Chapter 6: Problem 29

What assumptions does the model of intertemporal choice make that are not likely true in the real world and would make the model harder to use in practice?

Short Answer

Expert verified

The model of intertemporal choice makes several assumptions that are not likely true in the real world, which makes it harder to use in practice. These assumptions include perfect information, rationality, time consistency, a single utility function, and an infinite lifetime. In reality, consumers often face uncertainty and make irrational decisions, have time-inconsistent preferences, derive utility from multiple aspects of life, and have a finite lifespan. These real-world complexities limit the model's practicality and accuracy in representing actual consumer behavior.

Step by step solution

Assumption 1: Perfect Information

The model of intertemporal choice assumes perfect information. Consumers are assumed to know all the possible outcomes and risks associated with all their current and future consumption options. In the real world, however, this is often not the case because decisions are made under uncertainty due to lack of information or inaccurate predictions about the future.

Assumption 2: Rationality

The model assumes rational consumers, implying that individuals always make decisions that provide them with the highest utility, considering both present and future consumption. However, this assumption is often violated in the real world where consumers might give into temptations and make irrational decisions, leading to inconsistency in their choices across time.

Assumption 3: Time Consistency

In intertemporal choice, it’s assumed that a consumer’s preferences are time-consistent, meaning that their rate of time preference doesn’t change over time. However, in reality, consumers might be time-inconsistent, exhibiting a tendency to increasingly prefer present consumption as a given point in time becomes more imminent, pulling away from their once long-term oriented decisions.

Assumption 4: Single Utility Function

The model assumes that consumers derive their well-being based on a single utility function. However, in reality, different aspects such as health, social interactions and personal development may impact a person's utility, leading to multiple utility functions, which complicates the model.

Assumption 5: Infinite Lifetime

Another assumption is that consumers live infinitely, allowing them to smooth consumption over an infinite number of periods. This assumption clearly doesn't hold in the real world, as human lifespan is finite. The assumption simplifies the model but can distort important aspects of reality, such as individuals saving for retirement or life insurance. These assumptions, while necessary for simplifying the model, limit the model's practicality in illustrating real-world phenomena accurately.