What Is Time Inconsistency?
Time inconsistency refers to a situation in which a decision-maker's preferences change over time, in a way that future decisions contradict earlier plans. This concept is a core idea within behavioral economics, a field that integrates insights from psychology and economics to explain real-world human behavior. Essentially, an individual might make a plan for the future, believing it is the optimal course of action, but when that future arrives, they deviate from the plan due to a shift in their preferences. This deviation often stems from a greater emphasis on immediate gratification compared to long-term benefits. Time inconsistency highlights a fundamental challenge to the traditional economic assumption of perfectly rational agents with stable preferences.
History and Origin
The concept of time inconsistency gained prominence with the work of economists Finn Kydland and Edward Prescott. In their seminal 1977 paper, "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," they demonstrated how optimal policies announced by a government could become inconsistent over time, leading to suboptimal outcomes if economic agents formed rational expectations5, 6. Their work challenged the conventional rational choice theory by illustrating that even with perfect information and a desire to maximize a social objective function, a discretionary approach to policy could lead to a less favorable outcome than adhering to pre-announced rules. This foundational research, which later earned them a Nobel Memorial Prize in Economic Sciences, laid the groundwork for understanding how shifting preferences can undermine long-term plans not just in policymaking, but also in individual financial decision-making.
Key Takeaways
- Time inconsistency describes a situation where an individual's preferences change over time, leading to a conflict between a plan made in the past and a decision made in the present.
- It often arises from a stronger preference for immediate gratification (present bias) over future rewards, even if the long-term benefit is greater.
- This behavioral phenomenon can significantly impact personal financial planning, such as saving for retirement or sticking to a budget.
- Understanding time inconsistency helps explain why people might struggle with self-control when faced with choices between immediate pleasure and future well-being.
- Strategies like commitment devices can be used to mitigate the negative effects of time-inconsistent preferences.
Interpreting Time Inconsistency
Time inconsistency is often interpreted through the lens of specific cognitive biases, primarily present bias and hyperbolic discounting. Present bias refers to the tendency to overvalue immediate rewards compared to future rewards. Hyperbolic discounting is a more specific form of present bias where the discount rate applied to future payoffs is higher for near-term delays than for delays further in the future.
For example, an individual might heavily discount a reward one week away versus two weeks away, but show less difference in discounting between a reward 52 weeks away versus 53 weeks away. This disproportionate emphasis on the very near future can lead to inconsistencies in choices as time progresses and the "future" reward becomes "present." Consequently, actions aimed at maximizing long-term utility maximization may be abandoned for immediate, less optimal choices.
Hypothetical Example
Consider an individual, Sarah, who sets a goal to increase her savings rate for retirement planning. At the beginning of the month, she rationally decides that to achieve her long-term financial security, she will save $500 from her paycheck. However, when her paycheck arrives mid-month, she sees a sale on a new high-definition television that costs $300.
From her perspective at the beginning of the month, the future benefit of retirement savings (financial security, comfort in old age) was clearly more important than an immediate purchase. However, when the paycheck is in hand and the television is immediately available, the present desire for entertainment overrides her earlier, rational commitment to saving. She might tell herself, "I'll save more next month," but this is a classic example of time inconsistency, as her preference for the TV in the present moment contradicts her earlier plan for future savings, demonstrating a lapse in self-control.
Practical Applications
Time inconsistency has numerous practical applications across finance, public policy, and individual behavior. In personal finance, it helps explain why individuals often struggle with long-term goals like saving for retirement, paying off debt, or investing consistently. Many people intend to save more or spend less, but when faced with immediate temptations, they deviate from their plans. This has led to the development of commitment devices, such as automatic enrollment in 401(k) plans, or contracts where individuals face penalties for not sticking to their goals.
In public policy, understanding time inconsistency is crucial for designing effective interventions. For instance, policies regarding taxes, healthcare, and environmental protection often face challenges because the immediate costs outweigh the deferred benefits for individuals. Governments and policymakers, recognizing this, may implement "nudge" strategies or default options to guide consumer behavior towards more beneficial long-term outcomes4. The Federal Reserve Bank of St. Louis has published insights into how behavioral economics, including concepts like time inconsistency, can inform public policy decisions, such as those related to retirement savings3.
Limitations and Criticisms
While time inconsistency offers a powerful lens through which to understand human behavior, it is not without limitations or criticisms. Some economists argue that models based on time inconsistency may overemphasize irrationality, suggesting that seemingly inconsistent choices might actually reflect rational responses to changing information or circumstances. Traditional economic models are built on the assumption of stable preferences, and while behavioral economics challenges this, critics sometimes question the degree to which preferences truly "change" versus simply being revealed differently under varying circumstances.
Furthermore, identifying and measuring time inconsistency can be complex, as it requires distinguishing genuine preference shifts from rational responses to new information or unforeseen events. The insights from behavioral economics, including time inconsistency, have been widely adopted, but some still debate their novelty, suggesting that businesses have intuitively understood many of these behavioral quirks for decades2. Despite these debates, the concept provides a valuable framework for understanding divergences from purely rational financial decision-making1.
Time Inconsistency vs. Procrastination
While often appearing similar in their effects, time inconsistency and procrastination are distinct concepts. Time inconsistency refers to a shift in preferences over time, where a plan made for the future is abandoned when that future becomes the present, typically due to a stronger pull of immediate gratification. It implies a fundamental change in the valuation of outcomes at different points in time. For example, intending to save for retirement but then spending the money on a vacation because the vacation is suddenly valued more.
Procrastination, on the other hand, is the delay of an intended action despite knowing it would be better to complete it sooner. It often involves a failure to initiate a task or decision, often due to aversiveness to the task itself, rather than a preference reversal. While time inconsistency can lead to procrastination (e.g., continually postponing savings because immediate consumption is always preferred), procrastination doesn't necessarily imply a change in underlying preferences, but rather a failure of execution.
FAQs
Q: Can time inconsistency be overcome?
A: While inherent human tendencies like impulse control can make it challenging, time inconsistency can be mitigated. Strategies like commitment devices (e.g., pre-committing to a savings plan), setting default options (like automatic enrollment), and utilizing tools that make future rewards more salient can help individuals align their present actions with their long-term goals.
Q: Is time inconsistency always irrational?
A: From a traditional economic perspective that assumes stable preferences, it is considered irrational. However, behavioral economics acknowledges that human preferences are not always static and that the context or the passage of time can genuinely alter how individuals value different outcomes. The challenge lies in distinguishing between a preference reversal that leads to better overall well-being and one that leads to suboptimal outcomes.
Q: How does time inconsistency relate to discounting?
A: Time inconsistency is closely related to how individuals discount future rewards. While traditional economic models use a constant discount factor, behavioral economics, particularly through hyperbolic discounting, suggests that people discount immediate future rewards much more steeply than rewards further in the future. This non-constant discounting is what drives the inconsistency.