The Behavioral Economics of Discounting 1

The Behavioral Economics of Discounting

Digvijay Singh Rathore 21102075, Vishwash Shukla 21102077, Aniket Kalia 21102083,

Aryan Wazir 21102088, Saket Shubham 21102109

Punjab Engineering College, Chandigarh

Author Note

Under the guidance of Dr. Anju Singla.

The Behavioral Economics of Discounting 2

Abstract

Extending the price-quality–value model (Monroe and Krishnan in The perception of

merchandise and store quality 209–232, 1985) and means-end model (Zeithaml in J Mark 52:2–

22, 1988), we investigated the role of price discount on the perception of customers. With the

help of several research papers and web articles, we developed a conceptual model to investigate

the mediating role of the price discount effect (feeling aroused by price discounts) in the

relationship between price discounts and consumers’ perceptions (perceived savings, quality, and

value) and in the relationship between perceived value and purchase intentions in the context of

online apparel products. Since we came across the term Hyperbolic Discounting during

researching about Discounting in web articles and research, we also mentioned Hyperbolic

Discounting and the Prospect theory with its applications. The results showed that price discount

affect played an important mediating role in the relationship between price discounts and

consumers’ perceptions. When the direct effect of price discounts on perceived quality was

examined, consumers perceived the apparel product with higher discounts as lower quality (i.e.,

a negative direct relationship). However, when price discount affect served as a mediator, the

feelings created by a price discount led to a positive perception of product quality (i.e., a positive

indirect relationship). By considering the influence of price discount affect, our paper provides a

better understanding of the effect of price discounts on consumers’ perceptions of apparel

products.

Keywords: Apparel, Price discount, Quality, Affect

The Behavioral Economics of Discounting 3

Table of Contents

1. Introduction

1.1. Behavioral vs. Neoclassical Economics

1.2. Price-quality–value model and Means-end model

2. Literature review and Hypothesis Development

2.1 Effects of price discounts

2.2 Economic effects of price discounts

2.3 Informational effects of price discounts

2.4 Affective effects of price discount

2.5 Affect and perceived quality

2.6 Affect and perceived value

2.7 Mediating effect of price discount affect

2.8 Perceived savings and perceived value

2.9 Perceived Quality and Value

2.10 Perceived value and purchase intent

3. Hyperbolic Discounting

3.1 Prospect Theory

3.2 Applications

4. Conclusions
The Behavioral Economics of Discounting 4

The Behavioral Economics of Discounting

1. Introduction

A discount strategy is a pricing strategy in which a retailer offers a product at a lower

price than the regular total price for a limited period of time. It's about lowering the price of your

products and offering different offers to increase sales. In a discounting strategy, a company

temporarily lowers the cost of a product or service to bring it to market or to boost sluggish sales.

It focuses on two emotions that strongly influence behavior (Kaltcheva & Weitz 2006; Simonson

1992). However, researchers found conflicting results on the effect of discounting on perceived

product or service quality. Huang et al. (2014) and Rungtrakulchai (2013) found a positive

association. A high discount rate has led to a high perception of product quality. Garretson and

Clow (1999) found a negative relationship. A higher discount rate led to a perception of lower

quality. (1998a) found no relationship between discounts and product quality. A possible reason

for these inconsistent results is that the price-quality-value model and the means-end model

consider only the instantaneous effect of price. Nevertheless, discounts have an emotional effect

that evokes positive emotions. Shandon et al. (2000) identified hedonic benefits of price action.

This includes the unworthy self-perception of being a smart or good buyer, exploration (price

action stimulates us to explore a wide range of new fun) included. price action). Behavioral

economists take the opposite position that people, regardless of age or intelligence, are short-

sighted about what's best for them. Behavioral economics assumes irrationality in decision

making. Thus, individuals are prone to temptation and to make poor decisions, even though there

are better options for improving long-term outcomes. The resemblance to Homer Simpson

suggests that the term "Homer" economics replaces the homoeconomics of traditional economics
The Behavioral Economics of Discounting 5

when describing people (e.g., very detailed, relatively uninformed about the cost of action/use).

A keen observer of human behavior would agree that many behaviors are not rational. As a

result, students check her social media pages instead of taking notes during lectures, even though

knowledge acquisition can be lost and affect her chances of doing well in class. Teens choose

brownies over apples at lunchtime, regardless of long-term health problems. Teachers and

administrators should be empirically supported to gain student approval or expedite the

implementation of lesson plans despite lost student learning and consequent lower ratings of

educational effectiveness. deviate from the curriculum.

Below, we briefly summarize the distinction between behavioral and neoclassical

economics, then introduce the Price-Quality-Value Model and Means-end model that are the

focus of this article. The remaining sections then discuss each topic in turn.

