Behavioral Finance Discounted Utility

Discounted utility is a term that describes the way in which people place more or less value on a reward. In discounted utility, time is the major element. Future or past reward is valued differently, and generally more, than the present or immediate reward.

The term “utility” describes how desirable or satisfying a good or service is, or it describes the consumption of goods and services. Of course, the desirable goal is to increase utility, but there are perceptions that often do not go along with reality in terms of increasing utility. John Stewart Mills (1806-1876) was sure that society should manage consumption to ensure “the greatest happiness for the greatest number of people.”

Many others came along with the idea that it would be better to ensure the greatest happiness for those who could get that happiness. Then there are issues of social utility as opposed to personal utility. There is a point where there is satisfaction from consuming that which sustains life and that which sustains happiness, making concepts of utility that apply to social satisfaction/happiness and social welfare.

The operative concept in dealing with discounted utility is the concept of patience. In one easy example, people either have patience, and will save over time until there is enough money to get what they desire; or people will go into debt in order to get what they desire as soon as possible. People will wait for retirement until they get a return on investments; or they will spend all available money and even go into debt as they go.

Amazingly, the cost of debt as opposed to the returns on savings are often not an incentive to be more patient. But the return on savings might be less than the rising cost of goods and services, and the cost of debt might be more than the rising cost of goods and services. As a result, there might be issues of expected decline in the value of money, lack of trust or confusion about complexity and hidden fees, rather than impatience going on with calculating discounted utility.

Additionally, it is interesting that the concepts of trust, complexity and expected decline in value of money is not discussed in calculating utility. Many people simply do not trust banks, investment schemes or putting their money into someone else’s hands. People would rather spend available funds on something that is not only tangible, but is less expensive now. Many worry that they would be taking multiple risks and losses that include rising prices, rising cost of living, and potential theft, diversion or loss of their entire nest egg.

Officially, there are models for calculating discounted utility. The hyperbolic discounting concept, where the famous example of choosing one unit today over two units tomorrow, is the foundation for many of the models. In hyperbolic discounting, people would choose two units a year from now, even though the reward is the same as if they waited a day. A year from now, people would be likely to see the error of their ways and regret that they did not make the choice of twounits the next day, implying that ideas of value are not only different for increments of time, but they also change over time. 

But people probably turn down two dollars tomorrow because they do not trust that the promise will be kept. This is not clearly discussed in hyperbolic discounting or in utility theory.