17.6 David Laibson and the Pull of Instant Gratification

Keynes called the consumption function a “fundamental psychological law.” Yet, as we have seen, psychology has played a small role in the subsequent study of consumption. Most economists assume that consumers are rational maximizers of utility who are always evaluating their opportunities and plans to obtain the highest lifetime satisfaction. This model of human behaviour was the basis for all the work on consumption theory from Irving Fisher to Robert Hall.


More recently, economists have started to return to psychology. They have suggested that consumption decisions are not made by the ultrarational homo economicus but by real human beings whose behaviour can be far from rational. This new subfield infusing psychology into economics is called behavioural economics. The most prominent behavioural economist studying consumption is Harvard professor David Laibson.

The Hypothesis

Laibson notes that many consumers judge themselves to be imperfect decisionmakers. In one survey of the American public, 76 percent said they were not saving enough for retirement. In another survey of the baby boom generation, respondents were asked the percentage of income that they save and the percentage that they thought they should save. The saving shortfall averaged 11 percentage points.

According to Laibson, the insufficiency of saving is related to another phenomenon: the pull of instant gratification. Consider the following two questions:

  1. Would you prefer (A) a candy today or (B) two candies tomorrow?

  2. Would you prefer (A) a candy in 100 days or (B) two candies in 101 days?

Many people confronted with such choices answer A to the first question and B to the second. In a sense, they are more patient in the long run than they are in the short run.


This raises the possibility that consumers’ preferences may be time-inconsistent: they may alter their decisions simply because time passes. A person confronting question 2 may choose B and wait the extra day for the extra candy. But after 100 days pass, he finds himself in a new short run, confronting question 1. The pull of instant gratification may induce him to change his mind.

We see this kind of behaviour in many situations in life. A person on a diet may have a second helping at dinner, while promising himself that he will eat less tomorrow. A person may smoke one more cigarette, while promising herself that this is the last one. And a consumer may splurge at the shopping centre, while promising himself that tomorrow he will cut back his spending and start saving more for retirement. But when tomorrow arrives, the promises are in the past, and a new self takes control of the decisionmaking, with its own desire for instant gratification.

These observations raise as many questions as they answer. Will the renewed focus on psychology among economists offer a better understanding of consumer behaviour? Will it offer new and better prescriptions regarding, for instance, tax policy toward saving? It is too early to give a full evaluation, but without doubt, these questions are on the forefront of the research agenda.7



How to Get People to Save More

Many economists believe that it would be desirable for Canadians to increase the fraction of their income they saved. There are several reasons for this conclusion. From a microeconomic perspective, greater saving would mean that people would be better prepared for retirement; this goal is especially important as the baby boom generation moves into retirement over the next 20 years. From a macroeconomic perspective, greater saving would increase the supply of loanable funds available to finance investment; the Solow growth model shows that increased capital accumulation leads to higher income. From an open-economy perspective, greater saving would mean that less domestic investment would be financed by capital flows from abroad, so GNP would rise relative to GDP. Finally, the fact that many individuals say that they are not saving enough may be sufficient reason to think that increased saving should be a national goal.

The difficult issue is how to get people to save more. The burgeoning field of behavioural economics offers some answers.

One approach is to make saving the path of least resistance. For example, consider registered retirement savings plans (RRSPs). The similar arrangement in the United States is called the 401(k) plans. These are tax-advantaged retirement savings accounts available to many workers through their employers. In most firms, participation in the plan is an option that workers can choose by filling out a simple form. In some firms, however, workers are automatically enrolled in the plan but can opt out by filling out a simple form. Studies have shown that workers are far more likely to participate in the second case than in the first. If workers were rational maximizers, as is so often assumed in economic theory, they would choose the optimal amount of retirement saving, regardless of whether they had to choose to enroll or were enrolled automatically. In fact, workers’ behaviour appears to exhibit substantial inertia. As a result, policymakers who want to increase saving can take advantage of this inertia by making automatic enrollment in these savings plans more common. In 2009, U.S. President Obama attempted to do just that. According to legislation suggested in his first budget proposal, employers without retirement plans would be required to automatically enroll workers in direct-deposit retirement accounts. Employees would then be able to opt out of the system if they wished. Whether this proposal would become law was still unclear as this book was going to press.


A second approach to increase saving is to give people the opportunity to control their desires for instant gratification. One intriguing possibility is the “Save More Tomorrow” program proposed by economist Richard Thaler. The essence of this program is that people commit in advance to putting a portion of their future salary increases into a retirement savings account. When signing up, a worker makes no sacrifice of lower consumption today but instead commits to reducing consumption growth in the future. When this plan was implemented in several firms, it had a large impact. A high proportion (78 percent) of those offered the plan joined. In addition, of those enrolled, the vast majority (80 percent) stayed with the program through at least the fourth annual pay raise. The average saving rates for those in the program increased from 3.5 percent to 13.6 percent over the course of 40 months.

How successful would more widespread applications of these ideas be in increasing the national saving rate? It is impossible to say for sure. But given the importance of saving to both personal and national economic prosperity, many economists believe these proposals are worth a try.8

One straightforward way of stimulating saving is to shift from an income-based tax system to an expenditure-based tax system. This approach is supported by both traditional economic analysis (the intertemporal theory of Irving Fisher) and by psychological considerations. We now have about 55 years of survey data from a number of countries in which people are asked to rank how happy they feel. The startling conclusion is that people’s subjective happiness has not increased over this period, despite the fact that per-capita consumption has risen quite dramatically. Why isn’t this increase in material welfare registering in self-reported subjective happiness? Cornell economist Robert Frank rekindled the profession’s interest in James Duesenberry’s9 relative income hypothesis as an answer to this question. Frank focuses on what he calls positional goods. He argues that much of the satisfaction that individuals derive from these possessions stems from the fact that they allow the individual to demonstrate that they are relatively well-off—compared to others. In other words, people get higher utility from their own consumption (just as traditional analysis assumes), but, other things equal, they get lower utility when the consumption level of others rises (as psychological studies suggest). If everyone is consuming more positional goods as economic growth proceeds, the benefits—in terms of generating more happiness—can largely cancel out (since no one is doing relatively better than others). If consumption does generate negative externalities of this sort, standard microeconomic analysis gives us a clear policy prescription. Negative externalities need to be internalized with a tax. Hence, consumption taxes are supported by both Irving Fisher’s traditional analysis and by the positional-goods analysis. image