Chapter 1

Intertemporal choices

Summary

In this chapter the importance of intertemporal choices in everyday life is underlined and the necessity for rational choice theory for modeling them appropriately is emphasized. Then the standard economic model and its anomalies are sketched, followed by a short review of responses to these empirical challenges. The research questions and a short overview of theoretical concepts used throughout this book conclude this chapter. 2 Chapter 1

1. Introduction: Intertemporal choices

Do you prefer to receive $1000 now or $1200 in a year? Does your preference hold when the amount of money is substantively enlarged or reduced? Does preference change when the choice is between two consumer goods of corresponding value? Does it matter for your decision whether you yourself receive both goods or a friend gets both? Does it matter whether receipt of both alternatives is delayed the same amount of time? Why do some people invest in education or save substantial amounts of money while others do not and become drug addicts? Why are these questions important for social scientists?

Except for the last one, these questions are central to decision theory in so far as it is devoted to intertemporal choice. Though already in the early 19th century similar questions as the ones posed above received scientific attention, until recently the three disciplines sociology, economics, and psychology approached these problems from quite different perspectives. If sociologists have realized the importance of this topic at all it is usually assumed, following Parsons (1937), that weighting of future costs and benefits is learned via socialization. By contrast, economics has - beginning in the 19th century with the investigation why there are positive interest rates (Rae 1834) - given more attention this question. In the beginning of this century, economic research on intertemporal choice culminated in Fishers (1930) theory of interest and in Samuelsons (1937) Discounted Utility model (in the following DU- model) described in detail in section 1.3 below. Psychology, as the third social science interested in intertemporal choices, has headed by Mischel's work on delay of gratification in the 1960's explored intertemporal choice in more detail.1 Recently, interest in the behavioral mechanisms underlying intertemporal choices has increased in all three disciplines and there has been some convergence - at least for economics and psychology - in approaches towards these phenomena. In the following, how people balance current and future outcomes will be investigated by using arguments from all three disciplines.

1.1. The practical importance of intertemporal choices

Decisions occur frequently, where costs and benefits spread over different time points have to be compared, e.g., in the choice between spending time for leisure vs. studying, whether or not to engage in healthy behavior, whether to have children now or later, or selecting appropriate health insurance and pension plans. Given the abundance and importance of intertemporal choices, neglect of future consequences potentially has profound impact on a variety of settings. Examples include investments in human capital and social resources such as networks or cultural resources, household relations; refusing to make relation- specific investments such as children, professional relations; jeopardizing the long term gains from a relation by shirking, or health; smoking or behave in otherwise unhealthy ways. Furthermore, stable individual differences in such investments may cumulate across domains and over time: people who continuously (relatively) neglect the future reach lower levels of wealth and a relatively worse health state.2

1 Loewenstein (1992) provides a historical overview and an elaboration how economical and psychological research on intertemporal choice related to each other. 2 As to evidence concerning the stability of such individual differences across settings Mischel (1968) concluded that though situational factors are more important in determining whether people are short-term Intertemporal choices 3

Not only are intertemporal preferences potentially important in a variety of settings but there is also evidence for individual differences in the willingness to delay gratification, as well as for long-term effects of such differences. In a financial setting, Gately (1980) investigated consumer purchases, for example of air conditioners, where people had to make intertemporal trade-offs between the immediate purchase prices of a good and it’s long run energy costs. Discount rates for the long run energy costs were extremely high (up to 300% per year) and varied by 200% between individuals. Lawrence (1991) derives discount rates from expenses for consumption and reports differences in discount rates between races. As to consequences of differences in patience, Donkers and Van Soest (1997), using a nation-wide sample of Dutch households, demonstrated that, after controlling for income and family size, people more willing to wait for hypothetical rewards are more likely to own houses than less patient people. For educational achievements, Mischel, Shoda and Rodriguez (1992) report that children at age four, who were better able to delay gratification than their pre-school comrades, did significantly better at school more than a decade later. Moreover, these children turned out to be rated higher by their parents on such different abilities as social responsibility, achievement striving, verbal abilities, coping with stress and frustration, and intelligence.3 With respect to household behavior, impatient couples report more problems within and shorter duration of their relation (Snijders & Weesie 1998). Wunderink (1995) suggests effects of impatience on desired timing of births. As to deviant behavior, Hirschi and Gottfredson (1994) report correlations between several otherwise unrelated forms of deviant behavior such as car accidents, criminal behavior and drug abuse, and attribute this finding to a lack of self-control, which includes the ability to delay gratification. In addition, there exists a vast stream of research on intertemporal choices and addiction (Becker & Murphy 1988, Braun & Vanini 1998, Orphanides & Zervos 1998) or organizational behavior (Lindenberg 1995, O'Donoghue and Rabin 1999). Finally, differences in discount rates have been offered by Benartzi and Thaler (1995) as an explanation for the observation that people are much more willing to invest in bonds instead of stocks despite the latter offering much higher return in the long run (the 'equity premium puzzle'). They argued that when investing in stocks people sometimes experience (then) immediate losses. A strong focus on immediate outcomes in combination with loss aversion ('myopic loss aversion') thus might cause a preference for bonds. This reasoning was experimentally confirmed by Gneezy and Potters (1997). In the context of this research a study on consequences of impatience has been carried out. There, 165 students stated their concern about future consequences of their actions on a scale consisting of 12 items. Subjects relatively neglecting future consequences consumed more alcohol, more drugs, and were less likely to engage in sporting activities. In addition, these subjects did worse in a variety of topics related to education. For example, lower scores on the scale indicating less concern for future outcomes raised the probability of partying before exams, led to worse preparation of exams, reduced homework at high

or long-term oriented there are stable intraindividual differences. That is, subjects being more impatient than other in one situation are more likely to be more impatient in other situations. 3 Mischel et al. suggest (1992: 158), ‘that an early family environment in which self-imposed delay is encouraged and modeled also may nurture other types of behavior that facilitate the acquisition of social and cognitive skills’. Hence, more patient people should also be less aggressive and should engage in risky behavior less often. This view is consistent with the reasoning presented in this text and with results presented by Hirschi and Gottfredson (1994).

4 Chapter 1 school, and reduced the likelihood of following topics not required in a study. A more detailed account of the study and its results is provided in Chapter 5.

1.2. The importance of intertemporal choices for rational choice theory

Besides the relevance of intertemporal choices for several otherwise unrelated streams of research, it is also important to study intertemporal choices for theoretical reasons. Rational choice theory has always been dominant in economics, but has recently also become prominent in sociology and political science.4 But despite its sophisticated theoretical elaborations, political scientists Green and Shapiro (1994: 6) criticize empirical applications of rational choice theory in political sciences as ‘either failed’ or ‘banal: they do little more than restating existing knowledge in rational choice terminology.’ Further ‘rational choice hypotheses are too often formulated in ways that are inherently resistant to genuine empirical testing' (Green & Shapiro 1994: 9). According to these authors, this is due to models that are too abstract. These models generally either lack statements about the relevant behavioral constraints in a situation or they model these constraints wrongly. Blossfeld (1996) provides a related critique from sociologists and Herrnstein (1990) is one of the numerous examples for a similar critique from psychologists. Even within economics recently there has been some concern with the strong concept of rationality as employed by mainstream economists, resulting in a growing interest to incorporate findings from psychology and behavior decision making (e.g., Hogarth & Reder 1987; Rabin 1998). Two reactions to such a critique are possible: First, abolish the approach (suggested by Herrnstein 1990), and second, extend simple (in terms of abstractness of the underlying assumptions) microeconomic theory by stepwise adding more complex assumptions about preferences, goals and cognitive imperfections. Not surprisingly, proponents of rational choice theory have chosen the second possibility. Examples include Lindenberg (1992) with his ‘method of decreasing abstraction’ for sociology, and Rabin (1998) or Laibson and Zeckhauser (1998) for economics. The economic theory of households and the family provides a nice example of this strategy and will therefore be briefly reviewed. The economic theory of households was developed in the 1970s (see Becker 1981, 1991 for an overview of method and theoretical insights) and allows for a consistent explanation of many of the associated phenomena by means of standard economic theory with more complex constraints and goals. In these models households allocate their resources (money and time) to maximize a household utility function given their constraints. This analysis was extended by game-theoretical modeling of household behavior (Manser & Brown 1980; McElroy & Horney 1981; Ott 1992). Here the joint household utility function is the result of a bargaining process of household members having different interests. Frey and Eichenberger (1996) introduced some complexities at the individual level (taken from findings in experimental economics and behavioral decision theory) in order to explain some puzzles in the household formation process. They argue that judgement biases in the assessment of probabilities are responsible for

4 Hechter and Kanazawa (1997) provide an overview of recent successfully empirical applications of rational choice theory to sociology. Intertemporal choices 5 the underestimation of the probabilities of divorce and endowment effects5 result in too little search for and a biased evaluation of potentially better marriage partners. This present research aims at adding new constraints for intertemporal decision making. This is necessary for two reasons. First, given the evidence in section 1.4 below, in many situations current constraints are a poor description of reality and may lead to false predictions. Second, standard economic models by definition exclude many problems from study. Institutions, for example, serve as major means to overcome individual deviations from long-term rationality (e.g., Frey & Eichenberger 1996), an aspect of institutions usually neglected by economic theory. Lindenberg (1992) argued that often informal institutions (norms) guide behavior towards long-term goals while operating on the basis of short-term costs or benefits, such as social approval or disapproval. In addition, many individuals undertake action to limit their own possibilities for myopic behavior (Schelling 1992), for example. Standard economic theory has problems to explain these phenomena and has not given much attention to them (see Elster 1979, Schelling 1984, Lindenberg 1995). Assuming ‘rationality’ and the elimination of so-called ‘irrational’ behavior by the market, rules out all questions as to how and how efficient institutions and individuals promote rational (intertemporal) behavior. Consequently, Lindenberg (1998) explicitly stressed the necessity to develop an adequate theory of intertemporal choices: ‘At the present time, it looks like the most relevant foundation (for micro-sociology – AG) is research on short-term/long-term tendencies in decision making.’ Fortunately, in the last decades there has been an increasing interest in the positive validity of economic and decision-theoretic postulates. Anomalies6 to the axioms of subjective expected utility theory were found already in the 1950’s (Allais 1953) and several competing descriptive theories were developed (Kahneman and Tversky 1979, Luce and Fishburn 1991, Tversky and Kahneman 1992). Anomalies to other areas of standard economic theory received widespread attention in the last two decades, too. Experimental economics and behavioral decision making, both focussing on individual choice behavior, have become major streams in economics with their own journals (‘Journal of Experimental Economics, ‘Journal of Behavioral Decision Making’, ‘Journal of Risk and Uncertainty’) or regular sections on anomalous behavior (e.g., Thaler’s ‘Anomalies’ in the respected ‘Journal of Economic Perspectives’). Recently, also anomalies to the DU-model received considerable attention (e.g., Loewenstein & Elster 1992; special edition of the ‘Journal of Behavioral Decision Making [2000] on ‘Time and Decision’). Reviewing some of the anomalies Loewenstein and Prelec (1992: 574) conclude that the empirical evidence ‘present(s) a challenge to normative theory that is as least as serious as that posed by the more familiar EU (expected utility – A.G.) anomalies ... unlike the EU violations .... the counterexamples to DU are simple, robust and bear directly on central aspects of economic behavior.’

