Are we Experts on Money?

Since we all deal with money daily, we could say that each of us is an expert on money.

But is it really so? Do we excel at dealing with what economists call the blood of an economy?

Despite our tremendous familiarity with money, we tend to not be fully rational and accurate when we deal with it. Here is one of the most often encountered effects on the psychology of money.

We make different judgments when it comes to gaining and respectively losing money. For example, Claude is a small scale entrepreneur who has a bit of bad luck because one of his clients paid with a bad check and disappeared after receiving the goods. The sum owed and not paid isn’t huge, say about 220 Euros, but Claude is really annoyed and rightfully so. 

What do you think Claude will do? In essence he has two major options: one is to fight to the end and recover the amount owed while the other is to simply acknowledge a loss, go on with his business and to work hard to get some more clients so that he will be able to cover his loss.

What do you think he will do?

Claude is human and very likely he will devote many hours of work and some money to recover his debt.

But is this the smartest thing to do?

Not necessarily! The time and effort invested in the attempt to recover the lost 220 Euros could be used to achieve more gains (in the form of sales) and they could amount to more than 220 Euros, maybe even 300 Euros…

In essence, Claude is willing to put in a lot of effort in avoiding a loss of 220 Euros, but not so willing to put in the same effort to achieve a gain of 300 Euros…

For more about the Psychology of Money and how it influences decisions and behaviors related to money,

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Understand Human Nature through the Pikant & Naumof Training Programs

The training progams from Pikant & Naumof are a convenient way of acquiering knowledge on what influences human behavior and how people actually make judgments, choices and decisions. This knowledge on human nature can be transformed into very powerful means of understanding, predicting and influencing human behavior, may it be the clients', co-workers', employees' potential donnors' etc.

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Designing Decisions - Choice Architecture | Psychology of Choice

The design of a choice set significantly influences the choices people make. Choice Architecture is the intentional design of a choice environment aimed at guiding choice towards one particular option. 

Using choice architecture can influence both business aspects (e.g. increasing sales and profits) and individual well-being (e.g. increasing savings rates, stimulating pro-social behavior). 
 
During the Designing Decisions training You Will Learn How to Optimize Offers, Sales and Marketing Materials. Curious?

Thinking Money - Psychology of Money

Since everyone deals with money daily, we could say that we are all experts with money. Despite our tremendous familiarity with it, we tend to think about money in particular ways that aren't necessarily optimal or rational.

The way in which we think about money strongly influences our behavior in situations that involve monetary transactions. E.g. We tend to spend more when using credit cards than when we pay in cahs. 

During the Thinking Money training program You Will Learn How your clients, colleagues etc. think about and make decisions concerning money. Curious?

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Why You Want What You Want

We like to think that our choices are entirely the result of our preferences and sometimes restrictions such as budgetary. What we do not realize is the immensely powerful influence that the choice environment has on our decisions.

Let me explain briefly when the choice environment influences our choices and why we fail to recognize / admit that it does.

Let’s see when the choice environment plays a role.

Imagine a middle aged Italian lady named Cesarina. Her entire life she drank only Illy coffee. For her any other kind of coffee is an insult to her true Italian heritage. When Cesarina goes to buy coffee from the supermarket she buys only Illy coffee. Moreover, her very strong preexisting preference makes Cesarina to be immune to all the influences of the choice environment. It doesn’t matter how the coffee aisle and the shelves are arranged, Cesarina will always buy Illy Coffee.

I gave an example when the choice environment has no influence and I am sure that you have some very strong preexisting preferences of your own. But I bet that these are not many and quite often you were in a situation of having to choose in the absence of strong and preexisting preferences.

Did you ever buy a washing machine, microwave oven, TV set, on-line services (e.g. linked in account), mobile phone, laptops, tablets, olive oil etc.?

I am sure that at least one of these things you have bought. The main question is if you knew before starting looking / shopping for the product what you wanted? Did you?

Let’s take the example of a TV-set. Which of the two scenarios is more plausible: 

A. You knowing beforehand that you wanted a 81cm diagonal TV with a resolution of 1920 x 1080 and LED technology, you ordered it and you are very happy with it. 

