28 May 2013

Time, too, Is Relative ... Decisions about Money across Time

When I was a bachelor student, during my Economics courses, I have learned that taking a loan from the bank is equivalent with accelerating consumption. For example, if Said wants to buy a car that costs 15.000 Euros then he has two major options. First, Said can save money for a certain period of time, let’s assume three hundred Euros each month. After fifty months when the amount needed to buy a car has accumulated in his savings account, Said can go and buy the car. Taking this path, Said has one advantage and one disadvantage. The advantage is that he will pay for the car only the 15.000 Euros that represent the actual cost. The disadvantage is that for five years and two months (fifty months) Said will not have the car.

The second option Said has is to go to a bank and ask for a loan of 15.000 Euros and buy the car as soon as the loan is approved. If he follows this path, Said will have the car as soon as possible, but will have to pay across five years both the 15.000 Euros which represent the cost of the car and the cost of the credit, let’s say about 3000 Euros.

As my former Economics teacher would say, the 3000 Euros Said pays for the loan represent, in fact, a cost for having the car earlier.

Taking the car out of the picture, Said faces the following question: How much would you need to get now in order to give up 18.000 Euros in five years’ time?

In the case of Said buying a car, the answer was 15.000 Euros. However, let’s assume that you are faced with a similar question, namely what is the minimum amount you would accept now in order to give up 10.000 Euros in one year time? 

What is your honest answer? Would 8000 be enough? 9000?
From a rational point of view there is a (so called) correct answer to this. You should ask for at least 9803 Euros. This is because if you take this amount and place it in a bank deposit for one year with an interest rate of 2%, after one year you will have 10.000 Euros in your account.

However I am sure that you would have been happy with 9000 and for sure you did not compute the amount using the average interest rate for bank deposits in Euros. Don’t worry, most people ask for less than 9803 Euros and it is quite OK to do so.

You have just learned about time discounting or more accurately inter-temporal discounting. People are willing to give up a part out of a future outcome in order to get it faster. The so called correct answer to the question above, namely 9803 Euros, was obtained through a formula specific for the Discounted Utility Model. In an ideal world the discount rate would be equal to the interest rate on the financial markets. Simply put, in an ideal world, you should have a discount rate equal to the interest rate on the financial market, namely 2%. In the same ideal world, you should have asked for 9803 Euros, and then go immediately to the bank and place them in a deposit for one year, subsequently benefiting of 10.000 Euros in one year from now.

Most of the time, the discount rate is larger than the interest rate on the financial markets. For example if you would have accepted 9000 Euros now in exchange for giving up 10.000 Euros in one year time, then your discount rate would have been 10%, which is significantly larger than the interest rate for one year deposits in Euros, namely 2%.

You might wonder if this is wrong; if it is wrong to have a discount rate of 10% which is larger than the so called correct one of 2%? The answer is that it is not wrong, because the Discounted Utility model was never meant to be the correct one, or in more scientific terms the normative one. When it was proposed by Paul Samuelson in 1937 it was simply a proposition of a theoretical model. The author never claimed that it was the right model for describing or prescribing how decision over time should be made. However, this model was embraced by the scientific community and before long it gained the status of the correct model.

Let’s move away from the debate whether the Discounted Utility model is correct or not and focus on a very interesting aspect of decision making over time. Imagine that I’m asking you the following question:

What is the minimum amount you would accept now in order to give up 10.000 Euros in Four years’ time?

Would you accept 6000 Euros? Probably not… How about 7500? I think that you would be happy with this amount. Right?

The interesting thing that happens when deciding about how much we would want for giving up later rewards is that apparently we don’t hold the discount rate constant. Let me explain a bit more clearly. Let’s assume that you would accept 9000 Euros now in order to give up 10.000 in one year from now. This means that your discount rate is 10%. If we hold this rate constant, you should accept 8100 Euros in order to give up 10.000 in two years’ time. This is 10% less than 9000 Euros. Applying the same rate, you should accept 7290 Euros in order to give up 10.000 in three years’ time. Again, this is 10% less than 8100, which in turn is 10% less than 9000 – the amount you accepted in exchange for giving up 10.000 in one year time. The question was what is the minimum amount you would you accept to give up on 10.000 Euros in Four years’ time. In order to find this out we should discount again with 10% the 7290 Euros sum, leading to the amount of 6561 Euros.

However, most people would not be happy with this amount and would ask for more than 6561 Euros in order to give up on 10.000 Euros in four years’ time. My guess is that the minimum accepted amount would be higher than 6561 Euros, or at least that is what theory tells us. Probably 7500 Euros is closer to the amount you would be happy with in exchange for 10.000 Euros in four years’ time.

The key learning of this thought exercise is that close rewards are discounted more than distant once. Putting things differently, the discount you would be willing to accept in order to get the reward now instead of in 12 months is higher than the discount you would be willing to accept in order to get the reward in 12 months instead of in 24 months. This phenomenon is called hyperbolic discounting.  

