Final part of a series exploring how economic thought leads to cognition and cognitive behaviour
Hyperbolic discounting is often put forward as evidence of our supposed irrationality. According to Wikipedia it is a cornerstone of behavioural economics.
The idea being that humans don’t like waiting for rewards and prefer things sooner rather than later. We seem to have an inbuilt exchange rate where we are happy to give up (face) value for immediacy.
As an example:
Would you prefer me to give you $10 now or $12 in a week’s time?
What would you do? Most people take the money and run, preferring to have the money in their pocket. Why should this be so? A 20% increase in reward in just a week is an amazing rate of return. It’s many times the annual rate of return that you’d receive on a savings account from a high-street bank so why do people repeatedly turn their noses up at this deal?
Again, we need to step back from our cosy first world vantage and look at the needs of our ancestors and their environment. For most of our evolutionary history it didn’t pay to leave things lying about. Someone or something else in the environment was likely to come along and help themselves to it.
As well as losing out in absolute terms, we hand our competitors a relative advantage, which if allowed to continue could lead to us becoming dominated in our environment.
If we look at our shift away from a hunter-gatherer type existence, our development of agriculture and the domestication of plants enforced patience upon us. While our ancestors were forced to wait they could do so with some measure of content. The grains they sowed could not be eaten until they were ready to be harvested. Unlike with foraged produce, they were not at risk of someone coming along and profiting from their work – there would be no payoff in doing so.
Likewise, with the domestication of animals we learned that patience could provide us with a greater payoff. As long as we could ensure the animal’s health and security we could reap a return of eggs, milk and wool.
It is probably of little wonder that slaughter of male animals for meat was celebrated (through feast, sacrifice etc.). It was a community’s triumph over their natural instinct to consume the resource immediately and instead rearing it for greater reward later.
Our development of agriculture means that if you have the means to read this page you’ve probably paid little thought to where next week or next month’s food is coming and just assumed a supermarket will be open for you to shop in.
In an environment where supply is not constrained we have no requirement for patience.
Without the need to be patient we revert back to the instincts of our hunter-gatherer ancestors. We consume what’s in front of us least someone else should to our disadvantage. The difference being that our ancestors were forced to stop consuming when the resource or commodity ran out.
We haven’t twigged yet that our ancestors didn’t have the need for a “cease and desist” behaviour as the environment enforced it upon them.
If we survive to have descendants, maybe they will.
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Hyperbolic discounting changes a simple lottery to a compound one.
If we had the choice of choosing between a gift of $10 or $12, rationally we’d choose the later.
If we offered the choice between $10 now or $12 in a week’s time, most people would choose the later.
All lotteries involve an element of uncertainty and an element of capital. Uncertainty in both cases has been reduced and the same. However we have interpreted the capital available to us, we’ve calculated that it is better to take the money and run.
Luckily our modern environment is accommodating for our desire to have stuff now. Most items aren’t effectively limited in their supply – we can get our hands on them if we want to – and credit products are generally freely available to those that want them.
Talking a step back credit products put us in a bit of a quandary. The people offering them must be gaining a benefit for doing so otherwise it wouldn’t make sense for them to do so. On the other hand, given our apparent appetite for credit cards, personal contract purchasing (PCP), and personal loans we must think we’re the ones getting a good deal.
So what’s going on?
As a personal rule I always find in situations where everyone thinks they’re on to a winner it means someone will be a large loser in the future. This happened with the 2007-9 financial crisis, when Ponzi marketed international reply coupons, and when the Dutch bought tulip bulbs.
How can both sides be winners from unsecured credit products?
Credit products prey on our desire to maximise the benefit we achieve from the environment (gaining the largest relative advantage we can over it) and our fairness bias (stopping others gaining a relative advantage over us).
Thanks to our hunter-gather ancestors who picked fruit and berries when they came across them, rather than waiting for them to be perfectly ripe and risk someone else nabbing them, we are compelled to make sure we secure resources when we find them.
If we don’t spend, we’re the ones that face being outcompeted by others in our environment.
Some items in our environment are limited in their supply such as the partner we want or the house or area we want to live in. If we can’t secure them, then we’ve lost out, if not for good, certainly for the time being.
People that assume large amount of debt from credit products are in their own way being rational. It makes sense to spend money on your appearance or a nice care to impress and secure a good mate. Once a partnership has been formed, or a dream house sold, the resource is off the market. Logically the remaining resources the environment yield less utility.
Credit products allow people an avenue to outperform their environment and gain a relative advantage over it.
However, we fall into a trap though when all competitors in the environment have access to the same credit products.
This is Nash’s Trap.
