Fuzzy Math and Red Ink: When the Opportunity Cost of Consumption is Not What it Seems,” mimeo

The economics of intertemporal choice has varied the specification of every key aspect of modeling but one: it generally assumes that consumers correctly perceive the opportunity costs of intertemporal consumption tradeoffs. We present some new evidence that, together with earlier work, suggests that consumers hold biased perceptions about intertemporal tradeoffs: they tend to systematically underestimate the costs of short-term borrowing and the returns to long-term saving. We develop a new theory of biased perceptions that fits this evidence and is based on a well-established microfoundation from cognitive psychology: the general tendency to underestimate exponential series. With a household-level measure of biased perceptions in hand, we test the following predictions: more biased consumers will save less and hold less wealth, hold more short-term installment debt and fewer stocks, and use and benefit from financial advice relatively intensively. The data bear out these predictions. In all, the evidence suggests that many consumers systematically misperceive the opportunity cost of intertemporal tradeoffs, that there is a clear cognitive microfoundation for such misperceptions, an