1.1 Behavioral vs. Neoclassical Economics

Behavioral economics" is a bit of a misnomer, as all economics is concerned with how

people behave in an economic context. Behavioral economists note that standard economic

models, in their simplest form, assume that people act selfishly and rationally, taking into

account how human behavior is wrong. I often distinguish my work by (as ``economy'' or

``homo economics'') the possibilities of this model. It ignores salient features. Behavioral

economics has grown significantly from the increasing integration of psychological research into

the models used to explain or predict economic behavior. Neoclassical economics often relies on

the expected utility theory first put forward by Neumann and Morgenstern in the mid-1940s,

whereas behavioral economics reflects challenges to this model, particularly It begins with the

work of Kahnemann, Tversky, and von Thaler in the late 1970s and early 1980s. Thaler and

Mullainathan (2008) show how behavioral economists differentiate their work. They argue that
The Behavioral Economics of Discounting 6

the standard economic model has three unrealistic properties: infinite rationality, infinite

willpower, and infinite egoism. Bounded rationality recognizes that people have a limited ability

to process information, so they often solve less-than-ideal problems. Overall, we were able to

arrive at a solution in terms of heuristics or simple selection principles. Limited willpower

reflects imperfect human self-control. We can engage in unhealthy behaviors (eating and

drinking excessively, or smoking) while recognizing that such behaviors are harmful. Bounded

egoism refers to the fact that we can act altruistically. The neoclassical model is more complex

than assumed in this account and can accommodate many findings about behavior. For example,

other preferences (such as altruism and existence worth) have long been recognized in the

standard model. A significant component of behavioral economics is rejecting expected utility

theory as a decision-making model under uncertainty. Expected utility theory assumes

individuals assign utilities to results and favor the choice that maximizes the expected value of

this utility. Interestingly, Prospect Theory (Kahneman and Tversky, 1979) and related models

suggest that preferences rely on the reference point from which they are measured (with losses

valued more than gains and diminishing sensitivity with increasing distance from the reference

point) and that probabilities are assessed nonlinearly (with changes improbabilities near zero and

one more important than changes in intermediate probabilities). While some describe the

assumptions of expected utility theory as “rational” and options in contrast to that theory as

“irrational,” both models are simplifications. For the purpose of benefit-cost analysis, our goal is

to understand individual preferences over the outcomes of concern. If these preferences are

sensibly well-informed and steady, then they are useful for understanding the relative merits of

different policies regardless of whether they are consistent with standard theory or an alternative

model.
The Behavioral Economics of Discounting 7

1.2 Price-quality–value model and Means-end Model

The price-quality-value model proposed by Monroe and Krishnan (1985) and the means-

final model proposed by Zeithaml (1988) have been widely used to study the relationship

between product price and customer perceptions. I came. The price-quality-value model

describes the relationship between price, perceived quality, sacrifice, value, and willingness to

buy. In this model, price is one of the product's external characteristics that customers perceive

as a stimulus. Perceived sacrifice is a measure of the customer's insight into paying the price.

Monroe and Krishnan (1985) recommended that consumers perceive price differently. Some

people find the objective price high, while others find it low. Consumer perceptions of product

quality and financial sacrifice come from consumer perceptions of price. Although consumers

indicate that a higher price indicates a higher quality, they conclude that the higher the price, the

greater the economic sacrifice in purchasing a product. ) and perceived sacrifice (i.e. loss) leads

to perceived value. Ultimately, customers make purchase decisions based on perceived value,

and as their perception of value increases, so does their willingness to buy. Consistent with the

price-quality-value model (Monroe and Krishnan 1985), the means-end chain model proposed by

Zeithaml (1988) also explains the relationship between price, perceived quality, and perceived

value. increase. Originally proposed by Gutman (1982), a means-end chain is defined as one

consisting of an interconnected set of cognitive elements that let people select objects or

activities that enable these people to accomplish their desired goals. This approach can help

marketers understand the cognitive structure of product information that consumers retain in

their memory at a few levels of abstraction. Peter and Olson (1987) portray that a means-end

chain is a conceptual structure linking product attributes to functional and psychosocial

The Behavioral Economics of Discounting 8

consequences, and then to personal perception of value. Zeithaml (1988) proposed a means-end

model for consumers' perceptions of price, quality, and value, in which price is considered as an

extrinsic prompt of a product attribute, and price promotion can be a cue that signals quality

change. This model supports that price promotion (an extrinsic prompt of product attribute) may

influence consumers' perception of product quality (perceptions of functional and psychosocial

consequences) and consumers' perception of product quality is linked to consumers' perception

of value. The means-final model shows that price influences the perceived monetary price. The

perceived price of money affects perceived sacrifice and perceived quality. Perceived sacrifice

and perceived quality, in turn, influence perceived value and influence purchase intent.

