Archive | February, 2013

Hyperbolic Discounting (Or Why We Make Irrational Choices)

8 Feb

For ages, the economists have been saying that people make rational choices to maximize their benefit. That’s how the free-market economy works.

However, in the real world, this is what happens. Students don’t study and do their homework. People keep eating more junk. People buy gym memberships but don’t go regularly. People don’t save for future. Smokers can’t quit smoking. New year resolutions are broken by a vast majority of us. We all procrastinate.

While doing my research (on Google) on why college students don’t read books or don’t do their assignments on time, I came across the term Hyperbolic Discounting. It’s a term coined by psychologists to explain the phenomenon behind a lot of our irrational decisions.

Here’s a scenario:

When offered a choice between getting $20 today or $25 a month from now, most people would take $20 today. However, if $20 is offered six months from now and $25 seven month from now, most people would take $25. In both cases, the money offered is the same and the time difference is also the same, so a rational person should choose the higher amount. But no … that’s not what numerous research studies have found.

Students know very well that they should do their assignments and study in order to get good grades, which would lead to a rewarding job and career. However, the students prefer to have fun now and postpone studies until later. They start working on their assignments when it gets really close to the deadline. So much for rationality.

Here’s the explanation for people’s irrational choices:

Ideally, $20 is $20 today, tomorrow, and a month from today. If I’m a rational person, I’d choose $25 today, tomorrow, or a month later. This is called exponential discounting, which, when represented graphically, shows a smooth exponential curve.

However, what actually happens is that I place too much value on what I’m certainly getting today or tomorrow compared with what I may or may not get later. This is called hyperbolic discounting, which shows a hyperbolic curve of how we discount the value of something over time. I prefer to have something smaller, sooner than something larger, later.
Hyperbolic DiscountingSimply explained, on Day 1, the perceived value of something is very high. On Day 2, it drops significantly, and so on. After Day 7 or 8, the perceived value remains more or less constant. It shows that we don’t place too much value on things a few days later, let alone a few years later.

This explains why students prefer to have fun today, we make ourselves feel good by eating junk today and postponing our visit to the gym, and break our resolutions. This behavior might be the result of thousands of years of evolution when our ancestors didn’t know if they would survive another day in the savannah and preferred to live in the moment.

Related readings
Overview of Hyperbolic Discounting