B.      You had a vague idea of how big it should be, you went to the store (may it be e-shop), browsed around and chose one that was not too big, not too small, within your budget and had a nice image?

If you agree that option B is more plausible, then you realize that your preference was not preexistent, but it was constructed on the spot. In this case the choice environment – the products in the store and how they were arranged and picked – significantly influenced your choice.

So, unless you have a very clear preexisting strong preference, there is a good chance that your choice is influenced by the choice environment.

Let’s see why we fail to recognize the influence of the choice environment.

Let’s continue with the TV set example and imagine that on your way to the parking lot, a very nice person stops you and asks why you picked that particular type of TV set.

Very likely you are completely unaware of the influences of the choice environment. Moreover, you might be a bit confused yourself on the things that lead to your choice. But now you have made the purchase and in order to simply feel comfortable with yourself, you come up with different reasons. For example, you might say that this TV has a large diagonal and it is decently priced, that the brand of the manufacturer is a prestigious one etc.

All of these might be true, but they had nothing to do with your choice. They are simply post-rationalizations. These are simply the explanations you give yourself for the already done action.

Another way of seeing post-rationalization is to think if these reasons would have predicted your choice before entering the store. Very likely the answer is No.

Learn Choice Architecture: How to Design
Choice Environments that Influence Choice

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Learn Dutch co. – Pikant & Naumof Case Study on Optimizing Offers

Learn Dutch co. is a small education company which provides Dutch language courses for foreigners living in The Netherlands. The courses are structured on a proficiency base, ranging from beginners basics to working proficiency. Naturally most students start from the very beginning level, namely the 10 weeks long introductory course.

Learn Dutch co. faces the following issue: out of the students who took the introductory course (10 lessons, introductory level) very few - e.g. 20% - enroll in the second module of the course (10 weeks basic level).

This is a considerable issue since most of the people who enroll in the more advanced courses are individuals who took the basics courses at the same institute – Learn Dutch co. Thus increasing the enrollment rate for the second module of the beginners course (basics) will lead to higher income now and it will create the premises for having more students for the more advanced courses too. 

The Current Situation

At this moment, Learn Dutch co. has the following approach to encouraging people who took the introductory course to enroll in the second one: at the end of the last (tenth) lesson from the introductory course, students are informed that they can enroll in the second module (basics) by filling in a form. They can also choose from five options when they want to start the second module (e.g. July, September etc.). Moreover, people who took the first course and enroll in the second module get a 10% discount on the fee for the second course.

The Pikant & Naumof Analysis from a Behavioral Perspective

Before commencing the analysis one issue should be taken into account, namely the high variety of clients that Learn Dutch co. has. The motivations people have to take Dutch lessons are highly relevant. Some clients of Learn Dutch co. are expat housewives (husbands) who want to learn Dutch so that they can better understand what is sold in supermarkets or to chat with their neighbors. Others are foreign students who want to integrate a bit better and to figure out what is going on around them. Others are expats who usually work in English speaking environments, but want to learn the local language to not be completely isolated only in the expat community.

Considering this wide array of motivations for taking Dutch language courses and the background of different categories (e.g. expats working in multinationals work long hours and travel quite frequently, students have a considerable workload and not that much money etc.) we should be prudent in our expectations on improving the enrollment rates. This is not to say that nothing can be done, but rather to be realistic in what optimization of offerings can do in the given situation. So don’t expect miracles.

With regard to the decision process of enrolling or not in the second module (beginners basic) of the Dutch language course, we have to acknowledge that many students who approach the end of the first module (beginners introductory) face some considerable ambiguity. After 8-9 lessons, one is barely acquainted with the Dutch language (which by the way is not easy to learn) and continuing with another 10 lessons is perceived as an uncertain endeavor. It is obvious for everyone that ten more lessons of Dutch will only improve one’s ability of speaking Dutch. However, many students feel that they have not made the best out of the first course, that spending another X00 Euros on the second module is not necessarily the best thing they could do with the money, that Dutch is a difficult language and the progress achieved after ten more lessons will not be satisfactory and that anyhow, one can “get away” without learning the local language since every Dutch person speaks very good English and the Dutch are in general “foreigners friendly”.

