Week 5 - Time Preferences

Question 1

Present discounted value of lifetime consumption

Answer 1

How much all our future consumption is worth today

Question 2

3 assumptions of the model of rational, time-consistent discounting

Answer 2

1. Saving and borrowing both happen at the SAME RATE, r
2. NO UNCERTAINTY all the money/utility streams are known (big issue in finance)
3. There is a COSTLESS MECHANISM that ensures ppl only borrow what they can repay and will then pay interests.
   ^Also true for firms who always pay the stated interest if ppl invest in them.
   eg. direct debit by banks.

— assumptions 2 and 3 are more questionable in reality

The model has assumptions w/o empirical support but we use it b/c it’s very flexible. Can use it to think about savings decisions & how ppl make decisions over time.

Question 3

Time-consistent preferences

*Rational consumers = time consistent people

Answer 3

Choices a person makes today correspond to the same choices they’d make tmr/in the future
- so they will follow through w/o regretting it

Time-consistent ppl would compare the net present value of the diff. options & choose the one with highest NPV.

We will evaluate all their options from the perspective of time 0

Question 4

Present-biased preferences / time-inconsistency

Dynamic inconsistency

*the beta-delta model of quasi hyperbolic discounting accounts for ppl’s diff. levels of impatience and for the fact that there might be dynamic inconsistency (they might experience REGRET)

Answer 4

Very impatient when evaluating short-term tradeoffs but become much more patient with long-run tradeoffs

Time-inconsistent ppl would perceive the decision as a game. Reason by backward induction.

Dynamic inconsistency: A present-biased person will not make the same decisions on any given day.
Why? Today is the most valuable day from today’s perspective, but tmr is the most valuable day from tmr’s perspective!
> Timing matters a lot in this model.

Question 5

How to find out the decision that will be chosen for…
1. a rational consumer
2. a present-biased agent?

Answer 5

1. Compute PV and choose highest PV
   - The rational, time-consistent agent is making all decisions at time 0.
2. Reason by BACKWARD INDUCTION as it is a dynamic game. & consider only the payoffs that have yet to occur
   > Every next day becomes the present day for Kate and she makes decisions on that day, and changes the values.

• Then, to find best payoff that can be achieved from TODAY’S perspective, consider all utilities from today’s point of view.
• the difference in utilities (loss) = maximum price the present-biased agent is willing to pay for a COMMITMENT DEVICE to stick to their choice

Question 6

Nudges

Answer 6

BEHAVIOURAL INTERVENTIONS that gently alter ppl’s behaviour to their target behaviour w/o forcing them/not significantly changing their economic incentives.
- must be cheap and easy to avoid