Jake ElSarhan reporting for Econversations.
In recent meetings, a topic that has been popping up consistently has been that of behavioral economics. For any statisticians following this page, be aware that this is largely due to yours truly biasing the sample by steering discussions to that very subject.
Over the past two weeks, two interesting examples of irrationality have been discussed. The one examined today is that of hyperbolic discounting. To begin with, let’s imagine that a student named Marisa has been offered the choice of $100 now or $200 in one month. What is the rational choice? Why? What is the more common choice? Why?
Before we get into that, I need to clarify the difference between discount rates and discount factors. A discount rate (r) refers to the interest rate that is used to determine a net present value (NPV) from a given set of cash flows. For businesses, r would be determined by weighted average cost of capital, for individuals it might be the cost of borrowing. Generally, the discount rate is determined by market/economic factors.
In economic analysis, the discount factor (beta) is the measure for how people value time. The most basic form of a discount factor is 1/(1+r). The r chosen for the discount factor can include more abstract considerations, such as need for resources, and psychic (as in psychological) considerations. When implicitly calculating the psychic utility gained from $100 now or $200 in one month, the discount factor is what compares the figures. Different people will have different discount factors, and the r in the denominator is typically quite high, far higher than the market interest rate.
Obviously, the rational choice is $200 in one month. The NPV of $200 a month from now is considerably higher than $100. However, repeated studies demonstrate that the more common choice is $100 now. (“Not me Jake! I’d choose $200 in a month!” That’s the great danger. Studies show this bias affects you. So does advertising.)
The reason for this is that people have an ingrained focus on the present at the expense of the future. To borrow the terminology of Professor Baker, we might say that we make decisions using an excessively high discount rate, maybe 30 or 40 or 500%. Thus, taking the $100 today becomes rational, even though the market discount rate might be only 8% or something.
Here is where it gets interesting. If we asked Marisa if she’d rather have $100 in 12 months or $200 in 13 months, she’d probably say $200 in 13 months. This is rationally incompatible with the former example, but it can be expected given what we know about human nature. Therefore, we can say that humans engage in hyperbolic discounting which is when valuations fall very quickly for a short period of time and then level off. This is inconsistent and a large part of behavioral economics.
What explains this? The constant battle between the amygdala and pre-frontal cortex. The amygdala is standard for mammals, and is responsible for baser functions, and takes over in moments of immediate crisis, like fight or flight. It governs our reaction to our immediate circumstances and short term thinking. The pre-frontal cortex is uniquely developed in humans (even among primates) and is responsible for long-term thinking and so-called rationality.
To put it simply, the amygdala is why people have a tendency to take $100 now over $200 in a month. If you start thinking hard about it and decide you’d rather have the $200, that’s probably the pre-frontal cortex taking over. When confronted with a situation far into the future, it’s the pre-frontal cortex that is calling the shots. This explains hyperbolic discounting. This is a real science, it’s called neuroeconomics.
Next time, we’re going to examine a hypothetical individual named Shyam who chooses $100 both times. I fear the answer will have to do with consistency in an attempt at self honesty (is that a word,) and that it will be a fascinating analysis having to do with an overdeveloped pre-frontal cortex insisting on perfect harmony with the amygdala.