At the same time, after about nine lessons students start to understand a bit what is going on around them; they start understanding what the signs on the streets say, understand some of what is written on labels; they can have a very brief conversation with the florist or barkeeper etc. They would want to learn more, but are uncertain.

The decision to continue or not with the second module is a difficult one.

This uncertainty and ambiguity leads many students to not making a decision and going with the status quo, namely not continue with the second module.

Most interestingly, this ambiguity and uncertainty were nowhere in sight when students enrolled in the first module. Before starting the course, most students are (over) optimistic and feel / think that they will learn Dutch very fast, that they will have enough time to do their homework properly and to study on their own. This is pure optimism about the future and focalism (discarding other contextual factors that will occur in the future).

The Pikant & Naumof Behavioral Optimization of Offer

Considering the fact that most students are (overly) optimistic when they enroll for the first course and are uncertain and in doubt at the end of the first course when they have to decide whether they are going to enroll in the second course, Pikant & Naumof recommends the following:

First, eliminate from the Learn Dutch co. offer the “beginners introductory” course as an independent product.

Second, Offer the “Beginners introductory” and “Beginners basics” courses (total of 20 lessons) as one flexible product. This “combo” product should have the following characteristics.

When signing up for the beginners course, students are “by default” enrolled to continue with the second module after the first ten lessons are finished.

At the moment of enrollment students will pay only the fee for the first module (ten lessons). The payment for the second module will be done only at the end of the first module (in ten weeks from the beginning of the course).

After the first ten lessons (module one), students who are not happy with the course, or with their progress or are too busy can drop out of the second module and not pay the fee for the second module.

This Optimization should Work Because…

First, when signing up for a beginner course in Dutch (or any language) many people don’t have a clear idea of what they want to learn, more specifically they don’t have a clear picture of up to which level they should go. ... 

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Cut Costs with Paper & Ink - Behavioral Intervention Case Study

At company White a decision is made to cut down costs. One area that will be subject to cost cutting is office supplies. The office manager, Mrs. Boer, is not particularly happy with this decision, but agrees to implement it. She identifies two types of expenses that can be cut down, namely ink / toner for the printers and photocopying machines and printing paper.  

Mrs. Boer thinks of ways in which to convince her colleagues to save ink and paper. She considers writing a memo to the entire staff, telling them that in order to avoid difficulties the firm has to decrease the costs. In order to achieve this goal everyone has to make a small effort and do the following:

When printing or photocopying documents people should print in black and white since colored ink is more expensive than black one. They should also save paper by printing on both sides.

Mrs. Boer realizes that there is a good chance that her colleagues will not comply to the new requirements. She goes to the personnel management department and discusses the possibility of applying penalties for not conforming to these instructions. Finally it is agreed that some small penalties can be applied for repeated misbehavior, namely not printing in black and white and printing both sides.

Before sending the memo and making the changes to the internal code of conduct, Mrs. Boer hears about behavioral and decision sciences. She is a bit reluctant, but decides to get the advice of a specialist in these fields. Mrs. Boer contacts a behavioral specialist. She wants to get a second opinion. Naturally she wouldn’t mind if the outside view would match her approach.

The Brief Analysis from the Behavioral Perspective  

The behavioral and decision sciences specialist looks at the problem at hand and considers the following.

First, most of the times when people are printing or photocopying documents they are under time pressure or simply have other things on their minds. Making photocopies or printing is an auxiliary activity and usually it is done on auto-pilot. This implies that there is a good chance that people will simply not consider to push some extra buttons to make the printing be on both sides and in black and white.

Second, although the reason for applying these new rules on printing, namely cutting costs, is perfectly legitimate, it is not necessarily a goal that many people would be happy to strive for, accepting in the process some minor inconveniences in their work activity.

Third, trying to make people more attentive, to pay more attention when printing or making photocopies is not necessarily a good idea because this would take a piece of their brain power. It is without doubt that brain power should be preserved for the tasks that are truly important for their job performance.

The Behavioral Solution

The specialist in behavioral and decision sciences comes up with the following recommendations.

First, the goal of decreasing the consumption of paper and ink (toner) should be framed as a The White Company Going Green endeavor. Many people are more willing to pursue such a goal than they would be willing to join an effort to cut costs.

