Hyperbolic Discounting

Nature of hyperbolic discounting

The concept of hyperbolic discounting suggests that people tend to prefer immediate rewards
over future rewards, showing a tendency to be more impatient in the short term and more
patient over longer periods. This means that individuals apply a higher discount rate to near-
term rewards and a lower discount rate to future rewards, which leads to a phenomenon
called present bias.

The idea of alternatives to constant discounting was first introduced by Strotz in 1955. He
argued that the assumption of a constant discount rate might not hold true in real life and that
discount rates could decline over time. However, the existence of present bias alone does not
necessarily prove hyperbolic discounting, as other psychological factors might contribute to
it. For instance, Lee and colleagues (2013) suggested that the discomfort of delaying
gratification can create a sense of loss of control, leading individuals to demand higher
immediate rewards.

To better understand hyperbolic discounting, it is important to clarify key terms such as

discount rate, discount factor, per-period discount factor, and discount function.

In the standard Discounted Utility Model (DUM), the discount rate is a constant value used to
calculate the present value of future rewards. The discount factor represents the proportion by
which future utilities are multiplied to determine their current value. The per-period discount
factor is the multiplier applied to each subsequent period, and the discount function shows the
overall impact of discounting over time.

Phelps and Pollak (1968) introduced a quasi-hyperbolic function, represented as:

D(t) = 1 for t = 0 Bδ for t > 0

In this model, B is a value less than 1, meaning that individuals discount the immediate future
more heavily than later periods. If B = 1, the function reduces to the standard exponential
discounting of DUM. The value of B represents the degree of present bias, with lower values
indicating a stronger preference for immediate rewards. The model also allows for reverse
time inconsistency (RTI), where B > 1, meaning individuals might overvalue future rewards
relative to the present.

In practical terms, hyperbolic discounting provides a more accurate representation of how

people make decisions over time, as it captures their tendency to favor short-term rewards
while also planning for the future in a more rational way.

Advantages of Hyperbolic Discounting

There are two main advantages of the (β, δ) model, which are explained below:

1. Analytical tractability
This model is easy to analyze and work with, similar to the exponential discounting model. It
follows a simple pattern where, after the first period, the discount factor remains constant (δ),
just like in the exponential model. In the example shown in Figure 8.1, the values β = 0.7 and
δ = 0.98 are used to make it easier to compare with the exponential function over a ten-year
period.

2. Congruence with reality

The (β, δ) model matches real-life behavior better than the exponential model. It captures the
way people actually make decisions over time, which aligns with studies and observations.
The (β, δ) model reflects real tendencies.

Studies support the (β, δ) model by explaining common behaviors, such as:

 Gym memberships: People prefer long-term contracts even if they don’t fully use
them (Della Vigna & Malmendier, 2006).
 Homework deadlines: Setting deadlines improves grades and helps students manage
time better (Ariely & Wertenbroch, 2002).
 Credit card choices: People prefer cards with low initial interest rates rather than
lower long-term rates (Ausubel, 1999).
 Commitment savings: People willingly lock away money in savings accounts to
avoid spending (Ashraf, Karlan & Yin, 2006).
 Payday loans: Many people take payday loans and struggle to repay them (Skiba &
Tobacman, 2008).
 Retirement savings: Default settings in retirement plans greatly influence how much
people save (Madrian & Shea, 2001; Cronqist & Thaler, 2004).

These studies provide strong evidence that the (β, δ) model explains why people often
struggle with self-control and long-term planning.

Criticisms of the Hyperbolic Discounting Approach

While hyperbolic discounting is popular in behavioral economics for its real-world accuracy
and analytical convenience, it has faced several criticisms. These critiques mainly come from
two groups: defenders of the traditional Discounted Utility Model (DUM) and proponents of
newer models.

Criticisms from Defenders of the DUM

1. Failure to Use Front-End Delay

 What It Means: Many studies using the DUM overlook the initial time it takes to start
making decisions (called "front-end delay"). This can mix with transaction costs (e.g., the
effort or fees involved in making a decision).
 Example: A study might ask, “Would you rather receive $10 today or $15 in a week?”
without accounting for the time it takes to think about the decision or any effort needed to
claim the reward.
 Why It’s a Problem: Ignoring front-end delays can lead to unrealistic results, as real-life
decisions often have extra steps or costs that affect people’s choices.

