Lecture 5 Handout

Modeling Reference Dependence
Applications of Prospect Theory

Introducing Time Preferences
Evidence for Present Bias and Time-Inconsistency
Quasi-Hyperbolic Discounting Model
Economics 318: Foundations of Psychology and

Economics
Lecture 5
Josh Tasoff
Claremont Graduate University
Wed, February 16, 2011
1 / 43
Stochastic Reference Points
Now suppose that prices are uncertain. With probability qL the price will
be pL < pmin and with probability 1 − qL the price will be pH > pmax .
We now look at the “out-of-equilibrium” question of whether Botond
would buy the shoes at an intermediate price. We can think of this as a
very small chance that pM is the price (so this won’t affect the reference
point much) and then asking what happens when the price actually is pM .
Botond expects to get the shoes with probability qL and not to get the
shoes with 1 − qL .
Botond’s utility from buying at pM is
U = 40 − pM + qL [µ(pL − pM ) + µ(40 − 40)] + (1 − qL )[µ(40 − 0) + µ(−pM )]

= 40 − pM + qL λη(pL − pM ) + (1 − qL )(40η − ληpM )
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The term 40 − pM is the consumption utility from buying. The term
qL λη(pL − pM ) is the loss from paying more than under the low price.
The term (1 − qL )(40η − ληpM ) is the gain-loss from getting the shoes
but paying for them comparing to the outcome of having the high price.
The consumer’s utility from not buying at qM is
U = 0 + 0 + qL [µ(pL ) + µ(−40)] + (1 − qL )[µ(0) + µ(0)]
= qL η(pL − 40λ)
Now we find the highest pM for which Botond will buy.

Botond buys if
40 − pM + qL λη(pL − pM ) + (1 − qL )(40η − ληpM ) ≥ qL η(pL − 40λ)
40(1 + qL λη + (1 − qL )η) qL η(λ − 1)
pM ≤ + pL
1 + λη 1 + λη
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Suppose pL = 0 the good may be free. This unsavory inequality reduces
to
40(1 + qL λη + (1 − qL )η)
pM ≤
1 + λη
The right-hand side of the above inequality is increasing in qL . Since the
consumer expects to spend nothing no matter what, an increase in qL only
increases his expectation to get the shoes and hence the loss he will feel if
he does not buy. This attachment effect increases his willingness to pay.
Now suppose that pL ≥ 0 and qL = 1. Botond will buy if
40(1 + λη) η(λ − 1)
pM ≤ + pL
1 + λη 1 + λη
The right-hand side of this inequality is increasing in pL . Hence, in
violation of the law of demand, a decrease in the price distribution
decreases the consumers willingness to pay for the shoes.
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If there is a possibility of acquiring the shoes at a low price, by

comparison, the consumer considers paying the higher price pM to be a
loss. The greater the difference between pM and pL , the greater is the
sense of loss, and the more this “comparison effect” decreases her
willingness to pay.
For any fixed expectations Botond’s demand is downward sloping. The
key here is that a higher pL increases the expectation of payment and
hence a higher WTP.
Notice that these “attachment” and “comparison effects” go in opposite
directions. Having a low random price gets a consumer more attached to
the good and hence higher WTP. However when the higher price is then
realized, the consumer compares it to the lower sales price hence lower
WTP.
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Modeling Reference Dependence Labor Supply
Applications of Prospect Theory Asymmetric Price Elasticities
Introducing Time Preferences Insurance
Evidence for Present Bias and Time-Inconsistency Small Investors
Quasi-Hyperbolic Discounting Model Deal or No Deal?
Explaining a phenomenon in terms of reference-dependent