For a long time, the belief was that the mechanism behind hyperbolic discounting is the decreasing discounting rates. For example if the discount rate for the first year was 10%, then the discount rate for the second year would be lower, say 7%. Similarly, the discount rate for the third year would be even lower, say 5%. Quite recently, this assumption was challenged by a study conducted by Professor Zauberman and colleagues who proved that the mechanism behind hyperbolic discounting is not the decreasing discount rates, but rather the subjective perception of time. In this study the researchers proved that when taking into account the subjective perceptions of time, the discount rate remains constant.

To better understand, let’s focus a bit on what subjective perceptions of time mean. The essence is that a time period of, say, three years is perceived subjectively different from the sum of three one year intervals. Putting this in mathematical sequence, with sp being the subjective perception, it would look like this:

sp(3 years) < sp(1 year) + sp(1 year) + sp(1 year)

According to Professor Zauberman and colleagues, the subjective perception of time explains the difference between the minimum sums accepted to give up on sooner and later rewards. This finding is in line with conclusions on subjective perceptions of other types of values. For example, prospect theory tells us that people perceive probabilities different than their actual value, except for probabilities of zero and one. Similarly the contrast effect tells us that absolute values are judged depending on reference points. According to the study by Professor Zauberman and colleagues, time makes no exception to the rule of relativity. 

This post is documented from:

Frederick, S., Loewenstein, G. & O'Donoghue T. (2002), "Time Discounting and Time Preference: A Critical Review," Journal of Economic Literature, 40 (2), 351-401.

Zauberman, G., Kim, B.K., Malkoc, S. A., & Bettman, J. R. (2009). "Discounting time and time discounting: Subjective time perception and intertemporal preferences," Journal of Marketing Research, 46, 543-556.

21 May 2013

How to See Personality from a Behavioral Economics Perspective

In the 4D Model of Human Behavior Personality is one of the sources of human behavior. Although in popular belief it is seen as the only source of behavior, the reality is that Personality is, out the four sources from the model, the weakest one. Taking this into account, a legitimate question is why is it still included in the model?

To better understand why personality is present in the model, I suggest taking a look at it from a behavioral sciences perspective. If we accept the System 1, System 2 perspective or in other words the bird and computer brains, then we will see that several personality traits are significantly important. Moreover, personality traits are relevant for components of the other three dimensions of the model, Environmental influences, Social influences and Internal state.

In previous posts I have presented the personality traits that I believe to be most important. These are Intelligence, The Big Five Personality Traits, Need for Cognition, Need for Uniqueness, Regulatory Focus, and Life History Strategy adopted. In the following paragraphs I will present most of these traits from the perspective of behavioral sciences.

Let’s take a look at intelligence. A very brief and somehow superficial definition of intelligence is the capacity of processing information. At the same time, intelligence implies accurate processing of information. Moreover, all tests that measure IQ include time pressure. In simpler words, a person who takes an IQ test has very little time to answer each question.

If we take the dual system of reasoning perspective, we see that time pressure implies a dominant reliance on System 1 or the bird brain. This system of reasoning is fast whereas the computer brain (system 2) is slow. From this point of view, it could be inferred that intelligence is strongly related to the accuracy of System 1 (bird brain) reasoning.

Let’s take a look at need forcognition. A very frugal definition of this trait would be how much a person likes to think. A more elaborate definition would be the tendency to engage in effortful thinking. If we take the dual system of reasoning approach, need for cognition can be seen as a measure of usage system 2 or the computer brain.

Things are similar for the Openness to experience trait from the Big Five personality traits. This trait is correlated with need for cognition and it can be briefly defined as intellectual curiosity. Openness to experience is strongly related to the use of the computer brain (system 2).

Let’s take a look at need foruniqueness. This trait could be briefly defined as the degree to which a person expresses her own individuality and at the same time belong to a social group. This trait is strongly related to social competition which is a component of the social influences dimension. In my humble opinion, people with high scores on need for uniqueness are more likely to be more competitive and engage in fierce social competition.

Conscientiousness, which is one of the Big Five personality traits, can be briefly defined as ability to work hard and thoroughly. This trait is strongly related to self-control, which in turn is very important for the internal state dimension. I believe that conscientiousness score of a person would predict well the influence of visceral influences on the person’s behavior.

Life History Strategy adopted is a trait that comes from evolutionary psychology and indicates how much a person is inclined to invest in her own development and improvement and how much is she inclined to “advertise” herself on the social market. This trait is highly significant for social competition, a component of social influences. People who are more on the side of the Fast Life History Strategy are more likely to be more competitive on the social market and allocate more resources for achieving a higher social status. People who are more on the side of the Slow Life History strategy will devote more resources to investing in themselves and less on communicating their value on the social market.   

Regulatory focus is a trait that reflects which goals are more important for a person. People who are more on the prevention focus side tend to have very salient goals of avoiding losses. People who are more on the promotion focus side tend to have very salient goals of achieving gains. This trait is strongly related to the concepts of loss and risk aversions from prospect theory. People with a dominant prevention focus, compared with people with promotion focus, exhibit higher levels of both loss and risk aversions.