Researchers apply the price-quality-value model (Monroe and Krishnan 1985) and the means-

end chain model (Zeithaml 1988) to account for the effect of price on customer perceptions and

the relationships proposed in these models. (Dodds et al. 1991; Palma et al. 2016; Rao and

Monroe 1989; Suri and Monroe 2003). These studies consistently show that price has a positive

impact on consumers' perception of quality. A higher price means that consumers feel the

product is of higher quality.

2. Literature review and Hypothesis Development

2.1 Effects of price discounts

Previous marketing research has shown that discounts have both positive and negative effects on

customer ratings and purchasing behavior (Darke and Dahl 2003; Dorzdenko and Jensen 2005;

Kocas and Bohlmann 2008). Ragville et al. (2004) identified her three pathways of advertising

influence: (a) economic, (b) informational, and (c) emotional. They argued that the ultimate

impact of price action on purchase decisions is a combination of positive and negative economic,

informational, and emotional influences.

The Behavioral Economics of Discounting 9

2.2 Economic effects of price discounts

The economic effects of price reductions arise from monetary gains or non-monetary (such as

time and effort) gains or losses from price campaigns aimed at customers (Raghubir et al. 2004).

The positive monetary effect of price promotions can be achieved through coupon face value or

discount amount. An example of a positive non-monetary effect is that price promotions help

simplify the customer's decision-making process and reduce transaction time and effort.

However, there is a potential negative economic impact from price fluctuations. Customers may

spend more time finding the best deals or delay purchases to wait for promotional her offers.

According to the economic effect of discounts, discounts represent monetary benefits and

provide incentives for consumers to purchase products. Consumers feel that the higher the

discount, the more they save on the product. This association has been confirmed in many

previous studies. According to Krishna et al. As the most common variable used to measure

reaction to price action. (2002) Meta-analysis. For example, perceived savings can be derived

from price promotion comparison cues (i.e., the difference between external reference and actual

prices; Berkowitz and Walton 1980), price promotion messages (e.g., percentage vs. Dollar

terms; Che et al. 1998) and flexible price demands (e.g. savings of up to 50%; Biswas and

Burton 1993; Lee and Stoel 2016). In other words, perception of savings has proven to be a

useful measure of how customers perceive price promotions. There is a positive relationship

between discounts and perceived savings. This claim is in line with price-quality-value and

means-end model. In these models, price is what the customer pays and is considered a sacrifice.

It is therefore negatively related to perceived savings. A discount, on the other hand, is a

reduction of the original price and is recognized as a profit (Monroe 2003; Munger and Grewal

2001). Therefore, it is positively associated with perceived savings. Hypothesis 1 was therefore
The Behavioral Economics of Discounting 10

proposed as follows (see Figure 1). Apparel consumers' perceived savings increase as discount

rates increase.

2.3 Informational effects of price discounts

In addition to the economic effect of discounting, discounting also has an information effect,

which can be defined as the effect resulting from direct or inferential knowledge transfer

resulting from claiming a discount (Raghubir et al. 2004). . A common information method of

advertising effectiveness is quality inference. Ragville et al. (2004) proposed a negative

relationship between discounting and perceived quality. Customers tend to conclude that

discounted products are of poor quality, especially when they receive unexpectedly large

discounts that other retailers do not typically offer. Conflicting results have been shown for the

relationship between quality and quality. Discounting can improve perceived quality (Huang et

al. 2014), reduce perceived quality (Garretson and Clow 1999), or have no effect on perceived

quality (Grewal et al. 1998a).

According to Zeithaml (1988), when it is difficult to assess the quality of a product at the

time of purchase, the consumer's perceived quality depends more on the extrinsic attributes of
The Behavioral Economics of Discounting 11

the product than on the intrinsic attributes of the product. Product extrinsic attributes are not

physical parts of the product, but cues related to the product (price, brand, advertising coverage,

etc.), and product intrinsic attributes are the physical characteristics of the product (color,

texture, etc.). Where the consumer cannot predict the quality of service prior to service. For

example, in dental services (Garretson and Clow 1999) we expect quality based on the price we

pay. Deep discounts let consumers know they may be receiving poor quality service. On the

other hand, if consumers can expect product quality (for example, Starbucks always serves the

same coffee to everyone regardless of whether price promotions are used; Huang et al. 2014),

they would be excited to receive a price promotion, and a positive evaluation would result.

In the case of online apparel shopping, it is difficult for online shoppers to examine

the apparel quality at the time of purchase because fit and textures, which are important criteria

to evaluate apparel products, are not available. Consumers would be more likely to use extrinsic

cues (e.g., price discounts) rather than intrinsic cues (e.g., fit and textures) to evaluate the quality

of apparel products; price promotion would be a strong cue to infer apparel quality online. A

high price discount may signal to online apparel shoppers that the product is of low quality. This

proposition is consistent with the price-quality–value model and means-end model, in which

price and perceived quality have a positive relationship (Monroe 2003; Sweeney et al. 1999;

Zeithaml 1988). As a discount from the original price, the discount is negatively related to

perceived quality. Therefore, Hypothesis 2 was proposed.