utility involves answering three questions:
1 What kind of economic outcome is being evaluated in a
reference-dependent way?
2 What is the reference point for evaluating those outcomes?
3 What feature of the prospect-theory value function can explain
the phenomenon?
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Labor Supply
People’s labor supply is of fundamental economic importance.
Suppose that a worker can freely choose how many hours she works every
day, and there are frequent temporary changes in her hourly wage.
For example, on some days she can earn $5/hour, and on other days
$10/hour. Classical economic theory predicts that people will work more
when the wage is higher.
This is the same as saying people have upward sloping labor supply curves.
It would be very strange if the relationship were reversed – that people
work more hours when their wage is lower. Suppose a person worked 10
hours on a $5/hour day and 6 hours on a $10/hour day. Her earnings
would total $110. But if she reversed the hours she worked on the two
days her earning would be $130.
However looking at labor’s response to temporary wage changes is
difficult to observe since there are few professions in which wages change
from day to day.
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Labor Supply
Camerer, Babcock, Loewenstein and Thaler (2000) looked at the labor
supply of cab drivers in New York.
Cab driving is one of the few professions in which the wage changes from
day to day and drivers can choose how many hours they wish to work.
Drivers pay a fixed fee to take the cab out for 12 hours and can bring it
back whenever they want. Things like the weather, sports events,
conventions, etc. can have a big impact on demand.
The authors found that the drivers have a negative wage elasticity
between -0.503 and -0.269. That means that a 1% increase in the wage
leads to anywhere between a .5% to .25% decrease in the hours worked!
Looking only at inexperienced drivers, the elasticities are between -0.559
and -1.308 – even higher!
The author’s explanation is that cab drivers have daily income targeting.
They don’t want to end the day feeling like that had a loss. The reference
point is the earnings that the cab drivers expected to earn for that day.
And loss aversion is driving this result
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Asymmetric Price Elasticities

Hardie, Johnson and Fader (1993) looked at price elasticities from
decreases and increase of the price of orange juice. They found an
asymmetry where the elasticity for increases was 2.4x as high as decreases.
Here money and orange juice are being evaluated in a
reference-dependent way. The reference point is the current price since it
is the expected price. Since increases in the price feel like a loss people
curb their consumption more than when the price drops.
Heidhues and Kőszegi (2008) use reference-dependent preference to
predict that firms will reduce price variation over time and over products.
Regular prices in a supermarket or a movie theater, for example, often
stay the same for months, even though there is very little cost to changing
them (Chevalier, Kashyap and Rossi 2003). In addition, (Mills 1927,
Means 1935) firms subject to all kinds of shocks often charge an identical,
“focal,” price for non-identical products: Coke and Pepsi, movies tickets,
clothes of different sizes, sports events, online music downloads, etc.
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Insurance
Cicchetti and Dubin (1994) found that people are willing to
pay $0.45 per month for insurance on their phone bill to avoid
paying the repair fee of $60 if something goes wrong.
However the expected repair fee is only $0.26. This would
suggest that people are phenomenally risk averse.
Two aspects of prospect theory are likely driving this. The
first is overweighting of small probabilities. People likely
overestimate the probability of repair. Second people are
loss-averse which causes first order risk-aversion.
Likewise Sydnor (2006) finds that people overpay on housing
insurance to avoid the high deductibles. People behave as if
they are extremely risk averse, choosing deductibles much
lower than a risk-neutral person would choose.
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Small Investors
Odean (1998) acquired data on 10,000 randomly selected customer
accounts at a nationwide discount brokerage house.
Each stock in an individual’s portfolio is classified as a gain or loss each
day depending on whether its value is above or below the purchase price.
Odean finds that investors are much more likely to sell stocks that have
realized gains than realized losses. This is now referred to as the
disposition effect.
The prospect theory explanation is that the purchase price (or some
higher expected level) is the reference point, and selling above this level is
a gain, selling below is a loss which feels bad. The investor has a separate
mental account for each stock.
But what is so surprising is that the sold winners tend to continue to do
better than the held losers! Over two years (504) trading days, the sold
winners are almost 4% higher!
Additionally tax considerations should push the result in the opposite
direction. A sold loser can be reported as a loss but a sold winner is taxed.
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Deal or No Deal?
Post, van den Assem, Baltussen and Thaler (2008) analyze the Dutch
game show “Deal or No Deal”.
The show has huges prizes with a max of 5,000,000 EUR and average
winnings of 500,000 EUR
In the game, a person is given a suitcase with an unknown prize.
Gradually the contestant learns about the prize as other suitcases are
opened with contents revealed.
At each stage, the host offers the contestant a riskless amount in
exchange for the suitcase.
Each of these decisions is an indicator of risk-aversion. The finding is that
contestants accept more risk if they received bad news in the previous few
rounds.
The prospect theory explanation is diminishing sensitivity. Bad news puts
the contestant in the loss domain and so she becomes more risk seeking.
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Motivation
History of Thought