Second and most important, instead of asking people to be careful with the use of ink or toner and paper, a better solution would be to simply change the default settings of all printers and photocopying machines to print in black and white and to print on both sides. This approach is better suited to the state of mind which people have when printing and making photocopies, namely auto-pilot. Moreover, the burden of changing the setting of a printer or of a copying machine each time she or he makes uses them is eliminated.

Third, a memo will be sent by e-mail announcing the eco-friendly endeavor of saving paper and ink. In the same memo should be announced that if someone actually, really needs to print on one side or in color can still do so, by temporary changing the settings of the printers and copying machines.

The Behavioral Solution is Better

The behavioral solution has the following advantages:

First, the behavioral solution is non-intrusive since it does not add to the mental burden employees have already in a day’s work. This is advantageous because it allows people to use their cognitive resources for the truly relevant tasks a person has to solve each day.  

Second, the behavioral solution achieves the desired results with minimal costs and minimal inconveniences. The costs of applying the behavioral solution are very low. Changing the default settings of printers and photocopying machines can be done by an employee of the company, while writing and sending an electronic memo involve very little effort. Moreover, the inconvenience and discomfort of making new rules, establishing and enforcing penalties are avoided completely.

Third, the behavioral approach reframes the cost cutting endeavor into an environmental one, thus giving people a noble purpose and making the change more acceptable.

Can it be so simple?

The answer is simply: Yes! By making a minor change – resetting the default settings of the machines – can have a huge influence on human behavior. By reframing a very pragmatic goal – cutting costs – into a nobler or at least more socially acceptable one, people are more willing to accept changes and, if it is the case, minor inconveniences. Moreover, the behavioral solution still allows for free-choice, thus who really needs to print in color or on only one side can do so.

Do not apply this solution in companies or departments that actually need to print in color such as graphical design or advertising.  :)

NOTE: This case study is entirely fictional, though many companies and organizations would benefit by applying its propositions.

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The Shortcomings of Using Reciprocity in Marketing

In the past ten years there has been growing interest in using the so called weapons of influence. This term was coined by psychologist Robert Cialdini who has made a good name for himself outside academia amid the publication of his book Influence the Psychology of Persuasion.  In a nutshell, Professor Cialdini states that six major categories of means can influence behavior. These means received the name of weapons of influence and they are: (1) Reciprocity, (2) Commitment and consistency, (3) Social proof, (4) Liking, (5) Authority and (6) Scarcity.

Many pseudo-scientists who were directly interested started preaching that these means are the solution for all marketing related problems. Without denying the validity of the fact that each and every of these so called weapons of influence has an influence on decision making and on behavior, I am a skeptical when it comes to the claim that it is a must to use them in marketing. Most of my skepticism concerns the issue of which, if any, of these tools to use in a given context. Professor Cialdini has gathered a lot of knowledge on the so called weapons of influence and his book is rich in examples of using these techniques of influence, but there are no clear rules of how to apply the knowledge. I assume that the author didn’t intend to create a guide book on this, thus my critique is directed towards those who recommend head on using any or all or simply randomly picking one technique.  

A large dose of skepticism, from my part, surrounds the use of reciprocity in marketing, mainly in commercial marketing. One view is that offering free stuff, including samples and even actual products, to the actual or potential clients should trigger the mechanism of reciprocity, namely that people will buy more of the company’s products. Personally I believe that this view is deeply flawed and my critique three folded.

First, reciprocity by its very nature is a phenomenon that falls under social norms, whereas purchasing is most often a relationship that falls under market norms. You have probably heard about the study conducted by Professor Regan in which people reciprocated to the favor of receiving a coke by buying raffle tickets. This is an example that might lead to an erroneous belief that offering a gift will automatically trigger purchasing. When looking a bit more in detail, we see that the people who received a coke were asked to buy raffle tickets as a favor for the person who sells them and who is the person who offered the drink. In this case the returned favor is the act of buying and it is directed towards the person who sells tickets and not to the organizer of the raffle, in this case a high-school.

This very nature or reciprocity limits the possibilities for using it in commercial marketing. Imagine that a mail-order company sends you a package in which you find their catalog and a so called gift, say a computer mouse. There is a letter in which the company says that they hope you enjoy their gift and invite you to see if there is anything you want in their catalog.

