Analyze the following scenario and identify the behavioral tendency that best explains the individual's actions. Provide a brief justification for your answer.

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Present bias is a behavioral tendency where an individual places a greater weight on present satisfaction than on future well-being. This desire to postpone a decrease in living standards can lead them to not react to news of a future income drop. Consequently, they may continue to consume all their current income, only to face a significant reduction in consumption when their income actually falls.

Present Bias

Time-inconsistent behaviour occurs when an individual lacks the willpower to execute a previously formulated plan, often because their preferences change as the moment of action arrives. Economists use this concept to explain why someone might fail to save for a predictable future event, such as an anticipated drop in income. This failure to save is attributed to an internal struggle, rather than an external constraint, and is a common explanation for behaviors driven by present bias.

Time-Inconsistent Behaviour

It is important to distinguish between the inability to save and the inability to borrow. Being unable to borrow is typically an external constraint imposed by others, such as a bank denying a loan. In contrast, the failure to save is often an internal issue, such as a lack of willpower, since saving is a form of self-insurance that does not require the participation of another party.

Distinction Between Saving and Borrowing Constraints

Consumption Decision Scenario

A freelance graphic designer learns in January that a major client, representing 30% of their annual income, will not be renewing their contract when it expires at the end of June. Which of the following actions by the designer between January and June would most clearly demonstrate the principle of present bias?

An employee is notified on January 1st that their salary will be permanently reduced by 20% starting on April 1st. Despite this three-month warning, the employee does not reduce their spending and continues to consume their entire paycheck each month. Analyze this behavior by explaining the trade-off the employee is making between their well-being in the present versus their well-being after the income drop occurs.

Evaluating a Financial Decision

Imagine two individuals, Alex and Ben. Both learn today that their income will be permanently lower starting one year from now. Alex is a standard, forward-looking economic agent who prefers a smooth consumption path over their lifetime. Ben, however, exhibits a strong present bias. Contrast the likely immediate response of Alex and Ben to this news in terms of their current consumption and saving. Explain the underlying reasoning for the difference in their behavior.

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