But… that doesn’t make sense!
This story is the second in a series of 3 posts (note that they need not be read in a particular order). Each of them is a re-publication of a post that I wrote for a University Scholars’ module entitled “Making Connections”. We were told that the posts needed to have a thematic focus, and mine was “Economics: Thinking about the Basics”.
While I was initially sceptical about the aim of the module (to get us to reflect on our undergraduate experience) it did force me to think carefully about how my different learning experiences were connected, and I was mildly, but pleasantly, surprised at the results. I thought I would publish the posts here as well since, generally speaking, accessing them via Medium is much easier.
One of the central assumptions of Economics is that people behave rationally, and make decisions that maximize their utility. In this post, I look at instances where behaviour or decision-making did not conform to this assumption, and consider how the economic concept of present and future values can be used to reconcile the disparity.
That individuals behave rationally to maximize their own utility, or satisfaction, is a cornerstone of the study of Economics.
However, during the course of my undergraduate studies, I’ve questioned this assumption on numerous occasions. One such example was in my third year, while I was enrolled in Aaron Maniam’s module, Polycentric Governance. As part of our continuous assessment we were required to write 3 essays throughout the term, and it was while writing the second essay that the assumption of rationality and utility maximization surfaced again.
In my essay, I looked at the relationship between Amy Chua, author of Battle Hymn of the Tiger Mother, and her daughters. I sought to characterise said relationship using the Principal-Agent Problem we had discussed in class, and talk about the means through which Chua endeavoured to eliminate the problem. Chua’s daily regimen for her children was demanding, perhaps overly so, and she justified it by saying that it was “crucial to override [children’s] preferences”. Children, she noted, had a tendency to resist “not-fun” activities that require constant repetition and practice for them to excel, like learning a musical instrument. However, as they begin to earn praise for their mastery of a skill, the activity becomes one that is enjoyable.
There were two implications here that struck me. First, she had drawn a distinction between utility in the long and short run. Children, as she had pointed out, initially gain disutility from spending hours studying and playing the piano, as opposed to playing computer games and watching the television. In the long run however, she was implying that utility functions could be changed such that children gain utility from these previously misery-inducing activities. Utility functions could thus have a temporal aspect to them, and be different across time.
Second, she was implying that children, on their own, can’t make rational decisions. Not that they don’t, but they can’t. Because while fun and games may provide satisfaction in childhood, as adults, our utility functions change. Other variables enter the scene, such as the achievement of financial independence and stability. This is easier done if time is spent investing in education from an early age, which children may not be inclined to do, because they are unlikely to be able to see that far into the future. Hence, they are prone to making decisions that maximize their utility functions in the present, but sabotage future maximization. This then got me thinking: if children can’t be rational, but adults can, does that necessarily mean that we are?
This was the crux of the matter for me. Intuitively speaking, we know that while adults can think about consequences, plan for the future, and ensure we don’t act against our self-interest, we don’t always exercise this capability. We can still find ways to engage in activities that satisfy our short run utility functions, even though we know, with almost absolute certainty, that our long run utility will be compromised in some way.
One terrific example of this comes from my own experience as a sales intern for a wine company back in the summer of 2015. Prior to this stint, I had little to no experience of wine, let alone alcohol. This was of no concern to my employer, who only emphasised that I put in the effort required to research the products that were on offer. There was a particular occasion when I failed to do so, and needless to say, ended up with egg on my face, given that one of the people I was speaking to during a marketing pitch was an experienced connoisseur. I knew far ahead of time that he would be attending, and that neglecting my research would end up in a poor sales pitch. Yet I chose to do so anyway, opting to spend my time in the company of friends, all the while having that little voice gnawing at the back of my head, reminding me that this is something I would regret.
This was but one of many such experiences, and I trust most, if not all, readers can relate to this on some level. The question then, is why? Why do we allow ourselves to be swept away by momentary satisfaction, even though we know it will compromise our utility in the future? In other words, why does it appear that we cannot act rationally? One possible solution was offered by another economic concept: present and future values, otherwise known as the time value of money.
Time value basically explains to us that accepting a dollar today is more valuable than taking a dollar a year from now. Why? Because by taking the dollar now and saving it, the interest accumulated on that dollar allows us to do more with it in the future. So in assessing the value of something we are to receive in the future, one must calculate its value to us in the present, to understand if it is more worthwhile than something we could claim right now. Looking at the wine incident, and so many others like it, through this lens, one could understand how such decisions are made without the assumption of rationality being violated.
We know that certain decisions are likely to yield disutility in the future, but we have yet to actually experience that disutility, so we discount the future value of that disutility in the present ie. We downplay the consequences because of the temporal chasm, and are inclined to pursue the utility we stand to gain in the present moment, which has a higher value. It then becomes rational enough for us to proceed with this decision we know we will regret later. Of course, a follow up question would be, how do I(we) stop ourselves from doing that? Unfortunately, that is a question I have no answer to, but that is a tangential concern that is not the focus of this post. I certainly wish I could propose an answer, but I will have to let the readers do the thinking on this one. It’s too taxing for me right now, and I really want to watch those re-run episodes of Seinfeld.
