Yves Nosbusch

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Time inconsistencies in human behaviour dted 

 

This article, which is about impatience, is the first in a series that aims to illustrate advances in behavioural economics. This discipline, which brings together elements from psychology and economics, looks at aspects of human behaviour that are overlooked by traditional economic theories but which can have a major impact on important decisions related to savings, investments, employment contracts and the choice of a mortgage.

 

More impatient in the short term

Human beings seem to display much more impatience in their short-term choices than in longer-term trade-offs. For instance, a number of studies have shown that people are more inclined to reduce their consumption tomorrow in order to consume more today, than they are to commit to reducing their consumption in 101 days' time so that they can consume more in 100 days' time. These choices might seem intuitive, or even innocuous, but they are in fact impossible to reconcile in the context of a traditional economic model.

 

It is this type of observation that has motivated the work carried out by David Laibson of Harvard University since the late 1990s. In particular, he has developed the so-called "hyperbolic discounting" model, which represents a twist to the standard model of intertemporal preferences. This model incorporates in a particularly simple and elegant way the idea that there is a profound difference between short-term and long-term intertemporal choices, and that human beings often cannot resist the desire for what Laibson and his co-authors call "instant gratification". There are many examples of this in everyday life: we want to eat more healthily, exercise more, stop smoking, save more - but we want to put it off until tomorrow.

 

Conflict between today's “self” and the future “self”

This inconsistency between short-term choices and long-term resolutions gives rise to a sort of internal conflict between today's “self” and the future “self”. For example, today's “self” knows that it would be a good idea to save more for the future, but is aware that the future “self” won't be able to resist the temptations to spend that will present themselves. Laibson and his co-authors model this type of internal conflict using techniques from modern game theory.

 

This analysis has a number of interesting implications. For example, it predicts that today's “self” has an incentive to take steps that will constrain the future "self" to behave in the "right" way.

 

Attractiveness of "illiquid" assets

A notable - and somewhat counter-intuitive - consequence of this is the attractiveness of illiquid assets. As a reminder, traditional finance hails the benefits of liquidity: at first sight, an asset which can be sold rapidly with limited transaction costs seems more attractive than an asset that cannot be sold without generating considerable costs (in terms of time and money). In the context described by Laibson and his co-authors, illiquid assets have a particular appeal: they allow today's “self” to constrain the future “self” (commitment device). Assets such as property, private pension plans or life insurance policies which cannot be cancelled without significant costs give the future "self" a strong incentive to continue saving enough and not succumb to the temptation of short-term consumption.

 

 

The idea of a time inconsistency in human preferences is of course not new. The idea that self-imposed restrictions ex ante can lead to a better outcome ex post was already described in the Odyssey: Odysseus and his crew chose to tie themselves up so that they didn't fall prey to the song of the Sirens and wreck their ship on the rocks. The theory of hyperbolic discounting brings a modern, unified formalism to this type of problem, which has many important implications in areas as varied as healthcare and pensions. In particular, it can serve as a guide in the design of default options - the subject of a forthcoming article.
 

 

Article completed on 4 July 2014 by Yves Nosbusch, Chief Economist of the Bank

Published on paperjam.lu (in French) on 4 July 2014
 

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