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