Hypothesis 2 Discounting adversely affects perceived quality. Consumer-perceived apparel

quality declines as discounts increase.

The Behavioral Economics of Discounting 12

2.4 Affective effects of price discount

Emotion is a term commonly used in market research to describe general categories of

emotions, including emotions and moods (Bagozzi et al. 1999). In particular, the emotional

effects of discounts are the emotions evoked by accepting or missing promotions (Raghubir et al.

2004). In the current study, price discounts influence the emotions induced by price discounts.

Emotional pathways of promotional effects can also be positive or negative. Examples of

positive affective effects include consumers' joy or excitement when they find the best bargain

(Cox et al. 2005), consumers' feeling smart or happy when they find a bargain (Peine et al.

2005). et al. 2009), or when consumers pay discounted prices (Mano and Elliott 1997). On the

other hand, consumers may regret when they miss a deal or become envious when a special offer

is only available to certain customers, such as in the UK.B. New customers (Raghubir et al.

2004). Honea and Dahl (2005) and Peine et al. (2009) found that advertising enhances positive

customer impact. B. Luck, rising. Customers were proud to be smart shoppers when they took

advantage of the offer. Schindler (1998) also found that price advertising excites and empowers

customers. According to these previous studies, discounts are expected to increase their positive

impact on consumers.

Hypothesis 3 Price cuts have a positive impact on the price cut effect. Apparel Consumer's

positive sentiment grows as the discount increases.

Influence and Perceived Savings The Influence-as-Information model (Clore et al. 2001)

suggests that emotions provide information as components of inputs to information processing

and serve as important cues to guide judgment and decision-making. suggests. ; therefore,

emotional feelings can lead to higher or lower ratings for certain objects. Although no studies

have examined the effect of influence on savings perceptions, some studies have revealed this
The Behavioral Economics of Discounting 13

relationship. Hsu and Liu (1998) investigated the role of mood in price promotions and found

that the effect of price promotion (advertised selling price) on perceived transaction value (the

evaluation of satisfaction obtained from taking advantage of the price deal) was moderated by

buyers' mood states. When encountering price promotions, buyers in a positive mood will

perceive a greater transaction value than buyers in a negative mood, indicating that positive

affect has a positive influence on consumers' perception of price deal and therefore may

positively influence perceived savings. Heussler et al. (2009) examined the effect of affect on

perceived price fairness and found that positive emotions could compensate for the negative

impact of price increases on perceived price fairness, indicating that positive affect has a positive

influence on consumers' perceptions of price change and therefore may positively influence

perceived savings. According to the affect-as-information model and the above studies,

consumers who have greater positive affective feelings aroused by a price discount are expected

to perceive a greater amount of savings.

Hypothesis 4 The effect of discounting has a positive impact on perceived savings. Apparel

consumers' thrift consciousness increases as the price reduction effect increases.

2.5 Affect and perceived quality

Informative influence models (Clore et al. 2001) can also support the influence of

affective feelings on consumer perceptions of product quality. Consumers use her emotions as

inputs to information processing when evaluating product quality. O'Neill and Lamber (2001)

found that price effects positively influence price-quality inferences. Participants who were

satisfied with the price of athletic shoes strongly believed that higher price indicates higher

quality. Chebat et al. (1995) studied the effect of influence on perceptions of service quality in
The Behavioral Economics of Discounting 14

banks and also found that higher satisfaction was associated with higher levels of service quality

perceived in staff empathy and safety. Kempf (1999) investigated the role of emotion in

evaluating hedonic product tests and found that emotional responses such as pleasure and arousal

were important predictors of participants' ratings of the testing experience. Applying this

research to apparel discounts, consumers who experience more of the positive impact of price

cuts are expected to perceive higher product quality.

Hypothesis 5 The effect of discounting has a positive impact on perceived quality. Apparel

consumers are more aware of product quality as discounts increase.

2.6 Affect and perceived value

Perceived value is generally the value a product has in the mind of the consumer.