Everyone has to take on debt to avoid being outcompeted by others and being left at a relative disadvantage. With everyone talking on debt, none experience a relative advantage, but all experience an absolute disadvantage over time (the cost of interest).
No individual has an incentive not to take on debt as it will leave them prone to being outcompeted by others in their environment.
Unless we can form an alliance or agreement with the other individuals in our environment it makes no sense for an individual to change their behaviour as they will be worse of in competing for resources of limited supply.
Of course, in absolute terms the winner is the credit provider. As long as he remains passive in the environment he can happily collect rent from his customers. His only difficulty is when he is forced to become active such as a customer not paying or circumstances require him to raise interest rates where the borrower’s unfairness bias is likely to be tripped.
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As humans we are prone to thinking we’re special – we don’t see other life forms having colonised the planet in the same way as we have.
It’s not hard to see though that we’re social creatures, we form groups, but so do ants, some types of fish and birds as well as some other mammals to mention a few.
For these groups there must be a benefit for individuals from interacting with others compared to remaining solitary.
For schools of fish or flocks of birds this may be as simple as safety in numbers. The greater the number of targets in a group the less chance there is of an individual member being picked off by a predator.
For this tactic to work, each individual must, at some level, conceive the benefit they are receiving from it. In essence for a group to form and remain coherent cooperation must be established.
Cooperating shifts a relative advantage available in the environment to individuals that are group members compared to those that remain outside. It is not necessarily that we gain by being a member of a group, but that we would be disadvantaged by not being a member.
Once again we fall into Nash’s Trap. If other members of the environment join a group they are doing so in an attempt to shift the advantages they experience in the environment. If we enjoy a large advantage over them this may not concern us. If previously we competed equally or at a disadvantage we will be at a greater disadvantage unless we join.
If a group of pigeons start flocking an individual pigeon becomes increasingly disadvantaged and vulnerable to presence of a predator in its increasing isolation. That pigeon has to join the flock to avoid being disadvantaged.
We often make the mistake of thinking that we should cooperate as it’s a nice thing to do. It isn’t. We cooperate as it provides us with a relative advantage over the environment that we wouldn’t experience without membership.
Group membership comes at a cost. Unless they can find a way to freeload, an individual with have to contribute some resource to sustaining it – Being a member of a flock means that you can only move in certain ways.
For the group to survive the cost of membership to the group must be less than the disadvantage an individual would face if they were not in the group.
Think about things you have given up in your life. Generally people stop doing things as the effort is not worth it. The effort of going to an exercise class or meeting up with a friend who spends the whole night sobbing at how bad their life is outweighs the cost that you’d experience if you just didn’t turn up.
This principle underpins the majority of our social interactions. We rush to avoid a disadvantage (if the guy next door is going to have $10 now, I want $10 now as well rather than waiting a week for $12) and end up forming a group with everyone else that is avoiding the same disadvantage (all the pigeons in our flock are looking not to get eaten by a hawk). As long as the cost of being a member of the group don’t outweigh the disadvantages outside it, an individual will remain a group member.
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Nash’s Trap has an enormous bearing on our social interactions.
Seeking to avoid being relatively advantaged pushes us into forming groups. Individual will seek to maximise their U – effectively what they can get out of the environment.
Putting a number of individuals in a room – unless it is a London Tube train or a doctor’s waiting room – they won’t remain as individuals, they’ll start talking to one another.
This might seem like idle chit-chat but it belies the underlying process. Each individual is looking to gain a relative advantage over the environment. At this stage, being left out of a group would leave an individual at a disadvantage, so as soon as one group starts to form, others start to form as well.
Pretty soon we have a room of groups rather than a room of individuals.
For an individual within a group he’ll either be happy, indifferent or unhappy with the conversation within it. If he is unhappy with his group the disadvantage of leaving and becoming an individual again doesn’t outweigh cost of remaining a member.
But his only option is not to become an individual again. There are other groups in the room. The greater relative advantage to him would be to become a member of another group.
That is if they’ll accept him.
If members of this group are happy with it, to them, somehow, it is conferring them with a relative advantage over the environment. From them to maintain this level of benefit the prospective member must contribute some benefit to the group to avoid the existing members advantage being diluted.
As such there is a barrier to entry.
Another pigeon will be welcomed into a flock trying to avoid a hawk as it will increase the advantage that the existing members already have – There is even less chance of an individual bird being eaten.
An individual seeking access to a group that is perceived as drawing on the groups resources without a perceived equal or greater contribution will not be welcomed as they will be seen to be decreasing the relative advantage of existing member.
It is no wonder that immigration is often resented by an indigenous population. The benefits of the environment are diluted over the group and it is this loss of advantage that is resented.