Do you feel any sense of obligation towards the company? Do you feel that you should return the favor?

My guess is that most people don’t feel that reciprocating is appropriate. After all mail-order companies send packages to make people buy their products. It is hard to believe that sending you a computer mouse or any other so called gift is a favor that should be returned.  

What is very possible to happen is that the mere fact of receiving something would make you like more the company or might simply make you feel good. Subsequently it is possible that you would buy something from this company that you would have otherwise wouldn’t. However this is not reciprocity. You are not returning the favor of receiving a so called gift by purchasing something from this company; rather you feel good about receiving the item and subsequently order something. This is an illustration of the mood and affect heuristics influencing behavior and not a case of reciprocity. In a nutshell, if there is a purchase generated by receiving an item, it is not triggered by the reciprocity mechanism of returning a favor, but by the fact that you simply felt good that your received something.

An advocate of using reciprocity in marketing would give the example of charitable organizations that along with the letter that asks people to donate money for a good cause also send a small so called gift. Moreover, the advocate will point out that this works. The counterargument is two folded. First, it is not clear that there is anything different from the example above. People might simply feel good about receiving something, subsequently donating more money. Second and most important, the act of donating money to charities is not necessarily a commercial one. In other words, donating to a good cause is an action that falls under social norms and not market norms.

The second side of the skepticism of using reciprocity in commercial marketing is focused on the act of offering free samples or even free products. The rationale behind the practice of offering free samples is that people would try the product, like it and subsequently buy it. This, however, has nothing to do with reciprocity. Again, reciprocity is the returning of a favor and giving free samples is not a favor. There is no sense of obligation to return a favor because there was no initial favor.

The practice of offering free products has the rationale that people would buy more of the product after they have received the free one. Like in the case of free sample, this has nothing to do with reciprocity because there is no initial favor to return.

Most importantly, the practices of offering free samples or products come with a very large risk, namely the devaluation of the product. To better understand this, let’s go back to market and social norms. People are social creatures and social norms are very important and prevalent in our lives. However, people make a distinction between social and commercial relationships. If you go to a supermarket to buy groceries, there is no social element in the transaction. It is simply money in exchange for groceries. If a product is given for free, then it means that its price is zero. Subsequently any price the seller will ask later is huge. If you offer, say a magazine, for free and subsequently expect someone to pay even fifty cents for it, this will not happen. Something received for free has the price of zero and even if the seller asks only a few cents that amount is huge compared to the initial price of zero.

The third side of my skepticism on using reciprocity in commercial marketing is that it gives the possibility of free riding. With the risk of repeating, commercial transactions such as purchases in shops fall under market norms. This means that the social rules are not applicable and this includes that the fundamental norm of reciprocity, namely returning a favor, does not apply. Regardless of what is offered for free, may it be a sample, a product or even something completely unrelated such as small and usually useless gifts, it will be taken for free without anything being offered in return. Although people are not the cold thinking rational agents that Economics worships, humans are not stupid. If something can be taken for free, it will be taken. This is more the case if the part that offers something for free is not an individual, but an abstract organization or entity.

For example, in the largest supermarket network in The Netherlands – Albert Heijn – there is free coffee available for clients. The Dutch drink a lot of coffee and caffeine based drinks, so the idea is not bad. However, most of the people I have seen taking coffee for free fit the prototype of people who don’t buy too much simply because they can’t. It may very well be that for the corporation who owns these supermarkets the cost of giving free coffee is very low and any return in the form of increased purchases is covering the expense. However, my humble opinion is that this is only an opportunity for free riding.  

Let’s take a look at the up-side of using reciprocity or reciprocity-like mechanisms in commercial marketing. As you have learned up to now in both free riding and reciprocity a key role is played by the degree to which one can identify the source of the initial favor. Most people would not free ride if the free item was offered by a person who is self-employed or owns a small shop of coffee place. For example, people who go to the Bistro Chez Jacque will not take advantage of his free cookies and eat all of Jacque’s stock. However, the same people would have no problem in going to an Albert Heijn supermarket and drink all the free coffee they can without buying anything.

In a similar line of thought, if Jacque would give a drink on the house every once in a while the clients might reciprocate by leaving a larger tip. If the keeper of a small cheese shop offers his clients the possibility to taste the cheese it is likely that some of them might perceive it as a favor and reciprocate by buying a piece of cheese.   

