Behavioural Economics and Finance

EC3601  
Lecture 7:

THE DISCOUNTED UTILITY MODEL

 THE DISCOUNTED UTILITY MODEL

• INTRODUCTION
• FEATURES OF THE DUM
• ANOMALIES IN THE DUM
 INTRODUCTION
• Nature of intertemporal decision making
Flow of costs and benefits over time – buying a car, or
computer, joining a health club, firm building a factory,
government investing in rail network; taking drugs.
• Methods – DUM, anomalies, behavioural models in next
chapter.
 FEATURES OF THE DUM - 1

• Samuelson (1937) – DUM combined all factors affecting

time preference in a single parameter, the discount rate (ρ)
•  Nature of DUM
T-t

Ut(ct,...,cT) = Σ D(k)u(ct+k) where D(k) = ( 1 / 1+ ρ)k

k=0

Ut(20, 20, 20) = 20 + 20 + 20 = 49.74

1 + 0.1 (1 + 0.1)2 (1 + 0.1)3
 FEATURES OF THE DUM - 2

• Integration of new alternatives with existing plans

• Utility independence
• Consumption independence
• Stationary instantaneous utility
• Stationary discounting
• Constant discounting
• Independence of discounting from consumption
• Diminishing marginal utility and positive time preference
• Evolutionary biology and the DUM
 FEATURES OF THE DUM - 3

Assumptions:
• Utility independence – pattern of utilities does not matter
(people prefer rising profiles)
• Consumption independence – consumption in one period
does not affect utility in other periods, e.g. restaurants on
different nights (independence principle).
• Stationary instantaneous utility – preferences don’t change
• Stationary discounting – people use same discount rate over
lifetime; young and old discount more (more impatient)
• Constant discounting – at any period of time people use
same discount rate for all future periods
 FEATURES OF THE DUM - 4

• Independence of discounting from consumption - all

forms of consumption, costs and benefits, discounted at same
rate (DIY).
• Diminishing marginal utility and positive time
preference – DMU can cause positive time preference,
consuming later, e.g. restaurant meals in doggy bags.
• Evolutionary biology and the DUM - preference for own
offspring rather than offspring’s offspring, because more
closely related; but offset by fact that latter may be greater in
number.
 ANOMALIES IN THE DUM -1
• The ‘sign effect’
• The ‘magnitude effect’
• The ‘delay-speedup’ asymmetry
• Preference for improving sequences
• The ‘date/delay effect’
• Violations of independence and preference for
spread
• Implications of anomalies
 ANOMALIES IN THE DUM -2
• The ‘sign effect’ – losses discounted less than gains, loss
aversion; temporal loss aversion – time periods to losses appear
shorter than with gains, discounted less.
• The ‘magnitude effect’ - smaller gains discounted more
than larger ones.
• The ‘delay-speedup’ asymmetry - people prepared to
pay less to speed-up delivery than need to be compensation for
delay; reference points and loss aversion.
• Preference for improving sequences - people like rising
income and consumption profiles; reference points and loss
aversion.
 ANOMALIES IN THE DUM -3
• The ‘date/delay effect’ – difference in attitudes to dates in
future and extents, e.g. to July 11 2011, or in 8 months; latter
involves higher discount rate, perceived as longer
• Violations of independence and preference for
spread – restaurant dinners 2 weeks apart; elaborated choice
with dinner at home as alternative; preference reversal. Spread –
teachers in California schools prefer 10 payments over 12 per year.

Implications of anomalies – not mistakes; within-subjects

studies of ‘sign’ effects. Normative implications for DUM