2. Use of Hypothetical Rewards

 What It Means: Many studies use fake or hypothetical scenarios rather than real rewards
to test decision-making.
 Example: A participant might be asked to imagine receiving $100 now or $150 in a year,
but there’s no actual money involved.
 Why It’s a Problem: People might behave differently in hypothetical situations than they
would when real money or consequences are on the line.

3. Failure to Provide Interest Rate Information

 What It Means: Some studies don’t include clear information about interest rates, which
would help people understand the trade-offs in their decisions.
 Example: A study might ask, “Would you rather have $50 now or $100 in two years?”
without explaining the implied interest rate (in this case, 50% over two years).
 Why It’s a Problem: Without this information, people may not fully grasp how much
they’re gaining or losing by waiting, leading to less informed decisions.

Responses to These Criticisms

1. Addressing Front-End Delays and Hypothetical Rewards

 Solution: Many recent studies now use real incentives (e.g., actual money) and account
for delays or costs in decision-making.
 Why It Helps: Real rewards and costs make experiments more reflective of how people
behave in real life.

2. Interest Rates in Everyday Decisions

 Argument: While interest rates are crucial for financial decisions, they matter less in
everyday choices.
 Example: Deciding whether to eat dessert or join a gym doesn’t involve calculating
interest rates but is still a valid decision about the future.

Criticisms from Proponents of Newer Models

1. Subadditive Discounting

Subadditive discounting is a theory that explains how people value future rewards or
outcomes differently depending on the time frame they are considering. It highlights that
shorter time periods are discounted more heavily than longer ones when added together.
This behavior doesn't align with the assumptions of models like the Discounted Utility Model
(DUM), which treats time as being discounted consistently.
 Heavy Discounting for Shorter Delays: People show greater impatience for rewards or
outcomes in the near future compared to rewards in the distant future.
Example:

 Scenario 1: You are asked to choose between $10 today or $11 tomorrow. Most people
prefer $10 today because the one-day wait feels insignificant.
 Scenario 2: You are asked to choose between $100 in a year or $110 in a year and one
day. Most people choose $110, as the extra day doesn’t feel as important when added to a
long wait.
This shows how shorter time frames are "heavily discounted," while longer ones are
discounted more lightly.
 Why It’s Important: Subadditive discounting reflects how people’s impatience varies over
time, making it more accurate than the DUM in explaining real-world behaviors.

2. Lack of Psychological Foundation in Hyperbolic Discounting

 What It Means: While hyperbolic discounting (a model that assumes people value the
near future much more than the distant future) explains behaviors like procrastination,
it doesn’t explain why people act this way.
 Examples of Newer Theories:
o Psychological Discomfort: Some theories (Lee et al., 2013) argue that delaying
consumption causes discomfort, which makes immediate rewards more appealing.
o Connection to Future Self: Research (Bartels & Rips, 2010) suggests that people
feel disconnected from their future selves, so they prioritize immediate benefits
over future well-being.

Evolutionary Explanations

Some researchers also try to explain hyperbolic discounting through biological or

evolutionary mechanisms. The idea is that our ancestors needed immediate rewards for
survival, making instant gratification more important than future benefits. This is in contrast
to the exponential model, which assumes consistent discounting over time.

In summary, while hyperbolic discounting explains many real-world behaviors, it has faced
critiques about its lack of psychological grounding and ability to explain all decision-making
types. Newer models are trying to fill in these gaps, offering more detailed explanations of
why people prefer immediate rewards over delayed ones.

Modifying the Instantaneous Utility Function

In earlier discussions, various anomalies in the Discounted Utility Model (DUM) were noted,
and some of these are considered confounds in measuring time preference and discount rates.
One approach to address these anomalies is to treat them as part of the instantaneous utility
function. Below are models that attempt to modify this function.

Habit Formation Models

Habit formation models explain how past consumption influences current utility. According
to Duesenberry's (1949) hypothesis, current utility depends not only on current consumption
but also on past consumption. This relationship can be represented by a utility function where
the utility of consumption is influenced by a composite variable (Z) that reflects past
consumption levels, weighted by recency.

