Friday, April 16, 2004

Discounting the Future

Matt Gaddis over at Undergradecon, claims that students aren't rational.

Last night I was really trying to use economics to make my decision about what I should do for the night. Let me take you through my thought process. I was in the shower it was 10:00pm I had just gotten back from playing some basketball and running when I was deciding which of the following to do:

A) Go downtown to Brothers for $5 all you drink.
B) Stay at home and watch some TV.
C) Stay at home and do homework.

So I learned a little bit about decision making in my micro class and I was told people choose their decision based what option maximizes their utility. So I considered the utility of each.

A)Probably the greatest utility because drinking at bar is good times, BUT being hungover at work all day is no fun at all. So this raised some questions. Is the utility I am trying to maximize only in the short run so it only includes that night? Is their negative utility the next day and does that offset the positive from the night before?

Matt discovered the challenges of maximizing utility over more than one period. Several econ students at other schools emailed him to suggest he was not being irrational by going to the bars, but rather he was just heavily discounting the future.

I wonder when he'll stumble across the currently vogue idea of hyperbolic discounting?

One reason hyperbolic preferences are less convenient in a model is not only that there are more parameters but that the agent's decisions are not time-consistent as they are with a constant discount rate. That is, when planning for time two (two periods ahead) the agent might prepare for what looks like the optimal consumption path as seen from time zero; but at time two his preferences would be different.

Who hasn't awoken the night after drinking only to utter the requisite "I'm never drinking again" hangover mantra? Brad Delong has another example of hyperbolic discounting from the ASSA meetings in DC, where he spied one of its biggest proponents, David Laibson.

"My feet hurt. These marble floors are hard. I want to go sit down." "But here comes David Laibson, the master of hyperblic discounting. If we stay here, we can talk to him." "But then our feet will hurt worse later on in the afternoon." "Ah, but right now we don't care: you see, we are hyperbolic discounters, and so underweight future pain relative to present pleasure. It's true that later on we'll regret the fact that we spent so much time standing around and did not sit down. However, right now the benefits of discussing hyperbolic discounting with David Laibson are irresistible!" "But if we stay here, we'll be doing the wrong thing..."

You can find a nice paper by Laibson here.

Keywords: ECO308, ECO110, Discounting

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