Sweeney and Soutar (2001) explored the structure of value creation and identified her factors of

perceived value: quality, emotional value, price, and social value. The authors considered quality

and emotion as sub-dimensions of perceived value. However, in current research, perceived

value refers only to the price dimension of perceived value. This is because most pricing studies

define value as the value of money and use perceived value as a separate component from

perceived quality and emotion (eg, B. Dumana and Mattilab). 2005; Hsee and Rottenstreich

2004; Teas and Agarwal 2000). Current research suggests that price discount effects positively

affect the price dimension of perceived value identified by Sweeney and Soutar (2001). In

market research, the most commonly used theoretical models to study the relationship between

price and perceived value, such as the Price-Quality-Value model (Monroe and Krishnan 1985)

and the Means-End model (Zeithaml 1988), are cognitive approach. However, Holbrook and

Hirschman (1982) argued that most people are naturally pleasure seekers. In many situations
The Behavioral Economics of Discounting 15

where consumers make purchase decisions, they seek emotional benefits such as arousal,

excitement and stimulation. In addition to emotional models (Clore et al. 2001) as information

that can support the impact of emotions on perceptual value, emotion heuristics also support the

importance of emotions in perceptual value. Emotional heuristics (Slovic et al. 2007) suggest

that emotions can be used as mental shortcuts to help people make decisions and solve problems

quickly and efficiently. In relation to discounting, Aydinli et al. (2014) found that price

advertising reduces consumers' motivation to engage in mental exertion. When offered price

promotions, consumers rely on influence rather than extensive information processing (time

spent reviewing product information and choices) to make purchasing decisions faster and easier.

Previous studies supported the effect of impact on perceived value (Dumana and Mattilab 2005;

Hsee and Rottenstreich 2004). Dumana and Mattilab (2005) found that emotional factors

(pleasure and pleasure) were strongly associated with cruise travelers' values . Hsee and

Rottenstreich (2004) found that people who rely on their emotions for valuation are sensitive to

the presence or absence of stimuli (such as discounts) but insensitive to further changes in range

(such as sentences). discovered. Participants who were encouraged to judge value by feel were

willing to pay more for a 5-CD set than those who were encouraged to judge value by

calculation. . However, for the 10-CD set, participants encouraged to rate by feel were less

sensitive to the number of CDs available in the set and were more likely to rate by feel than

participants encouraged to rate by feel. I was proactive in increasing the value by evaluating

what supported that feeling. Role in perceived value. Informative influence models (Clore et al.

2001), influence heuristics (Slovic et al. 2007), and previous studies (Aydinli et al. 2014;

Dumana and Mattilab 2005; Hsee and Rottenstreich 2004) found that the positive We recognize

that the more effective apparel consumers are, the higher the cost performance.
The Behavioral Economics of Discounting 16

Hypothesis 6 Discounting effects have a positive impact on perceived value. Apparel More

discounts increase consumer perception of value.

2.7 Mediating effect of price discount affect

From Hypothesis 3 to Hypothesis 6, we examined the relationship between discounting and

discounting effect (H3), discounting effect and perceived savings (H4), discounting effect and

perceived quality (H5), and discounting effect and perceived value (H6). Hypothesis 7 was

proposed to examine the mediating effect of price discount effects on the relationship between

price discounts and three cognitive ratings (i.e., perceived savings, perceived quality, and

perceived value). . Previous studies have shown that consumer emotions evoked by external

stimuli influence cognitive appraisals (Isen et al. 1978; Obermiller and Bitner 1984; O'Neill and

Lamber 2001). In situations where information is limited, e.g., online shopping, emotional

responses are more likely to influence consumer decisions than cognitive responses (Shiv and

Fedorikhin 1999; Zeithaml 1988). . Consumers first respond to emotional responses as sub-

cognitive responses, and then consumer cognitive responses are influenced by emotional

responses (Campbell 2007; Shiv and Fedorikhin 1999; Zeithaml 1988). Furthermore, Zeithaml

(1988) argued that there are two forms of perceived quality: affective quality and cognitive

quality. Emotional quality is associated with temporary and experiential goods, whereas

cognitive quality, which requires a higher level of cognitive judgment, is associated with durable

and searchable goods. increase. As apparel is a durable and visible commodity, consumers are

more likely to judge product quality on their emotional state. The impact will affect their

cognitive ratings.
The Behavioral Economics of Discounting 17

According to these previous studies, price discounting in the context of online clothing shopping

in the current study was expected to increase positive impact, and increased positive impact was

associated with positive cognitive appraisals (i.e., perceived savings, perceived quality, and

perceived value). Therefore, discount effect is proposed as a mediator between (a) discount and

perceived savings, (b) discount and perceived quality, and (c) discount and perceived product

value.

Therefore, Hypothesis 7 was proposed as follows. Price reductions increased the positive impact

of apparel consumers, and this increased positive impact resulted in (a) perceived savings, (b)

perceived quality, and (c) consumers' Increased perceived value.

2.8 Perceived savings and perceived value

The price-quality-value model and means-end model propose that the trade-off between

perceived quality and perceived sacrifice (the perception of paying the cost) leads to perceived

value (Monroe and Krishnan 1985). Thus, there is a negative relationship between perceived

sacrifice and perceived value, and a positive relationship between perceived savings and

perceived value. Results from previous studies support these associations. Grewal et al. (1998b)

and Teas and Agarwal (2000) found that the higher the level of sacrifice perceived, the lower the

level of perceived value. Choye et al. (2010) investigated discounts and “scratch and save” type

price promotions and found that expected savings had a positive impact on perceived value.

