Dynamic Inconsistency - Stylized Examples

Stylized Examples

• Students, the night before an exam, often wish that the exam could be put off for one more day. If asked on that night, such students might agree to commit to paying, say, $10 on the day of the exam for it to be held the next day. Months before the exam is held, however, students generally do not care much about having the exam put off for one day. And, in fact, if the students were made the same offer at the beginning of the term, that is, they could have the exam put off for one day by committing during registration to pay $10 on the day of the exam, they probably would reject that offer. The choice is the same, although made at different points in time. Because the outcome would change depending on the point in time, the students would exhibit time inconsistency.

• Government policy makers also suffer from dynamic inconsistency, as they are best off promising that there will be lower inflation tomorrow. But once tomorrow comes lowering inflation may have negative effects, such as increasing unemployment, so they do not make much effort to lower it. This is why independent central banks are believed to be advantageous for a country: their independence frees them to only worry about making decisions for the greater good, not to keep government policy makers popular.

• One famous example in literature of a mechanism for dealing with dynamic inconsistency is that of Odysseus and the Sirens. Curious to hear the Sirens' songs but mindful of the danger, Odysseus orders his men to stop their ears with beeswax and ties himself to the mast of the ship. Most importantly, he orders his men not to heed his cries while they pass the Sirens; recognizing that in the future he may behave irrationally, Odysseus limits his future agency and binds himself to a commitment mechanism (i.e. the mast) to survive this perilous example of dynamic inconsistency. This example has been used by economists to explain the benefits of commitment mechanisms in mitigating dynamic inconsistency.

• A curious case of dynamic inconsistency in psychology is described by Read, Loewenstein and Kalyanaraman (1999). In the experiment, subjects of the study were offered free rentals of movies which were classified into two categories - "lowbrow" (e.g. The Breakfast Club) and "highbrow" (e.g. Schindler's List) - and researchers analyzed patterns of choices made. In the absence of dynamic inconsistency, the choice would be expected to be the same regardless of the delay between the decision date and the consumption date. In practice, however, the outcome was different. When subjects had to choose a movie to watch immediately, the choice was consistently lowbrow for the majority of the subjects. But when they were asked to pick a movie to be watched at later date, highbrow movies were chosen far more often. Among movies picked four or more days in advance, over 70% were highbrow.