This Econ 318 topic numero dos! This is the second most
important topic in the course.
As far as the innovations coming from behavioral economics, I’d say
this is where the field has had the biggest impact on the rest of the
profession.
The vast majority of economic decisions involve consumption
tradeoffs over time.
Will you study for your exam? It is costly now but yields a payoff in
the form of a better dissertation sometime in the future.
Will you buy that lovely new sweater? Or save the money and
invest it for retirement?
Should you purchase the big house and forego getting a new car for
the next five years?
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Motivation
History of Thought
You can exercise now to improve the quality of your health 10 years
down the road.
We call these intertemporal choices. There is a tradeoff between
costs and benefits across time.
Many economic decisions rely fundamentally on how people perceive
tradeoffs between present consumption and future consumption.
The classical model assumes that people are exponential
discounters.
To understand the strengths and weaknesses of the classical model,
we will introduce this model with a lesson on the history of thought.
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Motivation
History of Thought
History of Thought
This history of thought is based on Loewenstein (1992).
The earliest economists were interested in intertemporal choices
because they wanted to understand capital accumulation. Adam
Smith recognized that capital accumulation was a key determinant
of the wealth of nations.
But the puzzle for these economists was that if people cared solely
about utility, which at the time was interpreted as immediate
pleasure and pain, why would anyone save.
Rae, Senior, and Jevons suggested that the reason people would
save was because thinking about the future gave pleasure today in
the present. Jevons said that we have a “telescopic faculty” that
allows us to imagine the future and experience a fraction of our
future pleasure in the present. And this, they thought was the only
reason why we should save.
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Motivation
History of Thought
History of Thought
They used this conceptualization to explain why there is a positive
interest rate. People must be paid a positive sum in order to delay
gratification. They also suggested that people will care more about the
near future because that is easier to imagine.
Rae argued that four things affected the telescopic faculty: (i) uncertainty
that we will live to experience the future event, (ii) delay of gratification
is psychologically painful, (iii) concern for one’s descendants, and (iv)
willpower to restrain immediate desire.
At this point, economists only cared about intertemporal choice as it
related to capital accumulation.
In comes Böhm-Bawerk who revolutionizes the idea of intertemporal
choice. Consumption of an apple today is one good and consumption of
an apple tomorrow is a different good. The interest rate is the price used
to equilibrate demand and supply over time. Thus there is nothing
fundamentally different about consumption over time from consumption
over different goods.
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Motivation
History of Thought
History of Thought
Cheetos ramen tomorrow
ramen ramen today
Figure: The Fisher Diagram
Fisher took this idea and represented it graphically showing that

consumption over time can be seen as no different from static choices.
This eliminated any ideas like willpower from the analysis.
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Motivation
History of Thought
History of Thought
The next major innovation was Samuelson’s (1937) exponential
discounting model.
Samuelson’s model is conceptually the same as Fisher’s and
Böhm-Bawerk’s but explicitly breaks down choice over many different
periods.
The first main component is that individuals have an instantaneous utility
function that expresses the utility received at that moment. Instantaneous
utilities from different periods are traded off with each other.
The second main component of the model is the discount factor D(t)
which gives the relative value of instantaneous utility in t periods in the
future with instantaneous utility now.
If the individual lives for T periods then utility in period t ≤ T is given by
T
X
Ut (c) = D(τ − t)u(cτ ).
τ =t
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Motivation
History of Thought
History of Thought
Critically, Samuelson assumes that D(t) takes the exponential form
D(t) = δ t , where 0 ≤ δ ≤ 1.
Thus utility becomes
T
X
Ut (c) = δ τ −t u(cτ ).
τ =t
Samuelson chose the exponential form for mathematical convenience and

