What Is Time Inconsistent Preferences?
Time inconsistent preferences describe a situation where an individual's preferences about future choices change over time, leading to a conflict between what they plan to do and what they actually do when the future arrives. This concept is a cornerstone of behavioral economics, a field that integrates insights from psychology into economic theory to better understand decision making. Unlike traditional economic models which often assume perfectly rational choice theory and consistent preferences over time, time inconsistent preferences acknowledge that human behavior is often influenced by short-term gratification and emotional factors.
History and Origin
The recognition of time inconsistent preferences challenged the prevailing economic models of intertemporal utility and discounting. Early theoretical work on dynamic inconsistency in economic planning was notably explored by Finn Kydland and Edward Prescott in the 1970s, particularly in the context of optimal monetary policy. However, the application of these ideas to individual consumer behavior gained significant traction with the work of economists like David Laibson and Richard Thaler. David Laibson's seminal 1997 paper, "Golden Eggs and Hyperbolic Discounting," provided a tractable model for understanding self-control problems through the lens of hyperbolic discounting, which posits that individuals tend to discount future rewards more steeply in the near term than in the distant future.4 Richard Thaler, a Nobel laureate in Economic Sciences, extensively incorporated concepts of time inconsistency into his broader work on behavioral economics, illustrating how these inconsistencies lead to common human behaviors such as procrastination and insufficient savings.3 This foundational research helped to explain why individuals often struggle with self-control and deviate from their stated long-term financial goals.
Key Takeaways
- Time inconsistent preferences refer to a shift in an individual's desired choices as time progresses, creating a mismatch between earlier plans and later actions.
- This phenomenon is a core concept in behavioral finance, highlighting deviations from purely rational economic behavior.
- A common manifestation is present bias, where immediate rewards are disproportionately valued over larger, delayed rewards.
- It impacts various financial behaviors, including saving, investment, and debt management.
- Understanding time inconsistency helps in designing interventions like commitment devices to encourage goal achievement.
Interpreting Time Inconsistent Preferences
Time inconsistent preferences are typically interpreted as a deviation from the constant rate of future discounting assumed in traditional economic models, known as exponential discounting. Instead, individuals exhibit a higher effective discount rate for choices occurring in the near future compared to those in the more distant future. This often means that while someone might rationally plan for a long-term benefit, such as increased savings for retirement planning, their preferences shift as the immediate decision point approaches, leading them to prioritize short-term consumption. The presence of time inconsistent preferences can explain why people make choices that seem suboptimal from a long-term perspective.
Hypothetical Example
Consider Sarah, who sets a financial goal to save for a down payment on a house. At the beginning of the year, she resolves to save $500 per month. Her long-term self recognizes the significant future benefit of homeownership and the power of compounding.
However, as each month ends and her paycheck arrives, her "present self" faces immediate temptations. She sees a new gadget she wants, or friends invite her on a spontaneous weekend trip. While she had initially planned to save, the immediate gratification of spending the money on the gadget or trip weighs heavily on her, overriding her earlier commitment. She decides to save only $200 that month, promising to "catch up next month." This repeated behavior, where her short-term desires consistently undermine her long-term investment strategy for saving, is a clear example of time inconsistent preferences in action.
Practical Applications
The concept of time inconsistent preferences has profound implications across various domains:
- Financial planning and Savings: This phenomenon helps explain why many individuals struggle to save adequately for retirement or other long-term goals. Understanding it has led to the development of "nudge" strategies, such as automatic enrollment in 401(k) plans, which leverage default options to encourage desired behaviors by making the "harder" choice (opting out) the active one.
- Public Policy: Governments and policymakers grapple with time inconsistency when designing regulations, particularly in areas like public health and environmental protection. Policies determined to be optimal at one point may be perceived as suboptimal when the time comes for implementation, leading to deviations.2 For instance, a government might commit to a long-term fiscal discipline, but face pressure to increase spending for short-term political gains, exhibiting time inconsistent behavior.
- Banking Regulation: The issue of time inconsistency also arises in banking. Authorities may announce a policy of not bailing out failing financial institutions to prevent moral hazard, but when a crisis materializes, the short-term desire to prevent systemic collapse might lead them to implement bailouts, despite the long-term implications for encouraging excessive risk-taking.1 This highlights the challenge of adhering to pre-announced policies when immediate pressures conflict with long-term objectives.
Limitations and Criticisms
While the concept of time inconsistent preferences offers valuable insights into human economic behavior, it also faces certain limitations and criticisms. Some argue that classifying all deviations from exponential discounting as "inconsistent" might be overly simplistic, as changing circumstances or evolving information could legitimately alter preferences over time. Additionally, the debate continues over whether such inconsistencies are truly irrational or merely reflect a complex, adaptive form of decision making that considers both immediate and future states.
A key challenge lies in distinguishing between genuine time inconsistency and other cognitive biases or external constraints. For example, a lack of self-control might manifest as time inconsistency, but it could also be influenced by fluctuating income, unexpected expenses, or simply a lack of information. Critics also point out that while the models of time inconsistency, such as hyperbolic discounting, provide a framework for understanding the problem, predicting the exact degree or nature of the inconsistency for any given individual can be difficult in practice.
Time Inconsistent Preferences vs. Present Bias
While closely related, time inconsistent preferences is the broader category, and present bias is a specific and common type of time inconsistency. Time inconsistent preferences refer to any situation where an individual's preference ordering between two options changes as the timing of the decision or outcome changes. This implies that a plan made at one point in time might not be adhered to at a later point.
Present bias, on the other hand, describes a particular form of time inconsistency where individuals place a disproportionately high value on immediate rewards compared to future rewards. This means that people are much more impatient in the short run than in the long run. For example, someone with present bias might strongly prefer $100 today over $105 tomorrow (a very high implicit discount rate for the immediate future), but would be indifferent between $100 in 30 days and $105 in 31 days (a much lower implicit discount rate for the distant future). The key distinction is that while all instances of present bias are examples of time inconsistent preferences, not all time inconsistent preferences are necessarily attributable solely to present bias; other factors could also contribute to the shift in preferences.
FAQs
What causes time inconsistent preferences?
Time inconsistent preferences are primarily caused by psychological factors, particularly the human tendency to overvalue immediate gratification and undervalue future rewards. This often manifests as hyperbolic discounting, where the perceived value of a reward drops sharply as it moves from the immediate present to the near future, but then declines more slowly over longer time horizons.
How do time inconsistent preferences affect financial decision-making?
Time inconsistent preferences can lead to suboptimal financial outcomes by causing individuals to defer beneficial actions or engage in harmful ones. This includes under-saving for retirement planning, accumulating excessive debt, procrastinating on financial planning tasks, and failing to stick to an investment strategy.
Can time inconsistent preferences be overcome?
Yes, while inherent in human psychology, the effects of time inconsistent preferences can be mitigated. Strategies include using "commitment devices" (e.g., locking funds into an account with penalties for early withdrawal), setting defaults (like automatic enrollment in savings plans), or implementing "nudges" that subtly guide individuals towards choices aligned with their long-term financial goals.