On having multiple discount functions

Another interesting development in the world of Behavioural Finance is the idea that individuals have multiple discount functions. For example, researchers such as Prof David Laibson argue that we have at least 2 discount functions, one for the very short term say minutes, hours, days, and then another for the longer term. The tension the investor faces is the tradeoff between these two. For example, simple exponential discount functions argue that the change in  discount rate is more or less constant over time. Yet consider this thought experiment - imagine you were given two sets of choices 1) a) $100 now or b) $101 in 60 mins from now and 2) a) $100 in 1 week or b) $101 in 1 week and 60 mins. Almost everyone will choose 1a and 2b but this is not consistent with a simple discount function. The attraction of the immediate is overwhelming for most people, percieved as far more beneficial than any delayed extra value. Yet beyond the immediate people switch to a more rational process incorporating the extra delayed benefit. Its as if they have two discount functions, one that kicks in for the near term, emphasizing short term benefits and the second which is used to evaluate longer term costs and benefits. Even more fascinating some researchers are arguing that these discount functions actually correspond to different more or less developed parts of the cerebral cortex, associated with high level reasoning and more emotional animalistic instincts. But these discount functions are not merely quantitatively different, they seem to be qualitatively different too. For example, when you change the reward, say to ice cream or a candy bar, the short term benefits even more massively outweigh longer term benefits.

Of course, marketing people instinctively know these things we suspect, the offer of the free ipod when you sign up for a new credit card, peoples tendancy to spend hours negotiating on physical aspects of a car purchase, and then only a moment to decide whether to get auto financing (which is where most of the profits are made).

So what is the punchline - real physical things obtained immediately are valued much MUCH more than abstract non physical things delayed.