## Monday, March 22, 2010

### How Wishful Thinking Got Us Into The Financial Meltdown: Our Brains Made Us Do It

Image via Wikipedia

People have a better idea of what will happen financially today than they do in the future.

Studies of consumers show that a clear tendency to discount expected outcomes proportionate to their delays exist and often there is a preference reversal between the immediate and the delayed reward in the period of time just before the reward is due. Brain scans show which areas of the brain light up when immediate rewards are chosen vs delayed ones.

In short, do you want $30 now or$50 in the future? Most people take the money and run. However, given the choice between $30 in five years or$60 in six years almost everyone will choose \$60 in six years, even though that is the same choice seen at five years' greater distance.

Mathematically, this is expressed as how consumption (c) is dependent on how we look at our happiness of consuming (u(c)) over time. Consumption at any pair of points in time depends only on how far in the future our consumption is.
$U(\{c_t\}_{t=t_1}^{t_2})=\sum_{t=t_1}^{t_2}\delta^{t-t_1}(u(c_t)),$

This equation assumes that we look at our decisions constantly over time.  This is opposed to hyperbolic discounting where we change our minds over time and weight our decisions such that near term rewards counted more than long term rewards.

Hyperbolic consumption

$f_H(D)=\frac{1}{1+kD}$

In other words, we plan for the short term and not think about the long term consequences of our actions.

Brain areas active when participants make decisions with respect to the future  FMRI Scanning the main imaging paradigm
•  Testing Hyperbolic Discounting and Dual Decision Making
• Affective Decision Making
•  Visceral Effect
• Exponential Discounting:
Exponential discounting implies that a constant preference between rewards should exist over time. Hyperbolic Discounting implies that short-term is preferred over the long term and has been born out by brain imaging

In a nutshell,  there is a certain amount of neuropsychology that has teed us up for short term planning over long term planning.  People chose short-term gains over what they expected to happen with their mortgages over long term prudence.  This is greatly  oversimplifying things from a classical economic viewpoint but economists are looking seriously at neuroeconomics as a partial explanation of our economic situation today.