admitted that it was completely arbitrary.
He did show that it is the only functional form that will preserve
preferences over time – that is – it is time consistent.
The key is that instantaneous utilty at time t 0 and at time t 00 ≥ t 0 have a
fixed ratio when measured from a time t ≤ t 0 self.
00
−t)
The ratio of t 00 utils to t 0 utils is then D(t
D(t 0 −t)
= k for all t ≤ t 0 where k
is a constant.
If this ratio were to change over time then preferences would change over
time too.
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Motivation
History of Thought
History of Thought
Since we must have a fixed ratio for any t 00 ≥ t 0 , let t 00 = t 0 + 1.
Then rearranging D(t 00 − t) = D(t 0 + 1 − t) = kD(t 0 − t).
This must also be true for all t ≤ t 0 so now suppose we replace t
with t − 1: D(t 0 + 2 − t) = kD(t 0 + 1 − t) = k 2 D(t 0 − t)
Continuing this pattern onward we get that the only function that
will satisfy this relationship is the exponential discounting
D(t) = δ t . Notice that the ratio of utils between two time periods
(t 0 and t 00 ) is independent of the period of evaluation t:
00
D(t 00 −t) δ t −t 00
−t 0
D(t 0 −t) = δ t 0 −t
= δt .
What does this mean? In summary, this is the only form of
discounting in which people will have time-consistent plans. If I plan
to sacrifice x utils on Thursday for y utils on Friday (and this is
optimal today), the plan will continue to be optimal on every single
day up to and including Thursday (for any x and y that satisfied the
original optimality constraint). 20 / 43
Motivation
History of Thought
History of Thought
If I had another form of discounting I may plan to to sacrifice x utils

on Thursday for y utils on Friday, but when Monday comes along I
no longer think this is a good plan and I try to change my
consumption.
Anyway, all the psychology was compressed into a single parameter
δ for the sake of simplicity and elegance.
Of course it is very important to know what δ is if it truly can
summarize people’s intertemporal tradeoffs.
Frederick, Loewenstein, and O’Donoghue (2002) conduct a
meta-study in which they summarize the estimates of δ from the
last 25 years.
Values for δ are distributed almost uniformly between zero and 1.1,
with a little more weight in the 0.8-1 range.
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Motivation
History of Thought
History of Thought
Figure: Estimates of δ over time.

22 / 43
Motivation
History of Thought
History of Thought
This graph is quite an embarassment for our profession. The

implications are either that we are mis-measuring δ, it is wildly
unstable and varies widely over situations and people, or that our
model is improperly specified.
I will argue for the last explanation. Since many different
psychological factors are involved in intertemporal choices,
squeezing everything into one variable is likely to fail.
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Evidence for Impatience
Time Inconsistency
We now put forth the claim that people are present-biased. They
overweight current consumption to future consumption in a more
than exponential way.
Marshmallow Experiment.
Payday effect: Huffman and Barenstein (2005) document that the
consumption of working households in the United Kingdom is 12%
higher the week after their payday than the week before.
Payday for Foodstamps: In 2001, about 17 million Americans
received food stamps, with the average household getting about
$160 per month in benefits (Shapiro, 2005). Shapiro finds a 0.45%
calorie consumption decline per day after the receipt of food stamps
which comes out to a 13-14% decline over the month.
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Time Inconsistency

Payday Loans: about 10 million people borrow money through payday
loans, and do so at annualized compounded percentage rates often
exceeding 1000%. There are more payday-loan and check-cashing outlets
in the United States than there are McDonalds and Starbucks combined!
At the begining of class I asked half of you
Suppose I could give you either $100 in cash in 52 weeks or $x
in cash in 54 weeks. What is the x for which you would be
indifferent between the two options?
The average answer was $107.

I asked the other half of you
Suppose I could give you either $100 in cash right now or $x
in cash in two weeks. What is the x for which you would be
indifferent between the two options?
The average answer was $121.

25 / 43
Time Inconsistency
Classroom Evidence
Notice that all these questions are about short-run impatience. Now
vs. later.
This last question compared (now vs. later) vs. (later vs. more
later) and people exhibited far more patience when it is later vs.
more later.
Let’s compute people’s implied annual discount rates from these
answers. In the first question on average people needed 7% more
money to wait two weeks. This means the biweekly discount rate is
1 1
26
1.07 = 0.9346 which gives an annual δ = 1.07 = 0.1722. This is
a shockingly low discount rate. It means that a person would prefer
$100 next week to $660,000 in five years and one week.
Now there are some problems with how I asked this question. For
one the question wasn’t incentivized. If it were and people thought a
bit more carefully they might have responded with different answers.
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Time Inconsistency
Classroom Evidence
But even more shocking is the answer to the second question.

