• -Stick to budget
• -Will not procrastinate
• -The doer will eat healthy
3. Sophisticate: Irrational(Behavioral).sophisticate with human tendencies
but is aware that the self doer may deviate. Hence imposes consequences
𝛽 Captures time inconsistency
𝛽መ is planner self’s perception of the doer’s self 𝛽 .
Captures someone's behavioralness?/irrationality
Sophisticate Naif Rational(Econ)

Planner self Planner self Planner self

Doer Self
Doer self Doer self
Sophisticates Naifs Rational(Econ)

Planner self Planner self Planner self

Planner
self’s belief
about 𝛽 :
መ መ
𝛽=1
𝛽=𝛽 𝛽መ

Doer self Doer self

Doer Self 𝛽=1

𝛽 𝛽
1. For the Rational 𝛽 = 𝛽መ = 1 i.e., Classic discounting model. No
irrationality.
For naïve and sophisticated-Two extreme assumptions. Beliefs are
different

2. Full Naïveté : 𝛽መ = 1 . (But 𝛽 is different for the self doer i.e 𝛽 < 𝛽መ = 1).
• The planner thinks the doer self will behave rationally
• She does not realize she will change her mind.
• She assumes future selves will follow through on her plan.
• Surprises about future present bias.
• False optimism about future patience: “This time is different –I will do it .”
3. Full Sophistication: (𝛽 = 𝛽መ < 1)

• She understands perfectly that she will change her mind.

• She does the best given future selves’ correctly anticipated behavior.
• No surprises about future present bias-I may not do it.

In reality: 𝛽 < 𝛽መ < 1

𝛽መ somewhere between your true self(𝛽) and when you act perfectly(1)

• Most people between naifs and sophisticates

• Learning behavioral economics is learning how to become a sophisticate!!!
• Use our knowledge of ourselves and psychological concepts to become a
better version of ourselves.
Naïve student’s behavior: summary
At t = 0, she thinks she’ll learn the software before doing it becomes
very costly.
Therefore, she believes she won’t lose much by delaying.
At t = 1, she again perceives the cost of delaying to be relatively small,
so she delays again.
This kind of behavior might persist for many periods. It is an example
of procrastination.
Naïve procrastination can cause large welfare costs.
Sophisticated student’s behavior : summary

• She recognizes that if she delays, she’ll delay more.

• Since she knows that delaying until t = 1, it would be very costly, she
reluctantly does the STATA learning set at t = 0.
• So, she does better than the Naïve student in terms of utility.
• Unsurprising, since the sophisticated student understands herself
better than the Naïve student.
• Sophisticated procrastination (if it occurs) does not cause large
welfare costs
In reality: 𝛽 < 𝛽መ < 1
𝛽መ somewhere between your true self(𝛽) and when you act perfectly(1)
Sophisticates demands commitment devices !!! Such as
❖ Freezing credit(ATM) cards
❖Cancelling meetings with friends who drink
❖Making a schedule
❖Demand externally imposed deadlines
❖Temptation bundling
❖Equibs
How can we tell whether a person is Naïve or sophisticated?
• Mis-prediction of future behavior indicates (some) Naïveté .
• Use of commitment devices indicates (some) sophistication.
Demand for commitment devices
• Sophisticates take advantage of commitment devices (Naïves don’t).
• A pre-commitment is a way to lock future you into a decision. You
increase your chance of success by removing a temptation future you
may try and weasel out of. The idea is to make it hard for your future
self to back out.
Remember
With Constant discounting:
1. Discount rates do not change with horizon.
2. Dynamic consistency: no preference reversals
3. No demand for commitment devices
Examples:
• Schedule workouts with an exercise partner (socially costly to skip)
• Reward based with $150 deposit as individuals or in small
groups. Those who stopped smoking got their deposit returned plus
$650.
• Purchasing a smaller pack of cigarettes
• Purchase smaller sized lunch boxes (hassle costs makes it less likely
we overeat)
• Sign-up for fruit and vegetable subscription (financial costs to skip
and reduced friction for eating healthy)
Commitment contracts in health
Commitment devices have two componenets
Firstly, it’s a voluntary choice you make in the present that impacts your
choices in the future; you try align future choices to only those that
reflect your long-term goals.
This means you must be self-aware of where and when the gap exist
between your intention and actions.

Secondly, Commitment Devices adds a cost to not acting in line with

your stated intentions and goals.
Conditions required for a commitment device to be helpful for a person
• The person needs to have a self-control problem (𝛽 < 1).
• The person needs to be at least partially sophisticated (𝛽መ < 1).
• The commitment device needs to be effective.