  

The main idea is that reciprocity is a social act and in order for it to function the side that makes the initial favor must be a person and not an organization. People are going to buy an extra piece of cheese if the shop keeper offers them a free sample; this is even more likely if the shop keeper cuts the piece of cheese (the sample) in front of the customers, making it seem like he is doing it especially for them, like it is a favor. However, this is not true when the piece of cheese lies on a tray in an impersonal 5000 square-meters supermarket. Sales of cheese in supermarkets might increase by offering free samples, but people don’t buy it because they want to reciprocate. Rather they buy cheese because they were reminded that cheese should be bought or simply because buying cheese makes sense.

More impersonal entities such as web-sites or corporations can use reciprocity-like mechanisms, but these have to be in the form of clear trade-offs. One very good example comes from the Albert Heijn supermarket network. Each week some products are on sale and usually the discounts are considerable. This is nothing special since all supermarkets have weekly sales. The interesting thing about the Albert Heijn supermarkets is that the discount is given only if the client scans a barcode that is printed on the Bonus Card. This card is offered for free and usually without any long forms to be filled. This is an illustration of a clear exchange between the impersonal entity, namely the retail corporation, and the individual, namely the client. In this manner, the corporation gets what it needs, namely data to analyze and optimize their sales and the customer gets what she wants, namely the discount.

This type of clear relationship is not necessarily typical for social norms; if anything it is closer to market norms. It resembles reciprocity in the sense that it is a favor in exchange of a favor, but it is not exactly reciprocity.

Learn more on my book: It Makes (No) Sense: Between the Joy of Gaining and the Fear of Losing

Time, too, Is Relative ... Decisions about Money across Time

When I was a bachelor student, during my Economics courses, I have learned that taking a loan from the bank is equivalent with accelerating consumption. For example, if Said wants to buy a car that costs 15.000 Euros then he has two major options. First, Said can save money for a certain period of time, let’s assume three hundred Euros each month. After fifty months when the amount needed to buy a car has accumulated in his savings account, Said can go and buy the car. Taking this path, Said has one advantage and one disadvantage. The advantage is that he will pay for the car only the 15.000 Euros that represent the actual cost. The disadvantage is that for five years and two months (fifty months) Said will not have the car.

The second option Said has is to go to a bank and ask for a loan of 15.000 Euros and buy the car as soon as the loan is approved. If he follows this path, Said will have the car as soon as possible, but will have to pay across five years both the 15.000 Euros which represent the cost of the car and the cost of the credit, let’s say about 3000 Euros.

As my former Economics teacher would say, the 3000 Euros Said pays for the loan represent, in fact, a cost for having the car earlier.

Taking the car out of the picture, Said faces the following question: How much would you need to get now in order to give up 18.000 Euros in five years’ time?

In the case of Said buying a car, the answer was 15.000 Euros. However, let’s assume that you are faced with a similar question, namely what is the minimum amount you would accept now in order to give up 10.000 Euros in one year time? 

What is your honest answer? Would 8000 be enough? 9000?

From a rational point of view there is a (so called) correct answer to this. You should ask for at least 9803 Euros. This is because if you take this amount and place it in a bank deposit for one year with an interest rate of 2%, after one year you will have 10.000 Euros in your account.

However I am sure that you would have been happy with 9000 and for sure you did not compute the amount using the average interest rate for bank deposits in Euros. Don’t worry, most people ask for less than 9803 Euros and it is quite OK to do so.

You have just learned about time discounting or more accurately inter-temporal discounting. People are willing to give up a part out of a future outcome in order to get it faster. The so called correct answer to the question above, namely 9803 Euros, was obtained through a formula specific for the Discounted Utility Model. In an ideal world the discount rate would be equal to the interest rate on the financial markets. Simply put, in an ideal world, you should have a discount rate equal to the interest rate on the financial market, namely 2%. In the same ideal world, you should have asked for 9803 Euros, and then go immediately to the bank and place them in a deposit for one year, subsequently benefiting of 10.000 Euros in one year from now.