Hypothesis 8 Perceived savings have a positive impact on perceived value. Consumer apparel

perception of value increases as perception of savings increases.

The Behavioral Economics of Discounting 18

2.9 Perceived Quality and Value

The price-quality-value model (Monroe and Krishnan 1985) and means-end model (Zeithaml

1988) show that perceived quality can directly affect perceived value. Results from previous

studies support a positive relationship between perceived quality and perceived value. For

example, Teas and Agarwal (2000) found that the relationship between price and perceived value

is mediated by perceived quality. Perceived quality directly impacts consumer perceived value.

Grewal et al. (1998b) also found a positive association between buyers' perceived quality and

perceived value. According to the price-quality-value model, the means-end model, and these

previous studies, the following hypotheses were proposed. Consumers' perception of value for

apparel increases as perceived quality improves.

2.10 Perceived value and purchase intent

Studies have also confirmed this association (Kwon et al. 2007; Yang and Peterson 2004). Yang

and Peterson (2004) investigated online shopping behavior and found a positive effect of

perceived value on online shopper loyalty. Kwon et al. (2007) examined the mediating role of

perceived value in the association between team identification and intent to purchase team-

licensed apparel. Did. Perceived value perfectly mediated this relationship, supporting the

importance of the impact of perceived value on purchase intention. Therefore, we made the

following hypothesis.

Hypothesis 10 Perceived value positively influences purchase intention. Garment consumers are

more likely to buy when their perceived value increases.

The Behavioral Economics of Discounting 19

3. Hyperbolic Discounting

Hyperbolic discount functions induce dynamically inconsistent preferences, implying

a motive for consumers to constrain their own future choices. This paper analyzes the decisions

of a hyperbolic consumer with access to an imperfect commitment technology: an illiquid asset

whose sale must be initiated one period before the sale proceeds are received. The model predicts

that consumption tracks income, explaining why consumers have asset-specific marginal

propensities to consume. The model suggests that financial innovation may have caused the

ongoing decline in U. S. savings rates, since financial innovation increases liquidity, eliminating

commitment opportunities. Finally, the model implies that financial market innovation may

reduce welfare by providing “too much” liquidity

“Use whatever means possible to remove a set amount of money from your bank

account each month before you have a chance to spend it”

—advice in New York Times “Your Money” column [1993].

Many people place a premium on the attribute of self-control. Individuals who have

this capacity are able to stay on diets, carry through exercise regimens, show up to work on time,

and live within their means. Self-control is so desirable that most of us complain that we do not

have enough of it. Fortunately, there are ways to compensate for this shortfall. One of the most

widely used techniques is commitment. For example, signing up to give a seminar is an easy way

to commit oneself to writing a paper. Such commitments matter since they create constraints

(e.g., deadlines) that generally end up being binding. Strotz [1956] was the first economist to

formalize a theory of commitment and to show those commitment mechanisms could be

potentially important determinants of economic outcomes. He showed that when individuals’

The Behavioral Economics of Discounting 20

discount functions are non-exponential, they will prefer to constrain their own future choices.

Strotz noted that costly commitment decisions are commonly observed. we are often willing

even to pay the price to pre-commit future actions (and to avoid temptation). Evidence of this in

economic and other social behavior is not difficult to find. It varies from the gratuitous promise,

from the familiar phrase “Give me a good kick if I don’t do such and such” to savings plans such

as insurance policies and Christmas Clubs which may often be hard to justify in view of the low

rates of return. (I select the option of having my annual salary dispersed to me on a twelve-

rather than on a nine-month basis, although I could use the interest!) Personal financial

management firms, such as are sometimes employed by high-income professional people (e.g.

actors), while having many other and perhaps more important functions, represent the logical

conclusion of the desire to commit one’s future economic activity. Joining the army is perhaps

the supreme device open to most people unless it is marriage for the sake of “settling down.” The

worker whose income is garnished chronically or who is continually harassed by creditors, and

who, when one oppressive debt is paid, immediately incurs another is commonly

precommitment. precommitment irrational about such behavior (quite the contrary) and attempts

to default on debts is simply the later consequences that are to be expected. The inability to

default is the force of the commitment. Strotz’s list is clearly not exhaustive. In general, all

illiquid assets provide a form of commitment, though there are sometimes additional reasons that

consumers might hold such assets (e.g., high expected returns and diversification). A pension or

retirement plan is the clearest example of such an asset. Many of these plans benefit from

favorable tax treatment, and most of them effectively bar consumers from using their savings

before retirement. For IRAs, Keogh plans, and 401(K) plans, consumers can access their assets,

