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Chapter 3: Welfare Measurement, Hyperbolic Discounting and Paternalism
Kenneth Backlund and Tomas Sjögren 1 INTRODUCTION Today, there exists a literature which emphasizes that individuals may suffer from bounded rationality.1 Common examples are the tendencies among some individuals to overconsume alcohol or to undersave. If these decisions are regretted later in life, this behavior is not consistent with the assumption that individuals make rational choices, and as such, there is a potential role for government intervention. This has spurred a literature concerning paternalistic, or non-welfarist motives for public policy.2 One type of bounded rationality which has received particular interest is when individuals use a hyperbolic discount function to evaluate the future. Hyperbolic discounting captures the empirically observed tendency among individuals to apply higher discount rates to near-term returns than to returns in the distant future, meaning that the discount rate effectively becomes time dependent.3 For the discussion below, let us refer to the ‘low’ discount rate used by individuals to evaluate two points in a distant future as the pure rate of time preference, whereas the ‘high’ discount rate used to evaluate two points in the near future will be referred to as the effective rate of time preference. A time-dependent discount rate has the potential to cause a conflict between an individual’s long-run intentions and his/her short-run needs. As such, this may give rise to time-inconsistent behavior, whereby a young self can be viewed as imposing an intrapersonal externality on his/her future selve(s).4 Several papers have analyzed how paternalistic public policies can be used to...
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