People needed on average a 21% more money to wait. This implies
1
a biweekly discount of 1.21 = .8264 which gives an annual
δ = 0.0070. This means that a person would prefer prefer $100 now
to $5.782 trillion in 5 years. That’s more than 1/3rd of the GDP of
the U.S.!
How many people would prefer $100 now to $5.782 trillion in 5
years?
In any case it seems that people’s impatience in the short run is
vastly greater than their impatience for the longer term.
27 / 43
y z
median x yearly δ
15of Prospect
Applications 1 month Theory 20
Evidence for 0.032
Impatience
15Time-Inconsistency
ten years Time Inconsistency
100 0.83
Evidence for Present Bias and
Quasi-Hyperbolic
40Discounting Model
six months 50 0.64
40 four years 90 0.82
362 Table 6.1: Some Findings of
Journal of Thaler (1981)
Economic Literature, V o l . X L (
5 0.0 4
0 5 10 15
time horizon (years)
Figure l a . Discount Factor as a Function of Time Figu,re l b . Disco
Figure: Horizon
From Frederick, Loewenstein, and O’donoghue (2002)
(all studies) Horizon (studies w
Figure 6.3: Estimated Discount Factors as a Function of the Time Delay in
Frederick, Loewenstein, and O’Donoghue (2002)
although they did not interpret their 4.2 Other DU
results the same way. 28 / 43
Time Inconsistency
Evidence from Self-Control Issues

Ainslie (1992) conducted the most extensive studies of this sort. He
consistently finds that short-run discount factors are smaller than
long-run discount factors. This holds true for money, chocolates,
cookies, video games and has even been found in animals.
Ainslie found that a hyperbolic curve fit discounting over time
better than an exponential curve.
Ulysses and the Sirens. Circe’s advice.
Self-control advice online for credit cards:
Cut up your credit and store cards! If possible get rid of
all of your credit cards and store cards. They will only
encourage you to spend more money, and its far too easy
to let the owed amounts build up without realizing it.
Remember you aim to be debt free from now on!
29 / 43
Time Inconsistency
Evidence from Self-Control Issues
More suggestions for credit card spending:

Put it in a tub of water and stick it in the freezer.
Extreme? Maybe, but it will make you think hard about
any impulse purchases you make in the future while you
are standing there waiting for it to defrost.
These suggestions are similar to Circe’s recommendation that

Ulysses tie himself to the mast to resist the sirens.
This conflict between short-term desires and long-term desires is
dynamic inconsistency or time inconsistency.
More clearly, if a person reveals x ∗ y at time t and then reveals
y ∗ x at t 0 , and the environment, information, choice sets, etc.
have not changed, then the person has exhibited time inconsistency.
30 / 43
Time Inconsistency
Understanding Time Inconsistency
Let’s say Mona chooses a banana for lunch today from the choice
set {banana, apple}, but tomorrow she chooses to eat an apple.
Does that mean she’s dynamically inconsistent?
What would be an example of dynamic inconsistency using this
setup?
As we showed earlier, exponential discounting is the only form of
discounting that is dynamically consistent. Due to this assumption,
economists have assumed away any form of dynamic inconsistency
even though it is a fundamental aspect of human decision making.
31 / 43
Time Inconsistency
Some Issues With Measuring Time-Inconsistency

When we analyze the tradeoff across time we should be looking at a
tradeoff of utils. Unfortunately this isn’t observable.
Usually economists ask about a tradeoff in dollars. This makes three
implicit assumptions:
1 Dollars are consumed in the period that they are received.
2 Price levels are relatively constant over time (no inflation).
3 Consumption is relatively constant over time.
Thus, under these assumptions, if a person is indifferent between $1 now

and $X in τ periods
1 0 X τ 0
u (ct ) = δ u (ct+τ )
pt pt+τ
1
1 τ
δ=
X
However if these assumptions don’t hold, we’re in trouble. Fortunately,
studies on time discounting that have used actual consumption have
arrived at very similar results. 32 / 43
The Setup
Example