5 The endowment effect states that persons demand a higher selling price for objects which they already own than they are willing to pay in order to acquire the same object (in case of non-possession). This discrepancy grows with endowment time (Thaler 1980). 6 Anomalies, of course, are defined only against the axioms of standard economic theory. If a decision maker accepts these axioms as reasonable action principles, he should act in a certain way qualified as ‘rational’ – he may well behave differently, in case he does not feel that these axioms describe his preferences correctly. Economists usually regard these axioms as reasonable action principles for all people. Behavior departing from models based on these axioms then is called anomalous.

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Still there exist different viewpoints about how damaging these anomalies are to economic theory. Becker (1996: 22), for example states that ‘cognitive imperfections are sometimes important, but in recent years they may have received excessive attention at the expense of significant models of rational choice’. On the other hand, psychologists such as Herrnstein (1990: 356) concluded ‘rational choice theory.... accounts only poorly for actual behavior’ and should thus be abolished as a descriptive theory. In this dissertation, a mixed position is taken. Rational choice theory is seen as a useful means to analyze behavior but some assumptions will be investigated more closely and when being descriptively wrong they should be replaced with findings from behavioral decision theory (see Hogarth & Einhorn 1986; Rabin 1998, or Laibson & Zeckhauser 1998 for similar positions). By doing so, two main shortcomings of the many competing descriptive models in intertemporal choice presented in section 1.5 below can be avoided. The first shortcoming of these models is their limited range of application. For example, the prominent hyperbolic discounting model, accounting for procrastination of unpleasant tasks, is, despite of recent incorporation into axiomatic systems (Loewenstein & Prelec 1992; Ahlbrecht & Weber 1995), generally not related to other phenomena in intertemporal choice not to speak of phenomena outside of intertemporal choice. It would be more satisfying, however, if this hyperbolic discounting model could be related to other parts of economic and behavioral decision theory, e.g., S-shaped probability weighting functions or S-shaped utility functions. Second, competing descriptive models often use explanations unrelated to other economic assumptions. Akerlof (1991), for example, when investigating procrastination introduces the psychological term ‘salience’. While there is no general problem with explaining the delay of unpleasant tasks with changes in the salience of current and future costs and benefits, allowing for changing salience seems to be incompatible with the common assumption of stable preferences. The remainder of this chapter is structured as follows. First, the DU-model and predictions resulting from it will be shortly presented. Despite its descriptive shortcomings, the DU-model serves as a cornerstone against which competing models are tested. Second, existing anomalies to this model will be reviewed, and thirdly, current attempts to explain these anomalies and their shortcomings are analyzed. Finally, the central questions of this dissertation and general theoretical considerations will be presented.

1.3. The Discounted-Utility model

While philosophers, e.g. Rawls (1971), have frequently stated that future utility should not be discounted at all, economic theory assumes that people have a time preference (e.g., Olson and Bailey 1981). That is, they have a preference with respect to when outcomes should be received. Generally it is assumed that time preference is positive, i.e., people prefer to receive positive outcomes, such as monetary amounts, as soon as possible. Negative outcomes should accordingly be delayed as much as possible.7 The degree of time preference is expressed by a discount rate, describing the percentage of increase or decrease that is necessary to make a person indifferent between immediate and future rewards or

7 There exist different justifications for this proposition. Sometimes it is seen as a general psychological mechanism sometimes as a rational reaction upon the uncertainties of life and sometimes it is a theorem derived from more elementary propositions (e.g., Koopmans 1960, Fishburn and Rubinstein 1982). Intertemporal choices 7 losses.8 This concept was introduced by Fisher (1930) and further developed by Samuelson (1937). Later, axiomatic formulations have been developed, presented in some detail in Chapter 6, by, e.g., Koopmans (1960), Lancaster (1963), and, more recently, Fishburn and Rubinstein (1982). According to the DU-model introduced by Samuelson (1937), a decision maker should prefer a temporal sequence of consumption levels (c0, ...... , cT) to another sequence (c’0, ...... , c’T) iff: T T δ t δ t ∑ u(ct) > ∑ u(c’t), (1) t=0 t=0 with u being a utility function and δ being the constant 9discount factor per time period 10 t. ct and c't are sequences of consumption levels beginning at t = 0 and ending at t = T.

There is some disagreement about the relation between the discount factor δ and the market interest rate r. While in principle every δ is consistent with the model, Loewenstein and Thaler (1989: 182) state that due to the existence of capital markets, ‘consumers should make intertemporal trade-offs so that their marginal rate of time preference equals the interest rate’ for money. They argue that if time preference was higher than r, consumers could borrow to satisfy their preferences more adequately. Otherwise, consumers would be better of by saving. Consequently, time preference should also be equal for all goods and situations. Olson and Bailey (1981) conclude that in equilibrium 0 < δ < r, because capital can also be used for production and not just for consumption. An initial stock of capital x yields thus in a future period x plus the gains from productivity. The interest rate r has to account for this gain in productivity as well as for time preference δ. Hence, r will be larger than δ. Nevertheless, also Olson and Baily (1981: 9) state that: ‘The marginal rate of substitution between future and present consumption in long-run equilibrium will of course always equal the rate of interest’ for reasons elaborated by Loewenstein and Thaler. Lea et al. (1982) argue that discount rates should also depend on expectations about the future state of the economy, as well as on the expected future utility level of the decision maker. In this line of reasoning discount rates only have to respond to market interest rates. Practically, all these positions result in the prediction that discount rates at least for a larger sample of subjects should be closely related to the market interest rate. This prediction also underlies the familiar ‘present value’ concept and it is frequently used in economic modeling. For example, when modeling investments in

8 Discount rates may reflect other things than time preference. Suppose a person prefers $100 now over $110 in one year. He thus reveals a discount rate of more than 10% per year. This discount rate reflects his time preference, the market interest rate, the utility difference between the outcomes ($110 may provide the same utility as $100), uncertainty with respect to actually obtaining the outcome and the utility derived from the $110 in one year, and rational considerations (he may have an investment opportunity which in his perception yields more than 10% per year). 9 Constancy of the discount factor is not a requirement of the model but an additional assumption standardly made on normative grounds to prevent time-inconsistent behavior. If the discount factor varies over time an individual could depart from his or her initial long-term consumption plans without changes in prices, income, or information (see section 1.4.3 for evidence and discussion). Likewise δ usually is taken to be bounded by 0 and 1. 10 This actually describes sequences of outcomes. However, it follows from the additively separable form of this formula that sequences are simple aggregations of the single outcomes to which the axioms of Fishburn and Rubinstein apply.

8 Chapter 1 human capital, it is assumed that individuals take into account and discount returns on investment. The same holds for losses due to dropping out of the labor force. This discounting should equal the market interest rate (Mincer & Ofek 1982, Becker 1991 [1981]: 26). However, in the following section we will see that not only this strong implication, but also virtually every other prediction of the models as well as its axioms have been challenged empirically. The anomalies11 listed below were observed either in experiments using actual or hypothetical monetary payoffs or in field studies. The general pattern of the anomalies remained the same no matter which method has been chosen. The following anomalies have been demonstrated.

1.4. Anomalies 1.4.1. Negative discount rates

Perhaps the most striking anomaly, given a positive market interest rate, the impatience axiom and given that ‘the case for positive time preference is absolutely compelling... both in the positive and normative senses’ (Olson and Bailey 1981: 1), is that sometimes people exhibit negative discount rates. That is, people prefer to delay positive outcomes or to receive negative outcomes as soon as possible. This even has been observed for decisions dealing with monetary outcomes. In discussing negative discount rates, two distinctions are useful: sequences versus single-events and monetary/non-monetary decisions. Negative discount rates have been observed in three of these four domains. a) Sequences of monetary decisions

Loewenstein and Thaler (1989) and Lindenberg (1993) reported instances where people prefer to get their annual income paid in twelve monthly installments instead of receiving the same yearly income within nine months (with a higher payment per month in the latter case). Obviously, these people would have been better off financially, if they had chosen the latter mode of payment and had put the difference of the monthly payments in the bank. Further, Loewenstein and Sicherman (1991) reported that people have a ‘taste' for increasing wage profiles. In their experiment, subjects were given the choice between equal life earnings that could be received in either increasing or decreasing monthly payments. Most subjects preferred the increasing sequence and - although the percentage declined somewhat - most subjects still did so even after having been made familiar with the economic reasoning that, given a positive interest rate, present value maximization would imply preference for an (otherwise equal) decreasing wage profile over an increasing one. Related to this phenomenon is Frank’s (1992) observation that wages rise also in professions in which virtually no changes in productivity can be reasonably assumed, e.g. for bus drivers and airplane pilots. This rising profile can also only insufficiently be explained by the deterrence of employee shirking, because it occurs independently of the costs associated with shirking. Frank argues that employers, by offering jobs with rising wage profiles, react to preferences of potential employees.

