Lee mentioned prospect theory in a comment, but before we discuss behavioral economics, I would like to establish your risk aversion. So please answer the following without thinking too much about it:
Imagine that you delivered a service or job, which is worth 100$ dollars.
Would you prefer to get paid 100$ immediately, or would you be willing to wait 1 week for your payment and receive 101$ then?
This is not a trick question, just a simple question about what you would prefer.
added later: The 101 option is equivalent to an annualized interest rate of 67% and very few investments provide for this kind of return. One has to either have a very high risk aversion or face severe liquidity constraints to reject it. But if you ask friends or family you will get mixed results (try it).
This kind of delayed gratification experiment has also been performed many times by behavioral economists; in one typical case the interest demanded ranged from 5% to 240% per month . And in the famous marshmallow experiment half the children rejected an offer to double an asset they desired in 15 minutes. Not even high frequency trading can provide for such high returns.
This raises three questions:
i) Why are real interest rates so much lower?
ii) Why do behavioral economists never point out this discrepancy?
In the linked piece a guy who demands 5% per month is described as having a “flat discount function”.
iii) Finally, is behavioral economics relevant for the real economy and financial markets?
In my opinion the answer to i) is quite simple: Real interest rates are not set by cash strapped students or little children or any single person, but liquid markets dominated by large investors. But even an odd lot investor would probably think different about interest rates when she purchases bonds, than when asked the above question.
I admit that ii) is a real puzzle to me, but perhaps I am not familiar enough with the literature.
My answer to iii) is that our everyday experience just does not scale very well to the overall economy and financial markets in particular. There are many reasons why we may prefer the immediate payment of 100$ in everyday life. Perhaps we are worried that we might forget about it, it is a hassle to chase a payment one week later and perhaps such an offer would be somehow strange in real life and raise suspicion. Also, marshmallows taste much better than money.
Don't get me wrong, I think experiments uncovering behavioral bias and economic fallacies are interesting and one should know about them. The sunk cost fallacy is one of my favorites.
But I do not expect that behavioral economics is the secret sauce that will help us understand macro economics or financial markets better. What is missing imho is some kind of "renormalization procedure", which scales individual behavior to macro economics.
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