Game Theory, Dynamic Inconsistency and Decision Making

“Stay committed to your decisions, but stay flexible in your approach.”

-Tony Robbins

Game theory has interesting concept called as dynamic inconsistency. It refers to a disagreement between your earlier self and your later self about what your later self should do. Informally, it is a failure to act (or prefer) according to plan.

More precisely, if you think “If things turn out like X, I should do Y”, and then things turn out like X, and you don’t do Y, then this contradiction is called a dynamic inconsistency.

'We've got to get our clients to think of long term investments. By long term, I man until we retire.'

In economics, dynamic inconsistency describes a situation in which a decision-maker’s preferences change over time in such a way that a preference can become inconsistent at another point in time. This can be thought of as there being many different “selves” within decision makers, with each “self” representing the decision-maker at a different point in time; the inconsistency occurs when all preferences are not aligned.

An interesting experiment was carried out to understand this concept.

In the experiment, subjects of the study were offered free rentals of movies which were classified into two categories of movies – “lowbrow” (ex. The Breakfast Club) and “highbrow” (ex. Schindler’s List) – and researchers analysed 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 ex. if I want to watch Schindler’s list, I will watch it anyway, whether it is today or 2 weeks later.

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.

 

Thus time horizon can lead to inconsistencies in decision making.

 

“I bought a company in the mid-’90s called Dexter Shoe and paid $400 million for it. And it went to zero. And I gave about $400 million worth of Berkshire stock, which is probably now worth $400 billion. But I’ve made lots of dumb decisions. That’s part of the game.”

-Warren Buffett

Another example is that of campus placements. In beginning of course everyone wants to join only Fortune 500 Company, but if at the end of course there is recession in job market, candidates will grab any job offer rather keep trying for Fortune 500 companies.

Campus-Recruitment-in-School-India-Funny-Cartoon-Jokes

Mathematically if you are given an option of Vice (grab any job that is offered to you) or Virtue ( opt for only Fortune 500 company), look for payout in each case.

Vice gives yield of 100 now and 100 later, while Virtue gives yield of 25 now and 200 in future. Assume immediacy effect of 0.5 i.e. present gets discounted by .05

If you want to start immediately then present value is

Virtue= 25+ (0.5 x 200) = 125

Vice= 100+ (.5 x 100) = 150

So Vice is preferred, thus in short term Vice is always preferred because of discounting of future value.

But if you are looking for long term horizon, then entire thing is discounted

Virtue = 0.5 x (25 + 200) = 112.5

Vice = .05 x (100+100) = 100

Hence in long term Virtue gets preferred.

immediacy-effect1

 

 

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