11 Again, note that these findings only constitute anomalies only insofar as one is willing to subscribe to the axioms above. Intertemporal choices 9 b) Sequences of non-monetary decisions

According to Loewenstein and Prelec (1991: 349) ‘negative time preference is applied selectively, to those events that are seen as a part of a meaningful sequence, having a well- defined starting and ending point.' The consumption level of the end point of such a sequence exceeds the level of the starting point due to a wish of improvement. In an experiment, subjects expressed preference of a French dinner to a Greek dinner and also to get the former as soon as possible. Nevertheless they chose to receive the French dinner after the Greek dinner, if the interval between these two is short enough (one week) to make it appear as a sequence of events (Loewenstein and Prelec 1991, 1993). However, preference reversed as the interval between the two events was prolonged (half a year) such that both dinners were no longer perceived as a sequence. The explanation of a wish for improving sequences also applies to the Loewenstein and Sicherman observation. In addition, in a series of experiments Kahneman and his co-workers demonstrated that this wish for improving sequences possibly results in preference for sequences including more pain over sequences including less pain (Kahneman & Varey 1992, Kahneman, Wakker & Sarin 1997)). For example, people being exposed to the unpleasant experience of putting a hand in cold water for a short period of time rated this experience as more harmful than people putting their hand in cold water for the same amount of time plus a short period where the water was slightly warmed. Note, that the period where the water was slightly warmed still created an unpleasant experience for the subjects but led to an improvement (less pain). This improvement outweighed the additional length of exposure to unpleasant experience. Hence, preference for improving sequences appears to be fairly general.12 c) Single decisions for non-monetary events

Loewenstein (1987) reports experiments where subjects were willing to delay favorable events such as ‘a kiss from your favorite movie star' a certain time. On the other hand, subjects preferred to be exposed to an unpleasant event (‘a non-lethal electric shock of a hundred and ten volt') immediately, instead of delaying it as long as possible. Loewenstein argued that the delay of positive events is due to ‘savouring’ while getting over with things quickly is caused by ‘dread’. Displaying negative time preference then actually maximizes utility over the whole sequence. In this dissertation not much attention will be given to negative discount rates. The major focus will be on single events, for which negative discount rates seem to be somewhat exceptional. Note, that according to Loewenstein’s models, procrastination (delay of unpleasant experiences) should occur when people do not ‘dread’ this experience. That is, appointments at the dentist are kept when people are afraid of the treatment and cancelled and delayed otherwise. This counterintuitive result might be explained by the fact that subjects in the Loewenstein experiment stated that they would like to be exposed to negative events soon but not now. When actually facing the negative event they might, however, want to delay it further. Here further research might be needed.

12 Chapman (1996) demonstrated that this does not hold for sequences of health outcomes. In a series of experiments subjects preferred to be healthy when they are young, i.e., sooner as predicted by the DU- model, and delay sickness until old age. Chapman attributes this result to norms as well as subjects expectations: people usually are and expect to be healthy when they are young.

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1.4.2. Extraordinary high discount rates

As stated above, revealed discount rates should approach, and in a perfect market even equalize the market interest rate. Discount rates much higher than the usual market interest rates thus challenge this model13. Unfortunately for the DU model such behavior exists. Holocomb and Nelson (1992) report an experiment with actual payments ranging from to ‘high' (17 $) to ‘low' (5 $). Subjects chose between immediate and delayed payments with an offered interest rate of either 1.5 or 3 percent per day. Preferring the delayed payoff, including interest, thus reveals a personal discount rate below the offered interest rate and vice versa. In spite of the extraordinarily high offered interest rates, the largest percentage choosing the delayed payment (tomorrow instead of today) was 54 percent (for the 17$ and the 3% interest rate). For all other combinations only a minority chose the delayed payoff, the lowest value being 18% for 1.5% interest rate of 5$. In other words, a majority (82%!) revealed discount rates above 1.5% per day and 46% revealed a rate higher than 3% per day. Somewhat surprisingly, Holocomb and Nelson concluded that ‘this was not a startling result'. The Holocomb and Nelson experiments replicated the results of Benzion et al. (1989) and Thaler (1981). Thaler (in a less careful study) detected even higher discount rates for hypothetical choices. Also in field settings higher discount rates than implied by the market interest rate occurred. Hausman (1979) reports an estimated average consumer discount rate of 25% derived from actual purchases of air conditioners. Discount rates were calculated by taking into account buying prices and delayed savings on the energy use of the conditioners. Gately (1980) reports even more extreme results. Since myopic behavior occurs frequently and poses a strong challenge to normative concepts of rationality, in this dissertation I will look more closely at when it is likely.

1.4.3. Discount rates vary over time

This is maybe the best-documented and the most well-known anomaly concerning choice over time. According to the DU-model, to be called rational the discount rate should be independent of the time delay and thus result in an exponential discount function. Instead, data from experiments with both animals and humans shows that the discount rate varies with time delay (e.g., Ainslie 1992, Kirby 1995). Stevenson (1986, 1993) demonstrated that payoffs, as predicted by the economic models, are discounted at a ratio-rate. That is, delayed outcomes are devalued by a percentage of the amount and not by a constant premium for delay. However, usually, contrary to the DU-model, payoffs closer to the present are discounted at a much higher rate than those in the distant future. One important (and quite unpleasant) property of such behavior is that it gives rise to a so- called ‘dynamic inconsistency’ (Strotz 1956) or ‘preference reversal' (Ainslie 1975)14. Suppose, an individual compares two future payoffs, one smaller and sooner, the other

13 Throughout the text ‘high’ or ‘extremely high’ discount rates refers to discount rates much higher than the market interest rate. 14 The Ainslie term might appear strange, because ‘preference reversal’ usually describes varying buying and selling price for bets and lotteries (e.g., in Lichtenstein and Slovic 1973). When comparing two gambles of equal expected value, subjects bid more for the gamble with the higher winning probability, but charge a higher selling price for the gamble offering the larger amount. Thus, in the following time-varying discount rates will be described by hyperbolic discounting, common difference effect or dynamic inconsistency. Intertemporal choices 11 one larger but later. If he initially prefers the latter, he might well prefer the sooner payoff as both payoffs approach the present. This behavior implies a tendency to deviate from one's own (well-understood) long-term interests and might thus be exploited (see Strotz for further elaboration). The rates may well decline over time when the individual has no possibility to reverse his initial choice, i.e., if his initial decision is binding. Related to this overweighing of immediate rewards is the phenomenon of procrastination (Akerlof 1991, O’Donoghue & Rabin 1999). Because of the ‘undue salience' of present costs relative to future costs, a series of decisions - each resulting in not undertaking an unpleasant task now, but to delay it by one time unit - might lead to disastrous consequences in the long run without being fully anticipated at the moment of each decision. For the relevance of this ‘myopic' behavior for a classical topic of sociology (organizational sociology) see also Lindenberg (1993, 1995). In this book we will have a closer look when discount rates vary more or less strongly.

1.4.4. Magnitude and sign effects

There is convincing evidence that people discount small payoffs much more strongly than large payoffs - independent of the payoff sign (Thaler 1980, Benzion et al. 1989). This partly explains the high discount rates obtained by Holocomb and Nelson (1989). In addition, this implies that discount rates derived from experiments with actual payoffs using small amounts overestimates time preference. Further, the discount rate for gains and losses is different. Because losses loom larger than gains (Kahneman &Tversky 1979, Tversky & Kahneman 1991), they are discounted less strongly (Thaler 1981, Loewenstein 1988, Benzion et al. 1989).15 Since the gain-loss asymmetry is strongest for small outcomes, it can not be due to decreasing marginal utility, since for small outcomes the utility function is (almost) linear. For larger outcomes, observed discount rates might be higher than the pure rate of time preference, because the difference in utility between an immediate small and a delayed larger reward is smaller than the numerical difference between the two. Hence, time preference might differ from observed discount rates but this difference should be wider for large outcomes and should even disappear for very small outcomes, when the utility function is almost linear (Loewenstein & Prelec 1992). Note, that magnitude and sign effects do not necessarily constitute ‘anomalies’ to the DU-model or other normative models, since these model refer only to utility. Individuals are free to derive whatever utility they want from varying amounts. Because the magnitude effect in intertemporal choice is satisfactorily explained with an appropriate utility function (e.g., Loewenstein & Prelec 1992) it will not be further investigated in this book. The same holds for the gain/loss asymmetry. However, different value functions for gains and losses will be assumed in several of the following chapters. In addition, it will be investigated whether magnitude and sign effects can be generalized to other preference domains.

15 Shelley (1993) argued that the gain/loss asymmetry results from an interaction of outcome sign and time frame. Differing discount rates are observed when subjects have to delay either gains or losses which are otherwise due immediately. Subjects thus give up something now for the later, and thus discounted, receipt. In a ‘neutral’ question format, not involving delays, the gain/loss asymmetry disappeared in Shelley (1993) as well as in Ahlbrecht and Weber (1997).

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1.4.5. Different discount rates for different objects

According to economics, people maximize utility given their constraints, such as time and money. Different goods as well as different forms of money, e.g., lottery wins, income, bonuses, inheritances, are aggregated into final states of wealth. They are ‘fungible’. Consequently, the proportion of money spent immediately for consumption and money saved should be identical for a rise in income or a lottery win of equal value. However, Thaler (1990) and Shefrin and Thaler (1992) report that different forms of money had different marginal propensities to consume. A rise in income is much more likely to be spent for consumption than a rise in the savings for retirement. Akers et al. (1994) found that unanticipated money, ‘windfall gains’ was more likely to be spent immediately than money that was anticipated. The speed with which money is converted into consumption can be interpreted as being determined by discounting, thus resulting in different discount rates for equal amounts of fungible goods. Chapman (1996) found that discount rates for health, money and vacation trips differed even when controlling for utility. Empirical results on impulse buying (unplanned purchases which are regretted afterwards) also show differences in the likelihood of different goods to be purchased impulsively (Bellenger 1978, Dittmar et al. 1995). To sum up, there is ample evidence that discount rates differ between commodities of equal value. Despite the examples above, this anomaly has been relatively neglected in research on intertemporal choice. Therefore in this dissertation it will be investigated which goods are most likely to be discounted strongly.

