Designing Contracts that turn Dynamic Inconsistency into an Advantage

Traditional economics relies heavily on the assumption that people are rational. This assumption is highly unrealistic, as nobody is fully rational. Economists, however, were reluctant to drop this unrealistic assumption because being irrational was deemed equivalent to being unpredictable. A recent revolution in behavioral economics changed this perception by showing that people in general are irrational in certain highly predictable ways. One of ways that people are predictably irrational is being dynamically inconsistent.

In the last 20 years, economists have gained significant understanding of dynamic inconsistency, including how it generates various problems in our daily lives, and how various seemingly inefficient social institutions can actually be understood as devices to mitigate the dynamic inconsistency problem.

However, the conventional wisdom (that is, until this proposed project) remains that dynamic inconsistency is a curse that we have to accept as part of our lives. This PI is the first economist to point out that dynamic inconsistency needs not be a curse, but can be a blessing sometimes, provided that we know how to make good use of it. The intuition, once explained, is actually very simple: dynamic inconsistency means that your future self does not share the same preferences as yours. But your future self is still the same person as you are, sharing all your information and secrets, albeit not necessarily your interest. S/he is hence your most formidable enemy, and the most capable candidate to keep you honest. With her/him looking over your shoulder, your various claims about yourself can gain a lot more credibility. This can give you a leg up in contractual relationships, when trust cannot be taken for grant.

The objective of this project is to turn this deep insight into concrete advices for the general public, especially advices on how they should turn their own dynamic inconsistency problem into an advantage in contractual relationships. I plan to document these advices in at least one international refereed journal article, and present these advices in multiple conferences.

The long-term significance of the project is that it will increase the welfare of the general public as we change the way we look at our own imperfection in general, and our irrationality in particular. It will also inspire a new research agenda, where economists search for ways to turn our other kinds of irrationality into our advantage.