Most of the time, the discount rate is larger than the interest rate on the financial markets. For example if you would have accepted 9000 Euros now in exchange for giving up 10.000 Euros in one year time, then your discount rate would have been 10%, which is significantly larger than the interest rate for one year deposits in Euros, namely 2%.

You might wonder if this is wrong; if it is wrong to have a discount rate of 10% which is larger than the so called correct one of 2%? The answer is that it is not wrong, because the Discounted Utility model was never meant to be the correct one, or in more scientific terms the normative one. When it was proposed by Paul Samuelson in 1937 it was simply a proposition of a theoretical model. The author never claimed that it was the right model for describing or prescribing how decision over time should be made. However, this model was embraced by the scientific community and before long it gained the status of the correct model.

Let’s move away from the debate whether the Discounted Utility model is correct or not and focus on a very interesting aspect of decision making over time. Imagine that I’m asking you the following question:

What is the minimum amount you would accept now in order to give up 10.000 Euros in Four years’ time?

Would you accept 6000 Euros? Probably not… How about 7500? I think that you would be happy with this amount. Right?

The interesting thing that happens when deciding about how much we would want for giving up later rewards is that apparently we don’t hold the discount rate constant. Let me explain a bit more clearly. Let’s assume that you would accept 9000 Euros now in order to give up 10.000 in one year from now. This means that your discount rate is 10%. If we hold this rate constant, you should accept 8100 Euros in order to give up 10.000 in two years’ time. This is 10% less than 9000 Euros. Applying the same rate, you should accept 7290 Euros in order to give up 10.000 in three years’ time. Again, this is 10% less than 8100, which in turn is 10% less than 9000 – the amount you accepted in exchange for giving up 10.000 in one year time. The question was what is the minimum amount you would you accept to give up on 10.000 Euros in Four years’ time. In order to find this out we should discount again with 10% the 7290 Euros sum, leading to the amount of 6561 Euros.

However, most people would not be happy with this amount and would ask for more than 6561 Euros in order to give up on 10.000 Euros in four years’ time. My guess is that the minimum accepted amount would be higher than 6561 Euros, or at least that is what theory tells us. Probably 7500 Euros is closer to the amount you would be happy with in exchange for 10.000 Euros in four years’ time.

The key learning of this thought exercise is that close rewards are discounted more than distant once. Putting things differently, the discount you would be willing to accept in order to get the reward now instead of in 12 months is higher than the discount you would be willing to accept in order to get the reward in 12 months instead of in 24 months. This phenomenon is called hyperbolic discounting.  

For a long time, the belief was that the mechanism behind hyperbolic discounting is the decreasing discounting rates. For example if the discount rate for the first year was 10%, then the discount rate for the second year would be lower, say 7%. Similarly, the discount rate for the third year would be even lower, say 5%. Quite recently, this assumption was challenged by a study conducted by Professor Zauberman and colleagues who proved that the mechanism behind hyperbolic discounting is not the decreasing discount rates, but rather the subjective perception of time. In this study the researchers proved that when taking into account the subjective perceptions of time, the discount rate remains constant.

To better understand, let’s focus a bit on what subjective perceptions of time mean. The essence is that a time period of, say, three years is perceived subjectively different from the sum of three one year intervals. Putting this in mathematical sequence, with sp being the subjective perception, it would look like this:

sp(3 years) < sp(1 year) + sp(1 year) + sp(1 year)

According to Professor Zauberman and colleagues, the subjective perception of time explains the difference between the minimum sums accepted to give up on sooner and later rewards. This finding is in line with conclusions on subjective perceptions of other types of values. For example, prospect theory tells us that people perceive probabilities different than their actual value, except for probabilities of zero and one. Similarly the contrast effect tells us that absolute values are judged depending on reference points. According to the study by Professor Zauberman and colleagues, time makes no exception to the rule of relativity. 

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This post is documented from:

Frederick, S., Loewenstein, G. & O'Donoghue T. (2002), "Time Discounting and Time Preference: A Critical Review," Journal of Economic Literature, 40 (2), 351-401.

Zauberman, G., Kim, B.K., Malkoc, S. A., & Bettman, J. R. (2009). "Discounting time and time discounting: Subjective time perception and intertemporal preferences," Journal of Marketing Research, 46, 543-556.