1.4.6. Different discount rates due to framing effects

In the DU-model only absolute time differences matter for the evaluation of outcomes. Therefore, jointly shifting the receipt of two different outcomes available at two different time points should not alter preference between them. As seen above, this runs counter to empirical evidence. The DU-model also implies that speeding up the receipt of an outcome and delaying its receipt by the same amount of time have a numerically identical effect on the evaluation of this outcome. Suppose a decision maker has a discount rate of 5% per year. Then, speeding up-the receipt of a good by one year results in a 5% higher value, delay of one year to 5% devaluation. However, postulating different value functions for outcomes that are framed as gains and losses (Kahneman & Tversky 1979, Tversky & Kahneman 1991) leads to a different prediction. When benefits are delayed subjects give up (lose) something now in order to gain it later, they compare an immediate loss to a future gain. This gain is discounted. In a speed-up situation, they gain something now and suffer from a later discounted loss. In the delay case, they require compensation whereas in the speed-up case they are willing to pay a premium. Loewenstein (1988) demonstrated that, due to different value functions for gains and losses, subjects charge more to delay video recorders, restaurant dinners, or money receipts than they are willing to pay for accelerating their receipt (‘delay-speedup asymmetry’). This finding has been replicated in studies by Shelley (1993) and Shelley and Omer (1996).

1.5. How to deal with these existing anomalies?

The following overview summarizes several attempts to explain these empirical results and focuses on current streams of research. It contains the following sections: a) questions concerning the relevance of experimental research for actual behavior, Intertemporal choices 13 b) integration of the anomalies into neoclassical economic theory, c) relaxing assumptions of neoclassical economic theory in order to build competing models explaining certain anomalies, d) analogies to peculiarities to human choice under risk.

1.5.1 Denying the relevance of experimental results for actual behavior

Economists have up to now followed two strategies in order to generally reject the importance of findings demonstrating the existence of 'anomalies'. First, it has been argued that economics only deals with rational, i.e., consistent and utility maximizing, behavior - the above listed examples are thus excluded by definition. However, now there have been various attempts to demonstrate that even love, addiction, etc. though appearingly irrational can be well handled within economic approaches (for example in Becker’s work over the past decades) and hence, rational choice theory is of use for sociologists and political scientists, usually interested in appearingly 'irrational' behavior, as well. But if the economic approach is used as the leading paradigm, its anomalies and limitations are of central importance for a variety of disciplines. Second, anomalies may be taken seriously at the individual level, therefore being a very interesting topic for psychologists, but irrelevant on an aggregate level, thus being of no importance for economists. According to Frey and Eichenberger (1989a, 1989b) it might be claimed that: - anomalies at the individual level are irrelevant, if one assumes that deviations from the economic model follow a random distribution; - anomalies are only observed in experiments and, due to this ‘unnatural’ setting, have nothing to do with actual, i.e. real world, decisions; - the observed anomalies are due to insufficient incentives for serious behavior; - anomalies may exist, but in reality people learn from and thus avoid errors; - anomalies are eliminated by competitive markets - irrational actors score less well and thus disappear in the long run. As to the first argument – budget constraints drive out randomly distributed deviations from rationality at an aggregate level (Becker 1976 [1962]) - it can be stated that the above mentioned anomalies are far from being random. Instead, they reveal systematic behavioral tendencies, so this argument does not apply here. The same holds for the argument that the anomalies are caused by insufficient incentives for rational behavior. High incentives tend to reduce careless errors, but in general subjects behave similarly in case of high incentives. Camerer (1995) reviews evidence on this matter observed in a variety of contexts such as ultimatum games, experimental auctions or choice under risk and uncertainty and concludes that though it is likely that there are situations where incentives affect results, such effects seem to be the exception rather than the rule. Perhaps the strongest evidence against a general disappearance of anomalous effects in decision making when payments are involved comes from a study done by Kachelmeier and Shehata (1992) who investigated behavior under risk with Chinese subjects (Masters students with a background in economics). Although these subjects in some experiments could earn three times their monthly income, similar departures from neoclassical economic theory as in previous experiments occurred (Beattie & Loomes 1997 reach similar conclusions on the general effect of payments on choices under risk).

14 Chapter 1

Further, these anomalies are not restricted to experiments but were also found in ‘real life situations' (e.g., Lichtenstein & Slovic 1973, Hausman 1979), in situations where people are given the possibility to learn (e.g., Herrnstein, Loewenstein, Prelec & Vaugham 1991, Herrnstein & Prelec 1992) or in situations where experts (with sufficient possibilities to learn) make decisions (again Lichtenstein & Slovic 1973). Thaler (1987b, 1987c) and De Bondt and Thaler (1985, 1987, 1990) even report cases of anomalies in financial markets - where one can quite safely assume expert actors, high incentives, and almost perfect competition. Anomalous behavior seems to do quite well under certain conditions even in highly competitive markets. Summarizing the above arguments Frey and Eichenberger (1987: 15) conclude: ‘serious theoretical reasons and empirical observations exist for the belief that in economic markets as they exist in reality -....- individual anomalies are not eliminated at the aggregate level'. They should therefore be taken seriously in economics as well as in sociology. This statement underlines that for certain problems a more complex behavioral theory is needed.

1.5.3. Integration of the anomalies into neoclassical economic theory

Attempts to integrate the observed anomalies (for intertemporal choice) into neoclassical economic theory up to now only deal with certain anomalies like procrastination or varying discount rates. To Anderson and Block (1995) the problem of procrastination is due mainly to a misrepresentation of the individuals ‘true' preferences and not to a failure of their ‘true' utility maximization.16 They argue, that if people procrastinate or give in to a temptation, they do not fail to maximize utility, but have a couple of reasons to do so: They could want to make themselves or others believe they would have liked to make a different choice, they also could have other goals in a situation beside resisting this certain temptation (e.g. impress others) and finally, their ordering of preferences could have changed. For example, imagine a person fails to stick to his diet or to abstain from taking alcohol. This failure can, according to Anderson and Block (1995), be due to an only temporary wish to impress a person (maybe the spouse) which becomes less important as another goal appears. The failure might also be due to a strategic misrepresentation of the dieter’s preferences (i.e. the dieter did never really want to engage in this diet, but stated this wish only to keep the peace) and finally it can be due to a change in preferences, because ‘[t]he standard economic model assumes that individual preferences are consistent at any moment, yet not necessarily over time' (Anderson & Block 1995: 205). Therefore, people procrastinate or give in, because, given their set of preferences, it actually is the best they can do. So there clearly exists no problem for economic theory at all. Although anomalous phenomena may be due to a strategic misrepresentation of preferences, given the serious attempts that are sometimes made and the often quite high costs that are involved with these attempts, it seems rather implausible that people value, say, the next alcoholic drink more than the costs for a three-week therapy or undergo such a therapy for strategic reasons. The growing literature on self-command and commitment (e.g., Elster 1979, Schelling 1992, Ainslie & Haslam 1992) indicates that people are willing to pay quite significant costs in order to raise incentives not to deviate from their long-term

16 One could argue that they deny the relevance of anomalies and thus should be placed in the section above. However, that section reviews arguments accepting experimental anomalies but questioning their importance for aggregates in real world settings. Thus, an approach trying to prove that these results can be explained in standard economic terms is somewhat distinct. Intertemporal choices 15 interest in the light of short-term temptations.17 Further, it is strange to explain violations of the standard micro-economic model by temporary changes in preferences. For good reasons preferences should be regarded as ‘similar among persons and stable over time' (Stigler & Becker 1977: 76). Abolishing this assumption would lead to the possibility of ‘explaining' almost every action by a sudden - and maybe even temporary - change in preferences - as it is done by Anderson and Block, thus rendering a systematic testing of predictions impossible. In this case the remedy seems to be much worse than the disease. Another, more sophisticated, attempt to integrate part of the observed phenomena is via endogenous changes in preferences (Becker & Murphy 1988, Becker 1996, Becker & Mulligan 1997; Wathieu 1997 offers a similar approach). Here present consumption of a good influences the utility derived from its future consumption. For example, drug use now raises current utility levels but in addition alters (lowers) the utility derived from consumption of the same amount of drugs later. Becker and his co-workers introduce a good-specific stock of consumption capital, which, as in human capital theory, depreciates when not used. Different goods have different rates of depreciation as well as different influences on the utility derived from future consumption. For example, immediate drug use influences future utility from drugs stronger than immediate consumption of chocolate influences future utility from chocolate. Note, that this influence of present on future consumption need not be harmful. Exercising (jogging, doing piano lessons) potentially raise utility of future consumption and thus are positive addictions.18 Next to the initial rate of good-specific consumption capital, the depreciation rate of this capital, and the influence of current consumption on future consumption, intertemporal utility then depends on discount rates. People discounting strongly will presently consume more of harmful goods despite the negative future consequences. Therefore, subjects may maximize intertemporal utility even in case of addiction. According to Becker and Murphy (1988) utility maximization does not imply that these persons achieve very high levels of utility, i.e., that they are very happy, but only that given their set of preferences and their consumption capital they behave optimally. In addition, the initial choice of experimenting with drugs or alcohol might very well be made under uncertainty (Becker 1992). When deciding to experiment with the use of drugs or not, it may simply not be clear whether one will become an addict or not. Thus, people might become addicted and later regret that fact and also their previous choices, but they still acted rational. Therefore people may undertake considerable pain in order to stop addictions.19 This model raises interesting research questions, e.g., which people have a high time preference and are at risk of becoming addicted and where such high time preferences stem from.

17 Note, that the prime example for the use of commitments – Ulysses letting himself bind to the ship’s mast in order not to fall prey to the singing of the sirens - used commitments much more efficiently than his modern descendants. Contrary to their attempts to remove chocolate bars in order to stick to their diets, Ulysses is able to reap the benefits of giving in to a temptation, without having to pay the price for it. 18 Because investment in beneficial addictions is no potential anomaly, the focus in this chapter lies on the more familiar harmful addictions. 19 Note, that this model incorporates addictive behavior but no longer assumes that intertemporal utility function is time-separable. However, with regard to the violations of the separability axiom, such a violation is not necessarily a defect of the model. Ironically it also runs counter to Becker’s own theory of the family where he assumes that people discount future benefits at the market interest rate.