but they must pay an early withdrawal penalty. Moreover, borrowing against some of these
The Behavioral Economics of Discounting 21

assets is legally treated as an early withdrawal, and hence also subject to penalty. A less

transparent instrument for commitment is an investment in an illiquid asset that generates a

steady stream of benefits, but that is hard to sell due to substantial transactions costs,

informational problems, or incomplete markets. Examples include purchasing a home, buying

consumer durables, and building up equity in a personal business. Finally, there exists a class of

assets that provide a store of illiquid value, like savings bonds, and certificates of deposit. All of

the illiquid assets discussed above have the same property as the goose that laid golden eggs. The

asset promises to generate substantial benefits in the long run, but these benefits are difficult, if

not impossible, to realize immediately. Trying to do so will result in a substantial capital loss.

Instruments with these golden eggs properties make up most assets held by the U. S. household

sector. For example, the Federal Reserve System publication Balance Sheets for the U. S.

Economy 1945–94 reports that the household sector held domestic assets of $28.5 trillion at

yearend 1994. Over two-thirds of these assets were illiquid, including $5.5 trillion of pension

fund and life insurance reserves, $4.5 trillion of residential structures, $3.0 trillion of land, $2.5

trillion of equity in the noncorporate business, $2.5 trillion of consumer durables, and at least $1

trillion of other miscellaneous categories. Finally, note that social security wealth and human

capital, two relatively large components of illiquid wealth, are not included in the Federal

Reserve Balance Sheets. Despite the abundance of commitment mechanisms, and Strotz’s well-

known theoretical work, intrapersonal commitment phenomena have generally received little

attention from economists. This deficit is probably explained by the fact that commitment will

only be chosen by decision-makers whose preferences are dynamically inconsistent, and most

economists have avoided studying such problematic preferences. However, there is a substantial

body of evidence that preferences are dynamically inconsistent. Research on animal and human
The Behavioral Economics of Discounting 22

behavior has led psychologists to conclude that discount functions are approximately hyperbolic

[Ainslie 1992]. Hyperbolic discount functions are characterized by a relatively high discount rate

over short horizons and a relatively low discount rate over long horizons. This discount structure

sets up a conflict between today’s preferences, and the preferences that will be held in the future.

For example, from today’s perspective, the discount rate between two far-off periods, t and t + 1,

is the long-term low discount rate. However, from the time t perspective, the discount rate

between t and t + 1 is the short-term high user discount rate. This type of preference change is

reflected in many common experiences. For example, this year I may desire to start an

aggressive savings plan next year, but when next year actually rolls around, my taste at that time

will be to postpone any sacrifices another year. In the analysis that follows, the decisionmaker

foresees these conflicts and uses a stylized commitment technology to partially limit the options

available in the future. This framework predicts that consumption will track income. Second, the

model explains why consumers have a different propensity to consume out of wealth than they

do out of labor income. Third, the model explains why Ricardian equivalence should not hold

even in an economy characterized by an infinitely lived representative agent. Fourth, the model

suggests that financial innovation may have caused the ongoing decline in U. S. savings rates,

since financial innovation increases liquidity and eliminates implicit commitment opportunities.

Finally, the model provides a formal framework for considering the proposition that financial

market innovation reduces welfare by providing “too much” liquidity.

The Behavioral Economics of Discounting 23

3.1 Prospect Theory

The Model The original version of prospect theory is described in Kahneman and

Tversky (1979). While this paper contains all of the theory’s essential insights, the specific

model it proposes has some limitations: it can be applied to gambles with at most two non-zero

outcomes, and it predicts that people will sometimes choose dominated gambles. In 1992,

Kahneman and Tversky published a modified version of their theory known as “cumulative

prospect theory” which resolves these problems. The theory describes the decision processes in

two stages:

● During an initial phase termed editing, outcomes of a decision are ordered according to a

certain heuristic. In particular, people decide which outcomes they consider equivalent,

set a reference point and then consider lesser outcomes as losses and greater ones as

gains. The editing phase aims to alleviate any framing effects. It also aims to resolve

isolation effects stemming from individuals' propensity to often isolate consecutive

probabilities instead of treating them together. The editing process can be viewed as

composed of coding, combination, segregation, cancellation, simplification and detection

of dominance.

● In the subsequent evaluation phase, people behave as if they would compute a value

(utility), based on the potential outcomes and their respective probabilities, and then

choose the alternative having a higher utility.

In cumulative Prospect theory the weighting function is applied to cumulative

probabilities – for example, to the probability of gaining at least $100, or of losing $50 or more.