Personality is a valid predictor of behavior and I believe that seeing it from this perspective gives more opportunities to understanding its role.  

15 May 2013

Explaining to Yourself Your Own Actions - Need for Justification

Finding reasons for our actions is one very interesting and important psychological phenomenon. Self-justification is part of what is called cognitive dissonance which in a nut shell means that we change our beliefs to become congruent with our actions. For example if you would be forced to do something that you don’t agree with such as campaigning for the communist party (assuming that you dislike this party), later on you will start liking the communist party more than before. This is because you have done something that is against your own beliefs and now you have to make sense of your own actions. Because you need to have congruency between your actions and your beliefs and because your actions can’t be changed, you will alter your beliefs about the communist party.

This, however, is not what I am intrigued by. After all cognitive dissonance is a well-known effect and in the last decade it has been challenged and criticized. My interest is more on the side of how we find perfectly reasonable motives for our actions. An example is how we support with solid arguments our purchases. This is very different from cognitive dissonance because in the case of cognitive dissonance there are two major particularities. First a person is somehow forced to do something that is in disagreement with his own beliefs. Second, the person changes his attitudes or his beliefs after the behavior took place.

Imagine the following scenario. You go to a shop with the aim of buying some drapes. The same shop sells cooking-ware and you are magnetically attracted to a nice frying pan. In the spree of the moment you buy it. This was a totally unplanned purchase and not a very necessary one since you have five frying pans. On your way home you are thinking how you are going to explain your purchase to your significant other. While finding arguments for buying the sixth frying pan to provide your better half with, you think that one of the old pans was already too used, that the new one is ceramic coated and you heard on TV that the food cooked in such a frying pan is healthier and so on. Before arriving home, you have already good reasons to support your purchase in front of your better half.

Two very interesting things are that, first, when you made the purchase none of these arguments ever played a role. Cooking-ware manufacturers know that non-professional cooks buy cute stuff and subsequently design the products to be simply irresistibly cute. Your decision to buy the pan was made when you found it to be very nice and think that it would look good in your kitchen. The arguments about needing to replace the old one and the new one being ceramic coated that makes healthier food came only after you made the purchase, on the way back home.

The second interesting thing concerns you coming up with arguments to defend your purchase in front of your life partner who might be a bit critical with buying stuff that is not necessary. However, your better half is not the one who needs convincing the most. The person who needs the solid rational arguments is in fact you! You need to explain your actions to yourself and only after doing this you need to explain them to others. It is not unlikely that your life partner would be satisfied with a simple and more honest answer such as “I bought it because I liked it”. But you need to explain the action to yourself and very likely “because I liked it” is not satisfying enough. It might be an issue of ego, or simply a natural need of knowing that what you do is your choice.

The above mentioned example is quite trivial because it concerns impulsively buying a frying pan. At the same time, the need for justification is present in many areas of our lives. Quite often our actions are not result of our own reasoning and choice, but rather the outcome of a mixture of internal states, emotions and external factors such as the social and physical environments. However, we have the need to believe that there are good reasons for why we do what we do.

Justifying impulse purchases is only one illustration and as mentioned before not a very important one. Let’s think a bit about tax evasion and discrimination. Do we need to justify these behaviors? Of course we do, and I don’t mean in a court of law, but rather in our regular lives.

In my recent trip in my home country, I have encountered several juicy examples of the need for justification. For example, an entrepreneur who has a small business and somehow avoids paying in-full the taxes, explained me that he does so because public services are unsatisfying and the transport infrastructure is poorly developed. These sound like very solid arguments and the sad reality is that they are true. However, small scale tax evasion has nothing to do with bad roads and increased bureaucracy. It is simply something that is done by almost all small businesses to make an extra income. Most small firms do it because other small businesses do it; because it is possible to do it and because there are countless notorious examples of “stealing from the state and getting away with it.” However, going with the herd and following the example of corrupt politicians, business people and public servants are reasons that would make the small scale entrepreneur not very proud. At the same time justifying the small scale tax evasion with real problems such as bureaucracy and bad infrastructure is a lot more comfortable for the entrepreneur.

It goes similarly for discrimination. I have heard a lengthy and elaborate pleading against the Rroma (Gypsy) community and why this minority is the biggest problem of the country. Most of the arguments that supported this thesis were not very solid, but the person providing them was convinced of them. In the end of the so-called explanation, the old gentleman said that when he was a child he had a very negative experience with some members of the Rroma community. In 1934 he was kidnaped by a group of nomad gypsies and rescued by his parents a couple of months later.

The gentleman’s negative feelings towards his experience can’t be challenged, but finding so-called solid arguments to support the idea that an ethnic minority that represents less than 5% of the population is the main problem of the country is a bit far-fetched. However, this person needed to justify his negative feelings and supported them with reasons that in fact have nothing to do with the source of the feelings.

Quite often we justify to ourselves our actions and feelings (attitudes). The dilemma is whether we think before we do something or we think after we have done something and find reasons for our already done actions.