16 Chapter 1

The problem with this model, despite its correct observation that addicts sometimes regret their choices, is its neglect of the ongoing shifting preferences of addicted people and their sometimes even repeated tremendous efforts and expenses to stop their addiction. If subjects have already been addicted, they should be able to judge the risks associated with drug much better than when making their initial choices. In addition, it remains unclear why people at one time prefer to stay away from taking harmful substances and next time to succumb to the need for these substances.

1.5.4. Existing models to explain certain essential anomalies

Due to a plethora of competing models this section could be easily enlarged to a whole chapter. It will not, because generally these models do not cover a broader range of anomalies but are restricted to the anomaly under study (e.g., Akerlof's [1991] model of procrastination). As a result, they sometimes look like searching for an appropriate utility function. In this section only more general models will be reviewed. The most prominent model and a major descriptive advance over the DU-model is the well-confirmed hyperbolic discount curve (e.g., Ainslie 1975, 1991; Mazur 1987):

U (V 0) U (Vt) = , (2) (1+αt)

U(V0) being the immediate value of an outcome, U(Vt) its value at time delay t, α being a constant determining the steepness of the discount function, and t the number of time periods the reward is to be delayed. 20

Contrary to an exponential discount function, hyperbolic discount rates imply time-varying discount rates where the decision maker is relatively strongly aware of short delays. Due to the prominence of this ‘anomaly’ this hyperbolic discount function has been incorporated in several models as well as axiomatic systems. For example, Loewenstein and Prelec (1992), Harvey (1986) and Ahlbrecht and Weber (1995) developed axiomatic systems where the stationarity axiom is replaced with an axiom allowing hyperbolic discounting. Ahlbrecht and Weber (1995) further argue that hyperbolic discounting is normatively justified, i.e., rational, in cases where decisions are binding, that is, if current decisions are not reevaluated in the future. Certainly any successful theory of intertemporal choice must incorporate hyperbolic discounting. Yet, it remains quite unclear why certain things (clothes, alcohol or sweets) are usually related with ‘impulsive behavior' (Ainslie's term for the

20 There exist a variety of competing models for such a hyperbolic discount function, e.g., Harvey 1986, Mazur 1987; Loewenstein and Prelec 1992; Laibson 1997. The most general one, having been successfully tested also with survey data (Cairns & van der Pol 2000), is that of Loewenstein and Prelec (1992). They define decision weights (wt) for future time periods as follows: 1 (wt) = . Depending on the parameter values for h and α this formulation encompasses standard (1+αt) h /α exponential discounting, if α approaches 0, as well as Mazur's (1987) model above, if h / α equals 1. Note, that in Mazur's formula above as well as in the Loewenstein and Prelec model α may take negative values, indicating that a person values positive future outcomes more than immediate ones. If a person is indifferent between immediate and future outcomes, in the Loewenstein and Prelec model all parameters equal 1, while in the Mazur model α has to equal zero. Intertemporal choices 17 overweighing of immediate gains in his seminal 1975 paper), while others, such as the decision which bank offer to accept in order to pay back one’s mortgage for the following twenty years, are not. Consequently, Ainslie (1991: 335) raises the question: ‘But then, which is the ”true” discount function - the matching law (implying hyperbolic discounting – AG) or the exponential discount rate available from the bank?’ Unfortunately, he leaves the problem unresolved by answering that this depends on the circumstances, and focuses instead on the means of arriving at a proper exponential rate. To specify such circumstances is indeed one of this book’s aims: who is most likely to behave myopic and when? While hyperbolic discounting accounts for time-varying discount rates the anomalies concerning the sign and magnitude effect are modeled via the value function for gains and losses. Kahneman and Tversky (1979) introduced a value function that is split by a reference point in two parts. Above the reference point the value function is concave, below the reference point it is convex.21 In addition, the function is steeper in the negative domain, resulting in an S-shaped utility function. Loewenstein and Prelec (1992) applied a similar value function in their model for intertemporal choices. Besides for the sign and magnitude effects, this value function also accounts for anomalies in sequences and the delay/speed-up asymmetry. With respect to sequences, Frank (1992) points out that people react to events and evaluate them in relation to some reference point, mostly the status quo. Past levels of consumption form reference points for future levels of consumption (Kapteyn & Wansbeek 1982), thus leading to a preference for sequences with growing consumption profiles as reported by Frank (1992) and Loewenstein and Sicherman (1991). As to the delay/speed-up asymmetry, Loewenstein (1988) found that charges to delay a good are higher than premiums people are willing to pay for speeding-up the receipt of the good the same amount of time. In delay situations people experience an immediate loss compensated by a later but discounted gain. In a speed-up situation they experience an immediate gain followed by a later and discounted loss. If losses weigh more heavily than gains, delay charges are higher than speed-up premiums. Unfortunately, the specification of the (quite important) reference point and the ensuing distinction between gains and losses remain unspecified. Hence, only in certain situations can predictions be derived about when an outcome is perceived as a gain and when as a loss. It seems unlikely, for example, that the average shopkeeper views his daily sales as a loss and that the amount of money he gained in exchange is unable to compensate him for this loss. Loss aversion seems to be of no importance in this situation. Fischhoff (1983) investigating the stability of perceived reference points found that subjects differed remarkably in the perception of the relevant frame in a situation. The missing specification of what constitutes the reference point is also responsible for the contradiction that Loewenstein (1988), in his work on delay and speedup, states that anticipated consumption serves as the reference point. By contrast Loewenstein and Sichermann (1991) as well as Frank (1992) in their work on increasing wage profiles pose that the current level of consumption serves as the reference point. While both explanations seem intuitively plausible they are certainly not derived from theory.

21 Such a utility function does not exhibit decreasing marginal utility in the negative domain, i.e., decreasing marginal disutility. Consequently, economists frequently question the S-shaped form of the utility function. For empirical evidence favoring S-shaped utility and a discussion see Fennema and Van Assen (1999).

18 Chapter 1

Worse, capturing the above-mentioned effects (sign, magnitude, delay/speed-up asymmetry and negative discount rates in sequences) by choosing an appropriate value function implies that objects valued equally are discounted equally, no matter whether it is drugs or garden furniture. Chapters 3 and 4 will provide evidence against this prediction, by assuming, among other things, that value functions in the negative domain differ between goods according to their hedonicness (Dhar & Wertenbroch 2000). As to the phenomenon that different objects (here: forms of money) are discounted in a different way, Thaler (1990) and Shefrin and Thaler (1992) argue that people ”act as if they used a system of mental accounts... Specifically some mental accounts, those that are considered ‘wealth’ are less tempting than others that are considered ‘income” (Shefrin & Thaler 1992: 290). They view mental accounting as part of framing (Kahneman & Tversky 1984) and predict the mental account ‘income’ to have a higher marginal propensity to be spent for consumption than ‘lump-sum payments’. These in turn have a higher marginal propensity than ‘pension increases’. They also predict a much higher marginal propensity for so-called ‘windfall gains' (i.e., unexpected gains), if these gains are small and a lower marginal propensity if these gains are large, because in the latter case they are framed as ‘wealth'. Although a precise distinction between ‘small' and ‘large' windfall gains might be quite debatable in practice, the prediction that windfall gains have a higher marginal propensity than expected gains has been successfully tested (Akers et al. 1994). Note, that in this section ‘framing’ has been used for a variety of different phenomena. Frank (1992) and Loewenstein and Sicherman (1991) assume that people adopt a reference point that influences the evaluation of outcomes depending on whether they are perceived as gains or losses. Loewenstein (1988) does the same, but additionally shows that the perception of the reference point can be manipulated. Shefrin and Thaler (1992) further add complexity by introducing their system of mental accounts for which discounting is not only depending on the reference point but also on relating an outcome to a specific mental account which in turn is related to a specific discount rate. While these models have a much higher positive validity than the DU-model, they still leave many questions open. I already dealt with the problems related to the specification of the reference point. As to the existence of mental accounts that influence the discount rate, other problems remain. If mental accounts are crucial, an explanation of how many of them exist for a certain object and which accounts are associated with which discount rates would be very desirable. Unfortunately, Shefrin and Thaler tell us nothing about this problem. Second, and even more important, their model assumes the ordering of mental accounts to be static. This implies, that if people reveal much higher discount rates for alcohol than for money, say, when celebrating in a pleasant environment at parties, the same ordering still holds if an alcoholic drink is offered at a conference. This implication does not seem very plausible.22 Another stream of research focuses on the relation between intertemporal choice and choice under risk and compares models between the two domains. Because this approach to intertemporal choice differs from building descriptively more valid models, it will be covered separately in the following section.

22 It is of course also possible to assume that events are linked to mental accounts, thus allowing for identical forms of consumption to be linked to different mental accounts and to be discounted differently. This makes the need to systemize mental accounts and their relation to temporal discounting even more urgent. Intertemporal choices 19

1.5.5. Analogies between intertemporal choice and choice under risk

There is a striking similarity between most of the observed anomalies concerning choice behavior under risk and over time. That is, virtually the same violations of the standard models occur (see Chapter 6 for a demonstration). Based on this similarity, Prelec and Loewenstein (1991) as well as Quiggin and Horowitz (1995) argue that basically the same behavioral patterns underlie the deviations from the normative models. In both cases, alternatives are described by the notation (X, x), X being the payoff and x being either a time delay or a probability/degree of risk. Both choices (over time and under risk) are sensitive to the existence of reference points, i.e., it matters for the decision-maker whether the given alternatives include gains or losses. Further, in both cases the decision- maker is sensitive to manipulations of the time/probability parameter that normatively should not affect preference. Thus, in both choice domains there is a preference for sure/immediate events and in both choices an initial indifference between two outcomes disappears, if the time/probability component is altered by the same ratio or the same difference for each outcome. For example, a person being indifferent between a smaller but less distant and a larger but more remote reward, prefers the latter one if both choices are delayed the same amount of time. Prelec and Loewenstein (1991) describe this as the common ratio/common difference effect. Finally, in both preference domains (under risk and over time) the same effects with regard to sign and magnitude of the reward can be observed. Prelec and Loewenstein (1991) conclude that these similarities reflect the intimate connection between intertemporal and risky choice: delayed objects are almost by definition uncertain. The observed regularities therefore do not necessarily hold for other multi-attribute choices. In contrast with this view Rachlin and Rainieri (1992) generalize the hyperbolic discount functions observed in intertemporal choice to the discounting of risk, social distance and other. Their models include important aspects of intertemporal choice, such as hyperbolic discounting or utility functions differing between gains and losses. But two important problems remain. First, as expressed in the Ainslie quotation above, discount rates are highly dependent on situational characteristics.23 Otherwise different goods of equal value should be discounted identically. Such situational aspects are completely left out. Consequently, they cannot explain different discount rates within an individual. Second, there exist also personal differences in discounting (Mischel, Shoda and Rodriguez 1992). Some people manage better than others to stick to their long-term consumption plans than others as every member of AA can tell. While in principle compatible with the models above, after being to some extent investigated in the 1950s and 60s such personal differences have been largely neglected in the past decades.