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Individuals seek to maximise their U so it is only rational that they will seek to join a group that offers them a greater relative advantage. But they will only be accepted into a group if they can confer a benefit to its members and give them a greater relative advantage.
How do we escape this seeming paradox?
The lotteries that an individual forms their Us from are comprised of uncertainty and capital. To overcome a group’s barrier to entry – and for it to be worth their while – an individual must either reduce their collective uncertainty or increase their respective capital.
The former is easily seen with our flock of pigeons. By joining a flock an individual pigeon is reducing the chance that it will be picked off by a hawk and also of over birds as well.
The latter is more troublesome and subjective. Elements of capital require an estimation of value. Try giving a child a toy they already have as a present. It is generally met with protests as their expectation of getting something – the present – doesn’t provide them with any increase in benefit. They don’t value having two of the same toys as bringing twice the joy.
For an individual to remain rational and overcome a group’s barrier to entry by exchanging capital he must exchange something that he deems he has in excess and that the group deem they are deficient in for something that he deems he is deficient in and the group deems they have in excess.
In essence we have discovered trade.
Unless we are able to mutually reduce uncertainty we require trade for it to be worthwhile accessing our group and for the group to consider it worthwhile admitting us.
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Trade facilitates group membership but it can come with difficulties.
Say I have an excess of washing machines but I want a cow. I can probably find someone that has a spare cow but I need them to need a washing machine.
There is friction in this process of exchange.
If we could find an intermediary maybe we could speed the process up and facilitate the trade.
Luckily for us the local baker is prepared to step in and offer us loaves of bread for our respective goods. However he wants to be compensated for eliminating the friction in this process. He has taken on the burden of finding someone that wants a cow and a washing machine so he doesn’t give us as many loaves of bread as someone who needs what we have.
This creates a problem for us. We want to get the most we can in exchange but we don’t want to wait for the exchange.
If I can we could come to an agreement on value – that is 1 cow is worth 1 washing machine – could we create our own intermediary and cut out the baker as a middleman and avoid paying him a fee.
If we trust each other this is not a problem. If the item that we have is in excess we are not going to mind giving up its use but we wouldn’t want to give its value away. As such it shouldn’t be too much trouble for one of us to write the other an IOU. In my case IOU 1 cow.
Likewise, the counterparty in this trade might want to acquire something held in excess by someone else and we might find someone who wants our washing machine and gives us an IOU.
Eventually the community start using tokens to represent IOUs which we refer to as money.
There are (at least) two interesting things about money.
First, it is someone else’s debt. When you go to the shops and pay for something you are passing on the debt that someone owes you to someone else.
Secondly, it acts as a repository for value. We can use it to store our estimation of what something is worth until the time that we need it. We can use it to defer transactions. I might need 52 litres of milk a year but I don’t need it all at once. I can split my purchases up and buy a litre a week. I don’t have to worry about the milk I don’t use going off – that’s someone else’s problem – just as I don’t have to worry about spending money within a certain timeframe. Ignoring inflation for the time being – I can keep the money I received last week in my pocket and exchange it tomorrow, next week or next year without any problem.
The only problem with money is that it has to be exchanged for value.
It the dynamics of a group changes they might not deem the commodity they were selling us to be in excess any more. If the supply of whatever we were hoping to buy decreases and it is valued more highly then we will have to exchange more money for it.
If we can’t do this then we can’t overcome the barrier to access that group and become relatively disadvantaged.
This is how poverty becomes a social issue of exclusion, not just a lack of wealth.
Capital wealth is control of another’s debts. When an individual does not control a sufficient amount of the debts of others he is often denied access to the resources to sustain himself.
It is up to the group to decide if they value the pursuit of the debts of others over the value of the life of another.
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Occasionally possession of a resource in the environment is desired by one party and not willing to be relinquished by another.
The holder of the resource is not interested in exchanging it while the other party wants the benefit of it.
Each side feels relatively disadvantaged by not possessing the resource.
When a situation such as this cannot be resolved it leads to conflict.
Each group becomes tribalistic.
Group tensions rises. Individuals from one group share the feelings that the loss of resource would bring and bind together reinforcing it.
Individuals from one group become more tightly bound with its members. They all singularly feel the loss of advantage and share this in common with their fellow group members.
Group members can identify the source of their anticipated disadvantage and align against it.
Meanwhile members of the opposing group have gone through the same process.
When a resource is desired but unattainable resentment abounds.
Individuals make take action to lessen the disadvantage they feel. This may be a hindrance or a nuisance to those that hold the majority of resources.
When the majority feel disadvantaged it leads to insurrection and overthrow.
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