The quasi-hyperbolic discounting model comes from the work of
Strotz (1955), Phelps and Pollack (1968), Laibson (1997), and
Rabin and O’Donoghue (1999).
One parameter is added to the exponential discounting model:
T
X
Ut (c) = u(ct ) + β δ τ −t u(cτ )
τ =t+1
where β < 1. All future periods are discounted by a common factor

β.
This builds in an immediate stark tradeoff between now and later,
that differs from the tradeoff between later and more later.
The shape that this discounting function gives over time is not quite
hyperbolic hence we call it quasi-hyperbolic.
We will also refer to this model as present biased.
33 / 43
The Setup
Example
The model is almost as simple as exponential discounting but there

is a fundamental issue that this new parameter raises that we never
had to consider with exponential discounting – the issue of time
inconsistency.
Since the hyperbolic model generates time inconsistent behavior we
have to resolve what a person does when selves at different periods
of time have a conflict of interest.
O’Donoghue and Rabin (1999) provide an answer to this
conundrum. We conceptualize a person at each point in time as a
different “self”. Each self will have different preferences and hence
we have to resolve the interaction of these potentially conflicting
choices.
34 / 43
The Setup
Example
The authors take two extreme assumptions for analyzing this

situation. The first is what they call naı̈veté. A person who is naı̈ve
present-biased believes that her future selves will follow her current
plan of action, or in other words she believes that her future β will
equal 1.
The opposite assumption is sophistication. They assume a person
who is sophisticated present-biased knows her β and knows what
her future selves will do. Hence she plays a game against her future
selves based on the logic of subgame perfect equilibrium.
We will now explore this behavior with an example of each.
35 / 43
The Setup
Example
Example: Problem Set

Commitment
We now consider a student’s choice of when to do a problem set.

The longer the student waits the more costly doing the problem set
becomes (i.e. higher opportunity costs and the student begins to
forget the material).
Let β = 1/2 and for simplicity we assume that δ = 1. If the student
does the problem set at t = 0 it costs 2 utils, at t = 1 it costs 3
utils, at t = 2 it costs 5 utils, at t = 3 it costs 8 utils, and at t = 4
it costs 13 utils.
First suppose that the student has access to a commitment
technology like Ulysses. The student has a study group and will do
the problem set with the study group. When is the optimal time to
do the problem set?
36 / 43
The Setup
Example

Naı̈ve
Time Cost
t=0 2
t=1 3/2
t=2 5/2
t=3 4
t=4 13/2
Figure: Costs from t = 0 perspective.
If the student can commit, clearly the optimal time to do the problem set
is at t = 1.
Now suppose that the student cannot commit and she is a naı̈f. When
will she do the problem set?
Well at t = 0 the optimal time to do the problem set is tomorrow. So she
will delay at t = 0.
However, at t = 1 the student’s preferences have changed! 37 / 43
The Setup
Example

Naı̈ve
t = 1 self
t = 2 self
Time Cost t = 3 self
Time Cost
t=1 3 Time Cost
t=2 5
t=2 5/2 t=3 8
t=3 4
t=3 4 t = 4 13/2
t = 4 13/2
t = 4 13/2
Figure: Preferences at different time periods.
If the student can commit, clearly the optimal time to do the problem set
is at t = 1.
Now suppose that the student cannot commit and she is a naı̈f. When
will she do the problem set?
Well at t = 0 the optimal time to do the problem set is tomorrow. So she
will delay at t = 0.
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The Setup
Example

Naı̈ve
t = 1 self
t = 2 self
Time Cost
t=1 3 Time Cost
t=2 5
t=2 5/2 t=3 8
t=3 4
t=3 4 t = 4 13/2
t = 4 13/2
t = 4 13/2
However, at t = 1 the student’s preferences have changed! It is now

optimal for the student to do the problem set at t = 2 and thus the
student will delay.
At t = 2, the student’s preferences have changed yet again. It is now
optimal for the student to delay to t = 3 and so the student will delay.
At t = 3 the student will delay yet again. Thus the student does the
problem set in the very last period and incurs the highest cost! 39 / 43
The Setup
Example