23 Even Loewenstein claims that ‘As a research agenda it may be more fruitful (than investigating whether time preference is positive or negative - AG) to adress the more nuanced question of why intertemporal choice behavior is so unstable and to discover the situational determinants of time preference’ (Loewenstein & Sicherman 1991: 81/82).

20 Chapter 1

1.6. Problems treated in this book

In the previous sections the importance of intertemporal choices was stressed, the DU- model underlying most economic analysis and its accompanying anomalies were presented and some alternative models were reviewed. In this section the main problems treated in this book will be outlined briefly. Existing models in intertemporal choice were criticized for paying too little attention to varying discount rates within an individual.24 Hence, influences leading to high or low discount rates respectively will be specified. More specifically, it will argued that people act myopically when hedonic consumption is considered and that this short-term orientation is enhanced when consumption experience can be imagined vividly. By contrast people act according to their long-term interest when utilitarian considerations are prominent. Secondly, it was repeatedly underlined that existing models in intertemporal choice are agnostic with respect to individual differences in discount rates. Such differences usually are regarded as differences in tastes and hence, taken as given. In this book, we attempt to demonstrate that the ability to take future consequences of one’s actions into account is an asset produced by parents within their children. People are naturally shortsighted (see Ainslie 1992 for support) but are taught, mainly by parents, to take long-term consequences of their actions into account. Because parents differ with respect to abilities and restrictions to teach this ability and because people differ with respect to which they can learn this ability, people should differ systematically with respect to temporal discounting. Therefore, the first two problems treated in this book are:

When do people act myopically and who behaves impatiently?

In addition, existing models in intertemporal choice were criticized for being unnecessarily restrictive. In this book it is argued that behavioral regularities observed in intertemporal choice cannot only be applied to choice under risk, as to some extent has already been demonstrated by Prelec and Loewenstein (1991), but can also be generalized to other preference dimensions, e.g., to interpersonal or interspatial choice. Thus, the third problem treated in this book is:

How can the empirical results observed in intertemporal choice be generalized to other preference dimensions?

It will be argued that processes in temporal discounting are first much more specific than postulated by existing models, because these models do not take into account varying discount rates within individuals. It will also be argued that discounting is much more general than postulated in existing models: outcomes distant from a decision maker’s reference point are discounted in decisions concerning other preference dimensions than just temporal delay.

24 Recently, O'Donoghue and Rabin in a series of papers (O'Donoghue & Rabin 1999, 2000, 2001) as well as Laibson (1997, 1998) - all following suggestions from Schelling (1984) and Ainslie (1992) - used game- theoretical modeling to explain some of the empirical deviations of the DU-model. They argue that people consist of different selves that interact strategically to determine the behavior of a decision maker. From this assumption they also derive results as to when people are likely to behave impatient. The arguments developed in this book appear to be compatible with their reasoning.

Intertemporal choices 21

To tackle these problems, in the following sections a framing theory developed by Lindenberg will be presented which serves as an integrating framework to answer the two main research questions. It will also briefly be sketched how this theory is applied to answer the questions.

1.7. Theory, general: framing and overview of arguments

Because the research questions mentioned in the previous section will be tackled by using a framing theory, this section first briefly reviews other concepts of framing before elaborating the theory used throughout this dissertation.

1.7.1 Previous notions of framing in decision theory

Framing effects have been introduced into decision theory (for choice under risk) by the psychologists Kahneman and Tversky (1979). They developed a descriptive theory of choice under risk, Prospect Theory (PT), the central concepts of which have also been applied to intertemporal choice (e.g., Loewenstein 1988, Loewenstein & Prelec 1992). In Prospect Theory the value V of a prospect25 P is modeled by:

26 V (Pi) = v(xi) δ(di) (3) v(xi) being a value function and δ(di) being a weighting function for probabilities

Due to the existence of a reference point (usually the status quo) the value function implies that decision makers distinguish between gains and losses. Further, the function is concave above the reference point (for gains) and convex below it (for losses). It also is steeper for losses than for gains. These properties hold for risky as well as intertemporal choice. The probability weighting and intertemporal discounting function also show some similarities, viz. diminishing sensitivity with greater distance from the reference point. That is, changes on the risk or time attribute have less influence on the evaluation of prospects the more distant from the reference point they occur. For choice under risk this reference point can either be 'certainty' or 'impossibility', while for intertemporal choice it will generally be 'now'. Prospect Theory additionally assumes that there is an editing phase consisting ‘of a preliminary analysis of the offered prospects which often yields a simpler representation of these prospects’ (Kahneman & Tversky 1979: 274). In this phase the following four operations take place. Coding: Instead of integrating outcomes into final states of wealth, outcomes are usually perceived as gains or losses. When an outcome is perceived as a gain or a loss depends on a given (chosen or suggested) reference point.

25 Prospects are vectors either of the form (x1, p1; x2, p2; ...; xn, pn) for risky options and (x1, t1; x2, t2; ...; xn, tn) for intertemporal options. Xi describes the outcome attribute i in both prospects whereas pi and ti describe the corresponding risky or temporal attribute. A gamble offering a 50% chance to win $100 and a 50% chance to win nothing is thus described as (100, .5; 0, .5). For matters of convenience zero outcomes are usually omitted, hence the prospect reduces to (100, .5). The procedure for intertemporal options is analogous but note that in risky choice outcomes usually are mutually exclusive whereas in intertemporal choice this need not be the case. 26 This holds for prospects consisting of one outcome differing from zero and one risk or time attribute. For more outcomes the formula becomes more complex but the main properties remain unchanged.

22 Chapter 1

Combination: The probabilities of identical prospects can sometimes be combined. A prospect of (200, .25; 200, .25) will thus be combined and evaluated in the form (200, 50). Segregation: Some prospects contain a riskless component that is segregated from the risky component of the prospect. The prospect (100, 40; 300, 60) will thus be perceived as a prospect with a sure win of 100 and a 60% probability of winning an additional 200. Cancellation: Shared components of the offered prospects are cancelled. Thus a choice between (A, x; B, y; C, z) and (A, x; B', y'; C', z') will be reduced to a choice between (B, y; C, z) and (B', y'; C', z'), since (A, x) is a common component in each of these prospects. Elimination of stochastically dominated27 prospects also occurs during the editing phase. Kahneman and Tversky (1979) provide some empirical evidence for the existence of such an editing phase. However, no such effects up to now have been observed in intertemporal choice. Seidl and Traub (1998) report little evidence for the existence of an editing phase in choices with multiple attributes. To summarize, in Prospect Theory framing effects occur at several steps. They first influence the perception of the prospect via the editing operations. If these operations have an influence on the actual choice this constitutes a framing effect. Second, and most important, framing works via the setting of the reference point, i.e., via the distinction of outcomes as gains and losses. The evaluation of outcomes depends crucially on their perception as gain or a loss. In their famous Asian-disease problem28 Kahneman and Tversky demonstrate that the reference point can be altered by a different formulation and that such an alteration has considerable consequences for choice behavior. In a follow-up paper (1984) they also offer a third framing effect for multi-attribute choices. Kahneman and Tversky argue that 'in order to evaluate such a multi-attribute option, a person sets up a mental account that specifies the advantages associated with the option, relative to a multi-attribute reference state' (Kahneman and Tversky (1984: 346). The evaluation of such a prospect then depends on the balance of this mental account. Kahneman and Tversky (1984) introduce the following mental accounts: 1. A minimal account: only the differences between two options are included, shared features are of no relevance for the decision. 2) a topical account: the consequence of a choice is related to a reference level with respect to this choice, thus involving more dimensions. 3) A comprehensive account: the consequences of a choice are related to a reference level with respect to a wider range of choices. Framing effects here can be understood as a selection of relevant dimensions, which in turn influence the perceived costs and benefits of an option as well as the size of these costs and benefits. For example, options evaluated in a wider context as in the case of the comprehensive account appear much less important. Kahneman and Tversky (1984) suggest that decisions will generally be framed in terms of topical accounts.

27 A prospect (100, .1; 50, .5) stochastically dominates a prospect (100, .05; 50, .5) and will thus be preferred. 28 In the Asian-disease problem subjects have to choose between alternative programs to prevent a potentially deadly disease. Preference between alternatives depends on whether the consequences of the programs are described in terms of gains, ‘lives saved’ (which elicits risk-aversion’), or losses, ‘number of people dying’ (which provokes ‘risk-seeking’). Intertemporal choices 23

In intertemporal choice, researchers have applied PT mainly with its distinction between gains and losses via reference points (Loewenstein 1988, Shelley 1993), resulting in different discount rates for such gains and losses, on the existence of different mental accounts which are related to different discount rates (Thaler & Shefrin 1992) and on reference point manipulation within the gain or loss domain making outcomes appear more or less immediate (Roelofsma 1994).

