Choice Over Time

1. The Fall and Rise of Psychological Explanations in the Economics of Intertemporal Choice

· 1 · The Fall and Rise of Psychological Explanations in the Economics of Intertemporal Choice GEORGE LOEWENSTEIN INRECENT years, despite lingering skepticism, the influence of psychology on economics has steadily expanded. Challenged by the discovery of individual and market level phenomena that contradict fundamental economic assumptions, and impressed by theoretical and methodological advances, economists have begun to import insights from psychology into their work on diverse topics. This influence has been most pronounced in the area of decision making under uncertainty, but recently it has extended to the cognate topic of intertemporal choice. Economists have joined psychologists in using experimental methods to address fundamental questions about time preference. Moving beyond the usual attempts to measure discount rates, this research seeks to test critically the predictions and assumptions of the discounted utility model (DU), the most widely employed model of intertemporal choice. These studies have generally not affirmed the descriptive validity of DU; observed patterns of choice violate virtually everyone of the model's basic assumptions and, therefore, its implications. The exchange between psychology and economics has also occurred at a theoretical level. The descriptive inadequacies of DU have led economists and other social scientists to develop alternative theoretical models that incorporate psychological insights. Some of these 3 4 Historical Overview retain DU's multiplicative formulation, introducing specialized discount or utility functions. But others adopt radically different frameworks , modeling intertemporal choice as a collective action or principal -agent problem between temporally situated "selves." Although commonly credited to psychology, many of the insights currently enriching the economics of intertemporal choice were prefigured in the work of nineteenth- and early twentieth-century economists . In a period when the border between psychology and economics was less sharply defined, economists like Rae, Senior, Jevons, and Bohm-Bawerk addressed such fundamental questions as "Why do people discount the future?" In some cases their answers reveal a sophisticated grasp of psychology. It is possible to discern four basic historical stages in the evolution of the economics of intertemporal choice. In the first stage, nineteenth-century economists such as Senior and Jevons explained time discounting in terms of what psychologists now label motivational effects; these refer to emotional and/or hedonic influences on behavior. Both Senior and Jevons believed that willingness to defer gratification depended on immediate emotions experienced by decision makers. In the second stage, which was dominated by contributions from Bohm-Bawerk and Fisher at the turn of the century, intertemporal choice was viewed in cognitive terms, as a tradeoff between present and future satisfactions. Discounting was attributed mainly to inadequacies in the decision maker's ability to imagine the future. The third stage entailed an attempt to eliminate psychological content from the economics of intertemporal choice. In the first decades of the twentieth century, a distaste for psychology became widespread among economists. In part because of their dismay over new developments in psychology that did not seem amenable to interpretation as utility maximization (e.g., Freud's theory of unconscious motivations), economists sought to stake out the independence of their profession.1 The psychological richness that characterized early discussions of intertemporal choice was supplanted by mathematical and graphical analyses that seemed to render psychology superfluous . Psychological concepts reflecting motivational and cognitive influences-willpower and imagination-gave way to nonevocative terms such as time preference that were deliberately agnostic about underlying causes. Finally, in the last few decades, a fourth stage has emerged characterized by a renewed interest in psychology by economists interested I See, for example, Davenport (1901). Fall and Rise of Psychological Explanations 5 in intertemporal choice. The shift in perspective has benefited from research by contemporary psychologists. Much of this work is represented in the chapters of this book. This chapter follows the economics of intertemporal choice from its infancy to the present. The first section discusses the nineteenthcentury contributions of Rae, Senior, and Jevons. The second examines the pivotal work of B6hm-Bawerk and Fisher at the turn of the century. Section 3 examines the ordinal utility revolution and its consequences for intertemporal choice. Rae, Senior, and Jevons: Three Early Perspectives John Rae, an obscure and tragic economist of Scottish descent,2 provided the first in-depth treatment of intertemporal choice. Rae's interest in the topic, like that of other economists of the period, arose from his desire to understand changes in the standard of living over time and differences across countries. Earlier economists such as Smith had argued that...