• Naivete can lower effectiveness of commitment devices. A naive

person underestimate their present bias and might thus:
(i) not demand a commitment device that would help her.
(ii) demand a commitment device that doesn’t actually help.
Example
Article:
Soft Commitments, Reminders, and Academic Performance
Author(s): Oliver Himmler, Robert Jäckle and Philipp Weinschenk
Journal: American Economic Journal: Applied Economics , April 2019,
Vol. 11, No. 2 (April 2019), pp. 114-142
Problem studied
• A large share of students in higher education never obtain a degree,
and those who do graduate often take much longer than scheduled.
• In Germany, one in four students fail to obtain a tertiary degree
(OECD 2013), and only 40 percent of the students who obtain a
tertiary degree do so within the prescribed time.
• Both late graduation and non-completion imply a waste of resources
(for students as well as for universities) and a loss or delay of the
social and individual returns from higher education.
• At the society level: Human capital accumulation and growth
• At the individual level, there is ample evidence that higher education
not only generates monetary gains, but also a number of
nonpecuniary benefits, such as greater civic participation, life and job
satisfaction, and better health.
Relation with existing literature
Why students make non-optimal education decisions?
1. Students may lack the necessary information to effectively organize
their studies.
2. Limited attention can hamper students’ academic progress. This
means that although students have received the information on
how to best proceed in their studies, the information may become
less salient over time.
3. Problems with self-regulation may cause students to procrastinate
in their studies.
Experiment design
• A field experiment with the incoming fall semester cohort of business
administration students in the bachelor’s program of a German
university.
• A total of 392 students enrolled, and we randomly assign students to
3 treatments: control, reminder, and commitment device.
Commitment device in education(see Himmler at al.2019)
 Conceptual framework /Behavioural Mechanisms
1. Introductory lecture : serves to initially establish the same academic
goals for all students, by providing specific information about the course
schedule officially recommended by the university as well as the sign-up
procedures and deadlines, and by stressing the importance of investing
a sufficient amount of time into exam preparations.
This may fail to remain salient overtime
2. Reminder: set up a reminder scheme for a first treatment group.
Students in this group receive letters in the mail that remind them of the
course schedule and the upcoming sign-up period and exam week
3. If procrastination is the problem need for commitment device: an
agreement in which students declare that they will adhere to the exam
schedule recommended by the university
• The device has to be weak enough such that individuals are not
frightened off from participation, while it simultaneously has to be
strong enough to influence behavior.
• To create the leverage necessary in order to actually influence students’
behavior, we ask students to place their signature under the agreement
if they want to commit.
Empirical strategy
• 𝑦𝑖 = 𝛼0 + 𝛼1 𝑅𝑒𝑚𝑖𝑛𝑑𝑒𝑟𝑖 + 𝛼2 𝐶𝑜𝑚𝑚𝑖𝑡𝑚𝑒𝑛𝑡𝑖 + 𝑋𝑖 𝛽 + 𝜖𝑖

• Outcome measurement(y): Measure three outcomes, at two

different points in time: the number of exams that students sign up
for in November and the number of exams participated in and passed
in January
• 𝑋𝑖 is vector of controls high school grade, age, gender plus a set of
state fixed effects, indicating a student’s geographic origin
Results
• No evidence that the pure reminder treatment affects exam sign-up,
participation, and the number of exams passed. suggesting that
limited attention may not be a problem when students study for, sign
up for, or take exams.
• In contrast, the commitment device is highly effective. It motivates
students to take part in 11 percent more exams, and pass 13 percent
more exams than the controls, while maintaining the same grade
point average (GPA) as the control group
• Commitment device changes the behavior of procrastinators,
whereas it does not affect the outcomes of non-procrastinators.
Results

• Students who were offered the commitment device also participate in

more exams.
• The effects of commitment on participation and passing on the other
hand are particularly large in the statistics and accounting exams. Of
the other three, only in the law exam do they find a marginally
significant effect of commitment on participation.
• Commitment device may have helped more numerical courses
• No evidence for negative effects
 Any policy implication

• The commitment device is not only effective but also inexpensive,

both in absolute terms as well as in comparison to more traditional
measures of improving educational outcomes, such as hiring new
faculty, more finance and reducing class size.
Summary on commitment devices
• Many examples of demand for commitment in research studies
• Significant share of population struggle with self-control problems.
• Many of them are at least partially sophisticated.

• High variation in fraction demanding commitment across settings.

Why?
a. Uncertainty
b. naivete
c. Design of commitment devices varies across settings
d. Experience with commitment device
Time Prefernces: summary

• Exponential discounting
➢ Workhorse model of modern economics
➢Many important applications
➢ Model helps explain many facts of the world.
➢ But some facts are hard to match with exponential discounting

• Quasi-hyperbolic discounting
➢Simple modification of exponential discounting model
➢Additional parameter to capture emphasis on present
➢Can explain many observed behaviors more accurately.
➢Commitment devices may help improve outcomes but few examples of real-world
products that actually help people – much ongoing research in this area!
Next lectures

Risk preferences