1.7.2 Framing in sociology

Contrary to behavioral decision theory framing, has a long tradition in sociology, but with a different notion. It is traditional sociological knowledge that actors define situations, i.e. they determine which aspects are relevant in a given situation. Depending on this definition they choose a proper behavior (see already Thomas & Znaniecki 1928; later this idea was developed further in the works of Mead and Schütz). Behavior is thus a product of the situation and the actor's definition of it. The term framing for the process of identifying and defining situations was introduced by Goffman (1974). For a long time the importance of a definition of the situation has been stressed mainly by proponents of interactionistic sociology (such as symbolic interactionists or ethnomethodologists) and has been neglected by theories that place little value on interactions, e.g., microeconomic consumer theory. Only in the 1980’s some attempts to combine the insights of traditional sociology and rational choice theory have been undertaken by Lindenberg in the below- sketched framing theory and by Esser (1990, 1991, 1996), both arguing that such an integration might contribute to our understanding of anomalous behavior.29

1.7.3 Framing as used in this book

The framing theory developed by Lindenberg, which will be used in this book, is based on the Discrimination Model, originally developed for stochastic repetitive choice (Lindenberg 1980) and successfully tested experimentally (Lindenberg 1981). Later the model was developed into a more elaborate framing theory (Lindenberg 1983, 1989) for which Braspenning (1992) provided some empirical support and which Ligthart (1995) successfully applied to bargaining. Recently, applications in the field of intertemporal choice have been suggested (Lindenberg 1993, 1995, 1996). The theory links two major findings of economics and sociology. From economics it borrows that goods are scarce and behavior is thus heavily influenced by the relative scarcities of these goods. More precisely, if goods become more scarce, prices rise and demand drops. From sociology it borrows that an actor's definition of a situation heavily

29 Esser even claims that the failure to look at the definition of the situation is responsible for almost all anomalies rational choice theory: 'Den Kern nahezu aller Anomalien der Theorie des rationalen Handelns bildet ein Vorgang, der von der Soziologie immer schon sehr betont worden ist: In jede Handlungsentscheidung wird eine besondere "Definition" der Situation geschaltet, die erst die Präferenzen und die Erwartungen strukturiert, von denen dann erst die Selektion eines Handelns ausgehen könne (Esser 1996: 2). Since the ‘definition of the situation’ structures preferences, it is by definition responsible for behavior irrespective of whether behavior is to be called ‘rational’ or ‘anomalous’. However, because this approach allows goal salience to change depending on what frame structures the situation, rationality is only possible within a definition of a situation, i.e. within a given frame. Hence, the distinction between rational and anomalous behavior is meaningless. Toda (1981) provides a similar argument from psychologists.

24 Chapter 1 influences his subsequent choice. In other words, the relevant goods in a situation might be very different for different types of actors and also the effect of a rise in the relative price on the demand of these goods might be very different depending on situation and actor (Lindenberg & Frey 1993). By doing so, it is possible to integrate the rich descriptiveness of classical sociology (especially the studies on the definition of the situation undertaken by symbolic interactionists) with the theoretical tradition of economics. By assumption, actors have limited cognitive capacity. Given that actors have goals and that action structures are complex, actors are forced to define a situation in real life decisions in terms of these goals. That is, in a given situation actors have dominant goals and restrict their attention to goal relevant aspects. The theory postulates that there is only one overarching goal that structures the situation and becomes the dominant goal, i.e., the frame, that defines the situation.30 For example, in a market situation it is typically assumed that gain-seeking or profit-maximizing is the dominant goal. This structuring is triggered automatically, i.e., the individual is unable to choose a frame. Contrary to the sociologist’s concept of the definition of the situation, the discrimination model assumes that goals potentially relevant in the situation but pushed into the background by the dominant goal still influence behavior, but only indirectly. They remain in the background of the decision maker's mind and affect the salience (strength) of the dominant goal. In a typical market situation, for example, the goal 'behave altruistically' will not be dominant but it might raise or lower the salience of 'gain'. This salience of the dominant goal determines the effect of the net utility of the alternatives (gi - g0) on the probability that the given alternative i will be chosen. Expressed algebraically:

Pi = B (gi - g0) + 1/K, (4) 31 where Pi is the choice probability of option i; gi is the expected utility of option i; g0 is the mean expected utility of all options. The parameter B denotes the salience of the respective frame, depending on other goals and K is the number of all options.

Note, that formula (4) is about choice probabilities given frames. Hence, salience of frames in the discrimination model is exogenously given. As to frame selection, if no routine for handling certain decision situations has been developed, i.e., behavior is non- habitual, the goal that discriminates best between the choice alternatives becomes dominant, structures the situation and pushes other situational goals in the background. If a routine for specific kinds of choice situations has already been developed, the dominant goal established previously prevails, until it fails to discriminate between the choice alternatives. Suppose, as an example, you bought an expensive ticket (say: f100) for a theatre show that received mixed reviews after you bought the ticket. While you are just leaving

30 'One overarching goal' is a somewhat misleading term, since in the theory 'one goal' may well comprise several attributes or goal variables. Suppose the goal is 'being a smart consumer'. Choosing between consumer goods being described by a variety of attributes the actor may well be able to compare goods by considering and weighing all the attributes. 31 As in the previous footnote, note that options may be described by several attributes. The expected utility of an option therefore weighs these attributes to determine the utility of an option. To arrive at an expected utility this weighted sum of the score of attributes is again weighed by the probability with which this options is to be expected. Intertemporal choices 25 home to attend the show it begins to rain so heavily that you will get quite wet even when carrying an umbrella. The three most obvious goals in this situation are: a) to receive pleasure from attending the show, b) to avoid getting wet, and c) to avoid having thrown away f100 by not going to the show. Assume, you have no routine in handling such a decision situation. According to the model, alternative c should structure the situation. The enjoyment of the show is (due to the mixed reviews) unsure and thus not serving as a basis for a clear discrimination between going and not going. Because people in general are loss averse and because the subject already paid f 100, the utility difference between going and not going is likely to be larger in terms of losses than in terms of getting wet or not. However, the other goals do not vanish, but they remain in the back of the decision maker's mind and influence the salience of the structuring goal. In the example, the goal 'receiving pleasure from the show' raises the salience of the structuring goal 'loss-avoidance' and the goal 'avoid getting wet' lowers its salience. In this situation a change in the price for the theatre ticket (e.g., if your partner who bought the ticket tells you that the actual price was only f l0) has a much larger impact on the probability of 'going', than an increase in raining intensity. On the other hand, changes in raining intensity have a stronger impact if the dominant goal is ‘avoid getting wet’. Hence, changes in relative prices affect behavior quite differently depending on whether they occur on goods inside or outside the frame. To apply this theory to intertemporal choice, specifications are necessary as to what determines the salience of goals in an intertemporal context. Some goals promote behavior resulting in little attention to long-term consequences (say drug addicts search for means to overcome cravings) whereas other goals will make decision makers particularly sensitive to even small differences in long-term costs or benefits, e.g., when considering bank-offers to pay off your mortgage for the following 25 years. The remainder of this chapter lays out some mechanisms relevant in intertemporal choice. Note, that according to this model ‘rationality’ always is frame (or goal) dependent. Behavior is not necessarily rational across different frames. Behavior in one frame may appear ‘irrational’, if evaluated from another frame.

1.8. Application to intertemporal choice

To apply the theory laid out above, first the effect of goal salience on preference will be investigated, i.e., it will be tested for the effect of B on preference. Then, it will be investigated how changes in the choice set from which alternatives are chosen affect the discriminatory power of options and consequently preference. These tests are done in order to underline the general applicability of the discrimination model to intertemporal choice. Given that salience and discriminatory power are important in intertemporal choice, we will proceed by investigating other mechanisms for making goals salient, which lead to short-term or long-term orientation. For example, it will be argued that the salience of goals ignoring long-term consequences depends on characteristics of the good. More explicitly: hedonic goods, goods which provide direct utility, are more likely to lead to a frame in which ‘possession of the good’ is the dominant goal, than utilitarian goods are, goods serving as means to derive utility, even assuming that both goods have the same utility. Further, this

26 Chapter 1 likelihood depends on whether goods are presented vividly: staring at goods presented at a shop window affects preferences differently than choosing from a written list of items. It then will be argued that salience of frames depends on individual characteristics. The probability that in a specific situation a goal becomes dominant that ignores long-term benefits or costs, differs between individuals. Therefore, given identical resources and given an identical degree of deprivation, the propensity to frame this situation as ’end this miserable situation’ differs between people. Consequently, the probability of behaving impulsively differs between individuals, e.g., depending on whether how well they were socialized to delay gratification. Finally, the salience of rewards should decrease as a function of their distance from the decision maker. In intertemporal choice this is modeled by a discount function, may it be an exponential or a hyperbolic one. It will be argued that distance refers to several dimensions - outcomes might be risky (distant from certainty), temporally delayed (distant from ‘the present’), spatially distant (distant from ‘here’) or socially distant (distant from myself) – and that people discount outcomes according to their distance from a multi-dimensional reference point. While this is hardly a new statement – it is intuitively obvious that people prefer to receive benefits for themselves, ‘here’ and ‘now’ – it is also argued that these discounting processes follow similar discount functions and thus may yield almost identical preference shifts. Thus, preference reversals experimentally observed in intertemporal choice can be directly applied to interpersonal choice or risky choice due to a general influence of distance on salience. In the following sections, these considerations will be explained in somewhat more detail.

1.8.1 Framing theory, the discrimination model and salience in intertemporal choice

Lindenberg’s framing theory assumes that framing takes part habitually and automatically. If no decision routine for the respective decision situation has been established previously, the frame that discriminates best between choice options becomes dominant. The choice probability of the most favorable option within the dominant frame is enhanced or lowered by background goals depending on whether these goals are compatible with or run counter to the dominant frame. This model can incorporate hypotheses as to which people will be most impatient and when, as well as generate some new predictions. For example, the personal characteristics investigated in chapter 5 should influence the automatic triggering of the dominant frame. People with high self- control thus more often ‘select’ frames which call for far-sighted behavior, i.e., have lower discount rates, than persons with low self-control. One could add an index capturing this to formula (4) above:

Pij = Bj (gi - g0) + 1/K, (5) j being an index for a specific personal characteristic, e.g., patience.

