Behavioral Economics Part 2

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Behavioral Economics Part 2

Dr. Vinci Chow

Department of Economics The Chinese University of Hong Kong

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Do You Save?

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What Percentage of Retired Individuals Feel They are Not Saving Enough?

Source: Schroders Global Investor Study 2017

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Question

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Suppose I am going to give you $100 at this moment

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Suppose I can instead give you money after two weeks. How much money would it takes for you to not take this $100 now?

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What is the effective interest rate of your choice?

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Discounting

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We got an median of ____

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That works out as δ = ____ using two weeks as the time period

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If the standard model is true, the median

individual should be indifferent between $100 now and $100/ ___²⁶ = ________ in one year

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Real World Example:

Scheme $6000

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A one-time stimulus measure announced in the 2011-2012 Budget

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$6,000 cash transfer for every permanent resident of Hong Kong

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A choice of receiving an additional $200 by delaying the application for ~6 months

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What is the effective interest rate?

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How many of you chose to wait?

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• Short term—usually 2 weeks or less

• Intended to be paid back at payday, thus the name

• Very high effective interest rate

 e.g. 10% interest for a two-week loan

 Effectively (1.1²⁶ – 1) = 1001%

 Could go up to 7000% in reality

Real World Example

Payday Loan

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Impatience

Maybe people are just very impatient, and what’s wrong with that after all?

“It makes entire abstraction of every other human passion or motive; except those which may be regarded as perpetually antagonizing principles to the desire of wealth, namely, aversion to labor, and desire of the present enjoyment of costly indulgences.”

John Stuart Mill

Essays on Some Unsettled Questions of Political Economy

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Impatience

Maybe people are just very impatient, and what’s wrong with that after all?

“The Premium on the Exchange between present and future goods is based on a subjective element, namely the marginal preference for present over future goods.

This preference has been called time preference, or human impatience.”

Irving Fisher Theory of Interest

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Impatience

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Another thought experiment

• $100 in ten years, and $120 in ten years and two weeks

• Which one would you choose?

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People are not just impatient; they are

particularly impatient when you ask them to wait now

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This behavior is called present-biased

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Time Preference Modeling

Standard economics assumes that a decision maker discounts future by a constant fraction each time period—𝛿𝛿, which is called the

discount factor

Overall utility = utility in t=1

+ δ × utility in t=2

+ δ² × utility in t=3 + …

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Estimates of δ

Source: Frederick, Loewenstein and O’Donoghue. 2002. “Time Discounting and Time Reference: A Critical Review.” Journal of Economic Literature.

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Implied Discount Rate from Experiment

Source: Frederick, Loewenstein and O’Donoghue. 2002. “Time Discounting and Time Reference: A Critical Review.” Journal of Economic Literature.

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Evidence from Neuroscience

• Magnetic Resonance Imaging (MRI) scan while subjects choose between two rewards with different delays

• MRI measures blood flow in various part of the brain, which proxy for brain activity

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Evidence from Neuroscience

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Several regions in the brain are especially active when the reward is immediate

Source: McClure,

Loewenstein and Laibson.

2004. “Separate Neural Systems Value Immediate and Delayed Monetary Rewards.” Science.

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Evidence from Neuroscience

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Other regions are active regardless of the delay in reward

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Evidence from Neuroscience

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Decision seems to depend on the relative activity levels of the two groups of areas.

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Alternative Theories

• Suppose your friend tells you earlier that she does not want to eat ice-cream, but now when she is in front of some ice-cream, she eats it

• One explanation is she is present- biased: eating ice-cream is

unhealthy, but this mostly affect the future, while the enjoyment of eating ice-cream is immediate

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Alternative Theories

• It is also possible that she is tempted by the presence of the ice-cream and knowingly

choose to eat the ice-cream.

This is modeled as temptation utility

• Finally, maybe she is not even thinking rationally. The

presence of ice-cream causes her to enter a “hot” state, in which she acts by instinct. This is called Cue Theory or Two- Self Model

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Does Commitment Really Help?

• Employees at Philips Electronics

• Test group subjects can choose to increase their savings by 1-3%

automatically each year.

Increase will stop once savings rate reach 10%

• Among those who choose to join the program,

savings went up by ~1.5%

Source: Thaler, Richard H. and Shlomo Benartzi. 2004. “Save more Tomorrow: using Behavioral Economics to Increase Employee Saving.”

Journal of Political Economy.