For example, if someone has consumed a lot in the past, they might feel more satisfied by
consuming now. This model has been applied to topics like addiction and the equity
premium puzzle. It also links to prospect theory, particularly concepts like diminishing
marginal sensitivity, which suggests that people’s responses to consumption diminish as they
consume more over time. Habit formation can be further analyzed using prospect theory,
which includes reference points (e.g., past consumption), loss aversion, and diminishing
sensitivity.
Prospect Theory Models

Prospect Theory explains how people make decisions involving risks and uncertainty. It
challenges traditional economic models by showing that people don't always behave
rationally. Here’s a simplified breakdown:

1. Reference Points

 People don’t assess outcomes based on absolute values (like the amount of money
you have). Instead, they evaluate things based on a reference point. This reference
point could be your current situation, expectations, or social comparisons.
 Example: If you get $50, it feels like a gain if you had nothing before. But if you
already have $200, $50 feels like less of a gain or even a loss.

2. Loss Aversion

 People feel losses more strongly than gains. Losing something, even if it’s small,
hurts more than gaining something of the same value.
 Example: Losing $100 feels worse than gaining $100 feels good. This makes people
avoid risks that could lead to a loss, even if the potential reward is higher than the
risk.

3. Value Function (How People Feel About Gains and Losses)

 The value function is how people mentally “value” gains and losses:
o For gains: The more you gain, the less satisfaction each additional gain provides.
(This is called diminishing returns.)
o For losses: The more you lose, the more painful each additional loss feels.
 Example: If you already won $100, winning another $50 doesn't excite you as much.
But losing $50 feels worse if you already lost $100.

4. Probability Weighting

 People don’t assess probabilities (chances of something happening) logically. They

tend to overestimate small probabilities and underestimate large ones.
 Example: People might buy a lottery ticket despite very low chances of winning
because they overvalue the small chance of winning big.

5. The Fourfold Pattern of Risk Preferences

 People act differently depending on whether they’re facing a gain or loss and whether
the probability is high or low:
o For high-probability gains: People prefer certain, smaller gains.
o For high-probability losses: People are more likely to take a risk to avoid the
loss.
o For low-probability gains: People take risks for a chance at a big win (like
buying a lottery ticket).
o For low-probability losses: People avoid risk, even if the loss is large.
In Simple Terms:

 People care more about avoiding losses than making gains.

 They evaluate things based on how they feel about changes from their current
situation, not just the absolute outcome.
 And, they misjudge probabilities, often overvaluing rare events and undervaluing
common ones.

Why It Matters:

Prospect theory helps explain behaviors like why people gamble, why they might take out
insurance, or why they are hesitant to sell investments at a loss. It shows that human
decisions are often influenced by emotions and how choices are framed, not just by rational
calculations.

In short, Prospect Theory tells us that our choices are shaped by how we feel about gains and
losses and how we perceive risks, rather than just by objective facts.

Diminishing Marginal Sensitivity

Diminishing marginal sensitivity explains how individuals become less responsive to

additional consumption as they consume more. For example, when eating, the more one
consumes in a meal, the less satisfaction (utility) each additional bite provides. This can lead
to a shifting reference point, where people expect or consume more over time to maintain the
same level of satisfaction. This can be seen in behaviors like overeating or increasing drug
dosage to experience the same effect.

Anticipatory Utility Models

Anticipatory Utility Models focus on how people gain satisfaction (or discomfort) not only
from actual consumption but also from imagining or anticipating future consumption. This
adds a psychological dimension to decision-making and helps explain some behaviors that
deviate from traditional models.

1. Delaying Pleasure: People may choose to delay a positive experience to prolong the
joy of anticipation. For example, scheduling a vacation for months later allows them
to savor the excitement of looking forward to it.
2. Rushing Negativity: For unpleasant experiences, like a medical test or an exam,
people might prefer to get it done quickly to avoid the stress and anxiety of waiting.
3. Reverse Time Preference: Anticipatory utility can lead to behaviors opposite to
normal time preferences:
o Instead of preferring immediate rewards, people might delay them to enjoy
anticipation.
o Instead of delaying unpleasant events, they might speed them up to minimize
anxiety.
4. Uncertainty and Emotions: When future outcomes are uncertain:
o Hope can make people more patient, willing to wait for a positive outcome.
o Anxiety can push them to resolve uncertainty quickly, even if it means facing a
negative outcome sooner.
Including anticipatory utility helps explain real-world behaviors, like saving, procrastination, or decisions involving long-term
planning. Anticipatory utility highlights how people value the emotions tied to waiting for future consumption. It enriches
traditional decision-making models by capturing the psychological nuances of hope, anxiety, and the timing of rewards or losses.