Lecture 13 - Time Inconsistency Model and Consumer Behavior

Key Topics

• Real-world applications of the time inconsistency model

• Savings behavior versus borrowing: The time inconsistency model emphasizes how present-biased preferences lead individuals to prioritize immediate reward over long-term benefits, which significantly impacts their savings behavior and borrowing decisions.

• Procrastination and commitment strategies: Procrastination often results from time inconsistency, and various commitment strategies can help individuals overcome this tendency and adhere to their long-term financial goals.

Credit Card Borrowing Puzzle

• Observation: Many individuals exhibit counterintuitive behavior by borrowing on high-interest credit cards while simultaneously maintaining savings accounts that yield lower interest rates. This behavior is puzzling given standard economic theories that suggest individuals should minimize costly debt while maximizing savings interest.

• Data from 2022:

  • Total US credit card debt: $982 billion, indicating a significant reliance on credit.

  • 5% of disposable income is directed towards repaying debt, while the savings rate stands at 12% of disposable income, reflecting a discrepancy between debt repayment and saving behavior.

• Economic Questions: This scenario prompts an exploration into why individuals would borrow at high interest rates while being able to save at lower rates, which fundamentally contradicts the expectations from traditional economic models that assume rational behavior.

Quadratic Discounting Model Analysis (Laibson et al. 2007)

• Consumer Behavior: Evidence shows that consumers borrow for immediate needs, such as purchasing new technology (e.g., smartphones) yet aim to save for long-term objectives, such as down payments on homes.

• Model Fit: The parameters identified in consumer behavior modeling include:

  • Short-term discount factor: \beta = 0.90, indicating a stronger inclination towards present consumption.

  • Long-term discount factor: \delta = 0.96, revealing a consistent valuing of future savings.

• Discount Rates Calculated:

  • Short-term discount rate calculated at 14.6%, demonstrating a substantial penalty for borrowing costs.

  • Long-term discount rate measured at 4.1%, representing the more realistic appreciation of future savings.

Reasoning Behind Saving and Borrowing

• Consumer Preference: Despite intentions to save toward long-term goals, consumers often succumb to short-term desires due to immediate gratification, resulting in decisions that yield lower overall financial gains.

• Debt Acceptance: The inclination to incur debt can be partly attributed to the higher attractiveness of immediate benefits represented by the short-term discount rate of 14.6%, which surpasses the advantages of saving for future goals yielding 5%.

Exploiting Time Inconsistency

• Behavioral Insight: Present-biased individuals are prone to procrastination, which leads to financial behaviors that are not aligned with their long-term interests. This insight can be leveraged by companies and policymakers to design financial products that better cater to these consumers' needs, thus facilitating better financial outcomes.

• Examples: Effective examples of products designed to help consumers commit to their saving plans are commitment savings accounts, which restrict access to funds until specific financial goals are met.

DellaVigna and Malmendier (2006) - Gym Attendance Study

• Research Overview: This study examined data from 7,000 health club members between 1997-2000, aiming to uncover the relationship between gym membership contracts and actual attendance patterns.

  • Payment options analyzed:

  • Pay per visit: $12 each

  • Flexibility of paying $100 for 10 visits

  • Monthly contract at $85 provides flexibility

  • Annual membership at $850 offers long-term commitment yet restricts access.

• Contract Structure Analysis: The structure of contracts becomes pivotal in consumer choice, where monthly contracts often default customers into higher expenses but allow flexibility, while annual contracts require opting-in and entail greater commitment.

Standard Economic Model Insights

• Behavioral Predictions: The standard economic model suggests that consumers tend to select contracts based on expected usage versus costs. Those anticipating higher effort costs tend to prefer contracts that offer more flexibility, such as monthly payments, whereas those more accurately predicting their usage may choose more financially beneficial long-term contracts.

• Rational Expectations: Discussions on attendance forecasts reveal a tendency where individuals’ expectations about usage, although rational, do not align closely with actual attendance, particularly when emotional factors influence decision-making.

Attendance Expectations and Consumer Behavior

• Findings: The data indicates that monthly members incur higher costs per visit ($8.95 on average) while having lower overall attendance. Conversely, annual members perceived higher usage capabilities despite a reduced attendance rate at 9.5 times/month.

  • Post-Purchase Behavior: Monthly members tend to take longer to cancel memberships, indicating a resistance to relinquish what is perceived as a flexible option.

• Initial Attendance Trends: An increase in gym attendance rates initially does not perpetually decrease membership renewals, suggesting a more complex relationship between short-term spikes in usage and long-term membership retention.

Explaining Consumer Behavior

• Explanations: Key factors influencing consumer behavior include:

  • Overestimation of future gym usage, leading to a misallocation of financial resources.

  • Effects of time inconsistency present in consumer decision-making processes.

  • Naivety and a lack of foresight in budgeting for memberships and usage.

• Model Parameters: The study identified parameters where \beta = 0.7 indicating robust present bias, combined with \delta = 0.9995, highlighting a strong valuation of future savings compared to present spending.

Pricing Strategies for Firms

• Impact of Consumer Time Preferences: Non-present-biased consumers afford firms an opportunity to optimize profits from membership fees, while strategies must be adjusted for present-biased consumers to attract their business and ensure rational competitive responses.

Commitment Devices to Influence Saving Behavior

• Field Study by Ashraf, Karlan, and Zin (2006): This research focused on the effectiveness of commitment devices with 1,777 clients analyzing how different commitment savings products influenced consumer behavior.

  • Seed Account Features: Enabled participants to set specific measurable savings goals:

  • Date-based savings aiming for specific time milestones

  • Amount-based constraints led to 202 of 842 participants engaging with structured savings.

Measuring Time Preferences and Subsequent Saving Behavior

• Methodology: The study utilized hypothetical savings questions designed to gauge individual time preference, revealing that saving behavior varied significantly across different demographics.

• Findings on Time Preference and Saving: Analysis showed distinct outcomes according to gender and levels of time inconsistency among clients, emphasizing that gender and individual biases significantly affect saving strategies.

Conclusion

• Key Takeaways: The time inconsistency model offers critical insights into consumer behavior, particularly in the realms of saving and spending patterns. Understanding the intricate psychology of consumers is vital for developing effective financial products and policies that foster commitment, encourage savings, and ultimately enhance financial well-being.