Behavioral economics is a relatively young subdiscipline of economics that has garnered a noticeable amount of attention especially over the last two decades. It seeks to utilize findings from other scientific fields, especially psychology, in order to enhance the plausibility of neo-classical (mainstream) economic models without replacing or abandoning them . The inclusion of psychology into economic thinking is nothing new, however. Instead, it can be traced back to the period of the classical economists of the 18th century. While lacking the rigorous formal approach of today´s behavioral economists, the conception of the human nature and human decision making was surprisingly sophisticated at the time. For instance, time-inconsistent preferences, which are an important aspect of behavioral economics, have already been examined by David Hume and Adam Smith . Other phenomena, including loss aversion and overconfidence, have also been discussed by classical economists.
This thesis has the following structure: Chapter 2 explains a general, quite powerful model of dynamically inconsistent preferences. Special emphasis is placed on real-life examples as well as welfare analysis, including political implications. As we move along, we will constantly compare our findings to the results we would obtain from the neoclassical paradigm. The next two chapters take a closer look at time inconsistencies in the realm of financial decision making. We will examine the behavior of individuals regarding credit card debt in chapter 3, which will require the introduction of another model that is more specifically tailored towards the credit card market. However, the foundations laid out in chapter 2 will be helpful in understanding this second model of inconsistency. Chapter 3 will also discuss recent legislation in credit card markets in the US. In chapter 4, we discuss retirement savings decisions, specifically in the context of the 401(k) retirement plan . After having introduced two models already that explain how people and companies act in certain situations, in the chapter we will discuss several behavioral phenomena that help us explain the motivation behind the decisions of individuals. We will assess the costs and benefits of government interference into the market and the possible measures that might improve the market outcome. Chapter 5 concludes and discusses interesting questions that might be examined further in the future.
Table of Contents
1 Introduction
2 Theory of Dynamic Inconsistency
2.1 Prerequisites
2.2 The Multi-Selves Model
2.2.1 Sophisticated Consumer
2.2.2 Naïve Consumer
2.2.3 Screening of Consumer Type
2.3 Constrained Contracting: Two-part tariffs
2.4 Partial Naïveté
2.5 Application: Gym Attendance
2.6 Political Implications and Welfare Analysis
3 Credit Card Market
3.1 Introductory Remarks
3.2 Behavioral Model of Credit Consumption
3.2.1 General Setup and Assumptions
3.2.2 Complete Information
3.2.3 Incomplete Information
3.2.3.1 Unknown β
3.2.3.2 Unknown β and β
3.3 Welfare Analysis
3.3.1 Complete Information
3.3.2 Incomplete Information
3.4 Recent Legal and Empirical Developments
4 Retirement Savings
4.1 Introductory Remarks
4.1.1 Significance of Retirement Savings
4.1.2 The 401(k) plan
4.2 Behavioral Aspects of Retirement Savings Decisions
4.2.1 Model
4.2.2 Behavioral Phenomena
4.2.2.1 Self-control
4.2.2.2 Procrastination
4.2.3 SMarT Plan
4.2.3.1 Purpose of the plan
4.2.3.2 Main Features
4.2.3.3 Evidence
4.3 Recent Developments
5 Summary and Conclusion
Objectives and Topics
This master's thesis investigates the phenomenon of time inconsistency in financial decision-making, exploring how individuals' non-stable preferences affect outcomes in credit card markets and retirement savings. By applying behavioral economic models, the research assesses the extent to which these inconsistencies lead to sub-optimal financial outcomes and evaluates potential policy interventions.
- Analysis of the multi-selves model for dynamically inconsistent preferences.
- Investigation of exploitative pricing strategies in credit card markets.
- Evaluation of retirement savings behavior and the role of self-control.
- Assessment of policy measures like the SMarT plan and automatic enrollment.
- Welfare analysis of market restrictions and government intervention.
Excerpt from the Book
2.2.1 Sophisticated Consumer
The multi-selves model, which was first introduced by R.H. Strotz in 1956, is fundamentally rooted in game theory. We consider two periods. In the first one, consumers decide whether they want to sign up for a service. In period 2, the actual consumption decision is made. Unsurprisingly, the individual´s taste might change between the two periods, creating dynamic inconsistency. In this model, we assign a different player or “self” to each decision node, similar to the way we would treat an extensive-form game. Usually, game theoretic problems can be solved by finding a subgame perfect equilibrium, for example by utilizing backward induction. However, this concept implies complete information of the players about all future payouts. If we give up this assumption, we have to find different ways of solving the game.
Summary of Chapters
1 Introduction: Provides an overview of the emergence of behavioral economics as a subdiscipline that integrates psychology into economic modeling to improve predictive power regarding human decision-making.
2 Theory of Dynamic Inconsistency: Develops a theoretical multi-selves framework to model inconsistent consumer preferences and examines how firms use pricing strategies to address sophisticated versus naïve consumer types.
3 Credit Card Market: Applies behavioral models to the credit card industry, analyzing how credit companies exploit consumer naïveté and discussing potential welfare-enhancing market regulations.
4 Retirement Savings: Examines retirement savings decisions, focusing on behavioral impediments like procrastination and lack of self-control, and assesses the efficacy of programs like the SMarT plan and automatic enrollment.
5 Summary and Conclusion: Synthesizes the main findings across all chapters, confirming that time-inconsistent preferences lead to suboptimal welfare and that tailored interventions can improve financial outcomes for consumers.
Keywords
Time inconsistency, Behavioral economics, Multi-selves model, Sophisticated consumer, Naïve consumer, Credit card market, Retirement savings, Self-control, Procrastination, SMarT plan, Automatic enrollment, Welfare analysis, Loss aversion, Hyperbolic discounting, 401(k) plan.
Frequently Asked Questions
What is the primary focus of this master's thesis?
The thesis explores time inconsistency in consumer financial decision-making, specifically how preferences that change over time impact choices in credit card usage and retirement savings.
Which central topics are covered in the work?
The main topics include the theoretical modeling of dynamically inconsistent preferences, the exploitation of consumer naïveté by firms, and behavioral interventions to improve long-term saving outcomes.
What is the core research objective?
The objective is to understand how behavioral phenomena such as lack of self-control and procrastination contribute to suboptimal financial decisions and how market or policy structures can mitigate these welfare losses.
Which scientific methods are employed?
The author uses behavioral economic models, including game-theoretic approaches and the multi-selves model, alongside a review of empirical studies to analyze consumer behavior and welfare.
What is discussed in the main part of the thesis?
The main part analyzes models of time inconsistency in credit markets and retirement savings plans, evaluates the impact of pricing schemes, and investigates the success of programs like Save More Tomorrow (SMarT).
Which keywords characterize this work?
Key terms include time inconsistency, behavioral economics, consumer naïveté, self-control, procrastination, retirement savings, and credit card market efficiency.
What is the "multi-selves" model?
It is a theoretical framework used to model dynamic inconsistency by assigning a different "self" to each decision node, reflecting how a person's tastes might change between different time periods.
How does the SMarT plan help individuals save for retirement?
The SMarT plan mitigates the effects of procrastination and loss aversion by allowing employees to commit to future increases in their contribution rates that coincide with pay raises, thereby avoiding the perception of a loss in disposable income.
- Quote paper
- Hendrik-Sebastian Schmitz (Author), 2012, Time Inconsistency and Financial Decision Making: Theory and Evidence, Munich, GRIN Verlag, https://www.grin.com/document/210842