For the purposes of understanding the applications I describe later, the main thing the reader

needs to know about probability weighting is that it leads the individual to overweight the tails of
The Behavioral Economics of Discounting 24

any distribution – in other words, to overweight unlikely extreme outcomes. Kahneman and

Tversky infer this, in part, from the fact that people like both lotteries and insurance – they prefer

a 0.001 chance of $5,000 to a certain gain of $5, but also prefer a certain loss of $5 to a 0.001

chance of losing $5,000 – a combination of behaviors that is difficult to explain with expected

utility. Under cumulative prospect , the weighting function is applied to cumulative probabilities

– for example, to the probability of gaining at least $100, or of losing $50 or more. For the

purposes of understanding the applications I describe later, the main thing the reader needs to

know about probability weighting is that it leads the individual to overweight the tails of any

distribution – in other words, to overweight unlikely extreme outcomes. Kahneman and Tversky

infer this, in part, from the fact that people like both lotteries and insurance – they prefer a 0.001

chance of $5,000 to a certain gain of $5, but also prefer a certain loss of $5 to a 0.001 chance of

losing $5,000 – a combination of behaviors that is difficult to explain with expected utility.

Under cumulative prospect theory, the unlikely state of the world in which the individual gains

or loses $5,000 is overweighted in his mind, thereby explaining these choices. More broadly, the

weighting function reflects the certainty equivalents people state for gambles that offer $100,

say, with probability P . For example, in an experimental study by Gonzalez and Wu (1999),

subjects state an average certainty equivalent of $10 for a 0.05 chance of $100, and $63 for a 0.9

chance of $100. These findings motivate the overweighting of low tail probabilities and the

underweighting of high tail probabilities, respectively. Kahneman and Tversky emphasize that

the transformed probabilities P do not represent erroneous beliefs; rather, they are decision

weights. In the framework of prospect theory, someone who is offered a 0.001 chance of winning

$5,000 knows exactly what it means for something to have a 0.001 probability of occurring;

however, when evaluating the gamble, this person weights the $5,000 by more than 0.001.
The Behavioral Economics of Discounting 25

3.2 Applications

Prospect theory is primarily a model of decision-making under risk. Areas where risk

attitudes play a central role, such as finance and insurance, are therefore the most obvious places

to look for applications. We therefore begin by discussing efforts to integrate prospect theory

into these two areas, and then turn to other areas of economics.

Finance – Finance is the area of economics where prospect theory is most actively

applied. In this area of research, he primarily applies prospect theory in three contexts. 2) Total

Stock Market. 3) trading financial assets over time; We will take these in order. Why are the

average yields of some securities higher than others? The most popular framework for thinking

about this question is the famous Capital Asset Pricing Model (CAPM). This model is usually

derived under the assumption that investors value risk by expected returns, and is used for

securities with higher "betas", i.e., securities whose returns are more closely correlated with the

overall market return. says it should. It has a higher average return. Unfortunately, this prediction

has not received much empirical support (in this journal, Fama and French 2004). According to

the Prospect Theory, there exist a variety of factors that will lead people to make irrational

decisions. A clear understanding of the reason why and under what conditions people tend to

behave irrationally is useful in improving existing services and designing new services.
The Behavioral Economics of Discounting 26

4. Conclusions

In a discounting strategy, a company temporarily lowers the cost of a product or service

to bring it to market or to boost sluggish sales. However, researchers found conflicting results on

the effect of discounting on perceived product or service quality. A high discount rate has led to

a high perception of product quality. A higher discount rate led to a perception of lower quality.

Research found no relationship between discounts and product quality. A possible reason

for these inconsistent results is that the price-quality-value model and the means-end model

consider only the instantaneous effect of price. Behavioral economists take the opposite position

that people, regardless of age or intelligence, are short-sighted about what's best for them.

Behavioral economics assumes irrationality in decision-making.

The resemblance to Homer Simpson suggests that the term "Homer" economics replaces

the home economics of traditional economics when describing people (e. g. , very detailed,

relatively uninformed about the cost of action/use). Below, we briefly summarize the distinction

between behavioral and neoclassical economics, then introduce the Price-Quality-Value Model

and Means-end model that are the focus of this article.

Behavioral economists note that standard economic models, in their simplest form,

assume that people act selfishly and rationally, considering how human behavior is wrong.

Neoclassical economics often relies on the expected utility theory first put forward by Neumann

and Morgenstern in the mid-1940s, whereas behavioral economics reflects challenges to this

model, particularly It begins with the work of Kahnemann, Tversky, and von Thaler in the late

1970s and early 1980s. They argue that the standard economic model has three unrealistic

properties: infinite rationality, infinite willpower, and infinite egoism. Bounded rationality
The Behavioral Economics of Discounting 27

recognizes that people have a limited ability to process information, so they often solve less-

than-ideal problems.

The neoclassical model is more complex than assumed in this account and can

accommodate many findings about behavior. A significant component of behavioral economics

is rejecting expected utility theory as a decision-making model under uncertainty.

The Behavioral Economics of Discounting 28

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