Sophisticated
t = 0 self
t = 1 self
t=0 2 Time Cost
t=1 3 Time Cost
t=1 3/2 t=2 5
t=2 5/2 t=3 8
t=2 5/2 t=3 4
t=3 4 t = 4 13/2
t=3 4 t = 4 13/2
t = 4 13/2
t = 4 13/2
The student’s strategy is (delay , delay , delay , delay ). In other words the
student procrastinates.
What’s the intuition?
Now what would a sophisticate do? We solve using backwards induction.
In period 4, the student would have no option other than to do the
problem set so she will do it in t = 4. 40 / 43
The Setup
Example

Sophisticated
In t = 2, the option is to do it now and incur a cost of 5 or do it in t = 4

and incur a cost of 13/2. Thus she will do it now.
In t = 1, the option is to do it now with a cost of 3 or delay which will
result in doing it in t = 2 with a cost of 5/2. Thus she will delay.
In t = 0, the option is to do it now with a cost of 2 or delay which will
result in doing it in t = 2 with a cost of 5/2. Thus she will do it now.
So the sophisticate does it in the first period incurring the lowest cost.
Her strategy is (do, delay , do, delay ).
Here, actually all selves are better off from doing it in the first period
relative to doing it in the last period. So the sophisticate’s choice Pareto
dominates the naı̈f’s choice.
What’s the intuition?
41 / 43
The Setup
Example
Takeaway
Exponential discounting is the only functional form of discounting

that will maintain time consistency.
42 / 43
The Setup
Example
Next Class
More hyperbolic discounting.

Essay 1 is due next Wed, 2/23.
Problem Set 2 will be posted online. It will be due Wed, Mar
2.
43 / 43

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Modeling Reference Dependence

Applications of Prospect Theory

Economics 318: Foundations of Psychology and

Claremont Graduate University

Wed, February 16, 2011

Stochastic Reference Points

U = 40 − pM + qL [µ(pL − pM ) + µ(40 − 40)] + (1 − qL )[µ(40 − 0) + µ(−pM )]

Stochastic Reference Points

Now we find the highest pM for which Botond will buy.

Stochastic Reference Points

Stochastic Reference Points

If there is a possibility of acquiring the shoes at a low price, by

Applications of Prospect Theory

Explaining a phenomenon in terms of reference-dependent

Asymmetric Price Elasticities

Introducing Time Preferences

Introducing Time Preferences

ramen ramen today

Figure: The Fisher Diagram

Fisher took this idea and represented it graphically showing that

Samuelson chose the exponential form for mathematical convenience and

If I had another form of discounting I may plan to to sacrifice x utils

Figure: Estimates of δ over time.

This graph is quite an embarassment for our profession. The

Evidence for Present Bias and Time-Inconsistency

Evidence for Present Bias and Time-Inconsistency

The average answer was $107.

The average answer was $121.

But even more shocking is the answer to the second question.

Evidence from Self-Control Issues

Evidence from Self-Control Issues

More suggestions for credit card spending:

These suggestions are similar to Circe’s recommendation that

Understanding Time Inconsistency

Some Issues With Measuring Time-Inconsistency

Thus, under these assumptions, if a person is indifferent between $1 now

Quasi-Hyperbolic Discounting Model

where β < 1. All future periods are discounted by a common factor

Quasi-Hyperbolic Discounting Model

The model is almost as simple as exponential discounting but there

Quasi-Hyperbolic Discounting Model

The authors take two extreme assumptions for analyzing this

Example: Problem Set

We now consider a student’s choice of when to do a problem set.

Example: Problem Set

Figure: Costs from t = 0 perspective.

Example: Problem Set

Figure: Preferences at different time periods.

Example: Problem Set

Figure: Preferences at different time periods.

However, at t = 1 the student’s preferences have changed! It is now

Example: Problem Set

Figure: Preferences at different time periods.

Example: Problem Set

In t = 2, the option is to do it now and incur a cost of 5 or do it in t = 4

Exponential discounting is the only functional form of discounting

More hyperbolic discounting.

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