Hyperbolic Discounting: The underestimated power of behavioural economics

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Here are two options: 

Option 1: £150 today 

OR     

Option 2: £300 tomorrow. 

Which option would you choose?


Here a two more slightly different options: 

Option 1: £150 today

OR

Option 2: £300 in three years. 

Which option would you choose now?


The thought process behind switching from Option 2 in the first question to Option 1 in the second question, is known as temporal myopia. This is when the clarity of our future decreases with time. In this example, it was the three-year ‘delay gap’ that was introduced in the second question in comparison to the first. Temporal myopia forms the foundations of a type of behavioural economics known as Hyperbolic Discounting

Whilst economic theory suggests that consumers behave rationally (homo economicus) to maximise utility (satisfaction gained from consuming a product), we still manage to set aside our homo economicus tendencies to behave irrationally on a daily basis. This could be choosing a “smaller-sooner reward over a larger-later reward”, as seen in the example provided above of hyperbolic discounting.

This form of behavioural economics follows a hyperbola. This means that the longer the period of time from the present, the ‘discount factor’ of the options presented to you will diminish as time elapses. This can be drawn in the shape of a hyperbola, hence, the name hyperbolic discounting.

Worked Example

Many companies use this form of behavioural economics to create conversions in their marketing strategies. This is to attract as many irrational consumers to consume their products as possible. Hyperbolic discounting could be presented through a choice of a range of pricing options for time-based subscriptions on an online site, for example.

Let us use Company X as a worked example. It is an international magazine that focuses on politics, technology, business and economics. Readers have to pay a subscription to read articles written by Company X writers whether this is digital, in print or both. This magazine offers their readers the choice to pay £4.50 per week (Figure 1) subscription for a year (£230 in total) or £3.79 per week (Figure 2) for a 3 yearlong subscription (£580 in total).

Figure 1
Figure 2

It is clear to see that the second plan is cheaper per week and you would be better off by paying £580 upfront. However, due to consumer weaknesses at computation, readers would be willing to pay more for fewer magazines in total all because the upfront cost for one year is cheaper. As a result, this demonstrates our preferences of wanting an instant payoff of paying less now, instead of the long-term payoff of actually saving more money. Suitably, allowing businesses that offer subscriptions to maximise their profits all by using our habitual consumption preferences against us.

The lesson from behavioural economics is that people only save if it’s automatic

Richard Thaler, 2017 Nobel Prize winner

To conclude with the words of Richard Thaler, hyperbolic discounting enables consumers to choose the more “automatic” and instant option of saving now rather than the more strenuous wait of saving more in the long term. Such a simple principle holds so much power and influence on how we spend our money, all the while without us knowing that businesses use this strategy to profit off of our irrational decisions. Furthermore, in my opinion, at every chance that they get.


References

  1. Hyperbolic Discounting, https://breakingdownfinance.com/finance-topics/behavioral-finance/hyperbolic-discounting/
  2. Joseph P.Redden ,Hyperbolic Discounting, http://behaviorlab.org/Papers/Hyperbolic.pdf

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