Because this dissertation is mainly concerned with intertemporal choices, only personal characteristics with respect to temporal discount rates are considered. However, personal characteristics should also influence the salience of frames in other domains. Lindenberg (1996) explicitly assumes framing in general to depend on institutions and norms. Adherence to norms as well as institutional effects differ between subjects - and if specifications of these influences analogous to those presented in Chapter 5 can be made Intertemporal choices 27

- it may be reasonable to generally add such an individual index. For example, deviant behavior is more common and more pronounced for males than for females (Hirschi & Gottfredson 1994). This can be captured in formula 5 by assuming either that the expected utility of options available differs between sexes, that the salience of frames differs between sexes, or both. The hypotheses with respect to situation- and good-specific influences on discount rates likewise refer to the weight B in formula (4) and (5): for reasons elaborated below, hedonic goods and vivid presentations may lead to a larger salience of goals favoring short-term behavior, regardless of individual characteristics. However, it is possible to test the effect of discriminatory power on preference directly. For example, the attractiveness of the option ($100 in 4 weeks) according to the model should differ for the two choice sets C1: {($100 in 4 weeks), ($105 in 4 ½ weeks), ($120 in 6 weeks)} and C2 {($100 in 4 weeks), ($120 in 6 weeks)}. In the first choice set the option does not differ much from ($105 in 4 ½ weeks). Hence, a frame where ‘immediacy of receipt’ is a dominant goal does not discriminate between options and will therefore be replaced by a frame that discriminates better, while a frame where ‘amount of money’ is dominant does. The latter therefore is more likely to be dominant in this situation.

1.8.2. Good-specific determinants of patience: hedonic and utilitarian goods

It was already stated that the main shortcoming of the hyperbolic discounting perspectives is its failure to explain varying discount rates within an individual. Hyperbolic discounting heroically assumes that subjects reveal identical (hyperbolic) discount rates when buying designer clothes as in their gasoline purchases (see Chapman & Elstein 1995, and Dittmar, Beattie & Friese 1997 for counterevidence). Contrary to this position it will be argued that impatience is higher for hedonic than for utilitarian goods. Consumption of the former yields direct utility to a decision maker, while the latter serve as means to derive utility in future time periods.32 Hoch and Loewenstein (1991) argue that impulsivity is due to deprivation caused by the non-possession of certain goods. In this view, consumers adapt to the possession of a good and its actual non-possession then creates deprivation that is ended by buying the product. If hedonic goods provide direct utility, their non-possession elicits much higher levels of deprivation than the non- possession of utilitarian goods. Recently, in fact Dhar and Wertenbroch (2000) demonstrated that loss aversion is more pronounced for hedonic than for utilitarian goods. Hedonic goods thus should create feelings of deprivation more easily and more strongly than utilitarian goods and subjects should therefore prefer to delay consumption of utilitarian rather than hedonic goods. In addition, impatience for hedonic over utilitarian goods should be stronger when subjects consider which good to receive sooner than when subjects have to determine adequate monetary compensation charges for delay. Asking subjects about their preference for immediate consumption raises the salience of hedonic frames, because immediate consumption is much more attractive when it provides direct utility. By contrast, asking for compensation charges raises the salience of utilitarian frames, because subjects have to consider alternative expenses, thereby distracting from the hedonic experience of immediate consumption.

32 Alinda van Bruggen (personal communication) suggested this definition.

28 Chapter 1

1.8.3. Situation-specific determinants of patience: vividness

In intertemporal choice the importance of vividness has been stressed frequently. A recurrent speculation is that vividness raises impatience. People walking along a shop front with nicely placed goods, maybe even smelling them, generally are much more eager to buy these goods than when sitting in their armchair spending time reading. It is thus often argued that forms of goods’ proximity raise discount rates (Loewenstein & Hoch 1991, Loewenstein 1996). This expected influence of vividness on discount rates is also supported by empirical evidence. Mischel and his co-workers conducted a series of experiments (summarized in Mischel et al. 1992) on children’s ability to delay gratification. They demonstrated that children are much less willing to wait for the reward when the reward was actually present. But this seems to be only part of the story. While standing in front of a bakery, viewing and smelling the products probably enhances one’s propensity to consume these goods. However, no such effects are reported, nor are they likely to be reported, for people at gas stations despite the fact that the smell of gasoline might provoke extremely vivid images. Intuition often quickly provides us with vivid examples of how and why vividness affects our judgments. Unfortunately, scientific scrutiny by and large has not corroborated this view. In a review on research about vividness Taylor and Fiske (1984) paint a rather dark picture and conclude that there is little evidence for vividness effects. It is argued here that vividness affects discount rates by affecting the deprivation felt by decision makers in two ways. First, vividness raises the perceived hedonic/utilitarian qualities of a good. That is, goods presented vividly are judged as more hedonic or utilitarian than non-vivid goods. Second, vividness raises adaptation to owning the good, thus creating stronger feelings of deprivation and more incentives to overcome this deprivation by buying the product immediately. Therefore, there is an interaction between type of good and vividness. Vividness is assumed to affect preferences for hedonic goods more strongly than for utilitarian goods, because the non-possession of hedonic goods inherently creates more deprivation. In addition, again there should be an effect of the elicitation method on impatience. As argued in the section above this effect should be dependent on the way impatience is measured. In choices which good to receive sooner, vividness should raise the attractiveness for hedonic goods more strongly than for utilitarian goods. When subjects determine financial compensation for the delay of these goods, vividness should affect the attractiveness of hedonic goods to a much lesser extent.

1.8.4. Individual determinants of patience

Economic theory usually regards preferences as tastes and thus as given. Due to the non- existence of a reasonable theory of preference formation, tastes should be considered as 'similar among persons and stable over time' (Stigler & Becker 1977: 76). Only recently (e.g., Becker & Murphy 1988, Becker 1996) economists have begun to explore preference formation processes in more detail. As mentioned above preferences for the timing of rewards are an important part of a person's preference set. Fortunately, sociology has something to offer with respect to its formation: while tastes for chocolate ice cream instead of banana are probably distributed and acquired randomly among a population, delay of gratification is something that has to be taught. Consequently, children generally have more difficulties to realize that they cannot have all the pleasant Intertemporal choices 29 things nicely displayed in supermarkets than do the standard (non-pathological) adult. To delay gratification is a major part of socialization, being taught mainly by parents but also by peers, institutions, such as schools or universities, and even professions. In this book the focus lies mainly on parental socialization for two reasons. First, with respect to later socialization factors it is not clear whether patience is a cause for further socialization or an effect of socialization. For example, a patient person, will be more likely to have higher educational achievements. He will be more likely to study instead of spending time on other things and more likely to value educational achievements, because they are seen as a valuable investment. This initial preference will again be reinforced by further attention of socializing institutions such as schools. Second, parental reinforcement and modeling influences children's preference formation more strongly than do other institutions (Bandura & Walters 1963). It is proposed here that parents differ in their ability to teach their children self- control. In addition, incentives and restrictions for parents to teach their children self- control differ. For example, parents with a high social status have more to lose when being blamed for misbehavior of their children than parents of low status (Coleman 1990, Cchapter 11). Hence, the former are expected to place greater value on a proper socialization. As to restrictions, parental time to teach children is reduced for single parents or when many children are present in the household. The latter reasoning is supported by results from research in areas where parental socialization is also relevant. For example, educational achievements generally are lower for children with many siblings due to limited parental resources, such as reading time or expenses (Downey 1995).

1.8.5. Outcome distance and discount rates

As stated above the relation between time delay and uncertainty has received considerable attention. It is argued here that empirical results obtained with respect to one preference dimension, e.g., risk, can in fact be applied to other preference dimensions as well, e.g., temporal delay. After a short comparison of the axioms underlying EU theory and DU theory, it will be demonstrated that the empirical regularities obtained by behavioral decision theorists apply to the outcome dimension (usually money) as well as to the distance dimension (time or risk). Then these regularities will be applied to other distance dimensions, viz. interpersonal and interspatial choice. For example, a person indifferent between $100 today and $150 in four weeks prefers the latter option when a time delay of four weeks is added to both options. Likewise, a person being indifferent between a sure win of $85 and a gamble offering $100 with a 90% chance prefers the later option, that is the higher amount, if a 30% chance of winning nothing is added to both options, i.e. the second choice is between ($85; .7) and ($100; .6). The addition of a four weeks delay is structurally equivalent to the addition of a 30% chance of winning nothing, because both alterations raise the distance of the considered options from the respective reference points (immediacy and certainty). Similar effects are expected to occur for other distance dimensions. Imagine the above-mentioned decision maker who is indifferent between $100 today and $150 in four weeks. Instead of choosing between temporally delayed outcomes adding an identical additional distance to both options should also change preference for interpersonal choices. Suppose, for example, the two amounts would be due to two persons being socially distant to varying degrees from the decision maker.

30 Chapter 1

1.9. Outline of the book

In the previous sections it has been stressed that intertemporal choices are relevant for real life decisions as well as rational choice theory. In addition, the DU-model, its accompanying anomalies, and competing models were explained in some detail. Further, a short overview of arguments used throughout this book was presented. Now, the rest of this book will be outlined briefly. Chapter 2 will test some of framing theory’s predictions concerning the effect of salience on preference and how salience depends on the choice set from which alternatives are chosen. In Chapter 3 hypotheses concerning good-specific influences on discount rates will be derived and tested experimentally. It is argued that hedonic goods are discounted more heavily than utilitarian or functional goods. In Chapter 4 it will then be investigated how a vivid presentation affects impatience for both types of goods. It will be argued that vividness raises impatience for hedonic goods more strongly when subjects have to state whether they would like to receive a hedonic or a utilitarian good sooner. For utilitarian goods vividness raises impatience more strongly when financial compensation charges have to be determined. Chapter 5 will specify how personal characteristics affect patience and how patience in turn has real consequences. It is suggested that parents differ in ability and incentives to teach their children to delay benefits. Experimental tests of these hypotheses are presented as well. Chapter 6 will compare similarities in the axiomatic systems underlying Expected Utility theory for choice under risk and Discounted Utility theory for intertemporal choices. Then the main empirical ‘anomalous’ regularities in intertemporal and risky choice will be compared and generalized to interpersonal and interspatial choice. It will be argued that decision makers compare outcomes to a multi-dimensional reference point and, due to diminishing sensitivity, discount deviations from this reference point in a similar fashion, viz. hyperbolically. Because anomalies in intertemporal choice and choice under risk are compared in this chapter there is some overlap between chapter 6 and section 1.4. in the current chapter. I am fully aware of the redundancies, but unfortunately presenting a full overview of anomalies in intertemporal choice together with a review of the main accompanying anomalies in choice under risk would mix up two different stories and therefore reduce accessibility of the text considerably. Chapter 7 will present empirical results of the generalizations of anomalies in intertemporal choice and choice under risk to interpersonal and interspatial choice. Chapter 8 will summarize and discuss the main ideas and results and present some suggestions for future research.