Time preference

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In economics, time preference (or time discounting,[1] delay discounting, temporal discounting[2], long-term orientation[3]) is the current relative valuation placed on receiving a good at an earlier date compared with receiving it at a later date.[1]

There is no absolute distinction that separates "high" and "low" time preference, only comparisons with others either individually or in aggregate. Someone with a high time preference is focused substantially on their well-being in the present and the immediate future relative to the average person, while someone with low time preference places more emphasis than average on their well-being in the further future.

Time preferences are captured mathematically in the discount function. The higher the time preference, the higher the discount placed on returns receivable or costs payable in the future.

One of the factors that may determine an individual's time preference is how long that individual has lived. An older individual may have a lower time preference (relative to what they had earlier in life) due to a higher income and to the fact that they have had more time to acquire durable commodities (such as a college education or a house).[4]

Examples[edit]

A practical example is if Jim and Bob go out for a drink and Jim has no money so Bob lends Jim $10. The next day Bob comes back to Jim, and Jim says, "Bob, you can have $10 now, or at the end of the month when I get paid I will give you $15." Bob's time preference would change depending on if he trusted Jim and how much he needs the money now, thinks he can wait, or would prefer to have $15 at the end of the month than $10 now. Present and expected needs, present and expected income affect the time preference.

Neoclassical views[edit]

In the neoclassical theory of interest due to Irving Fisher, the rate of time preference is usually taken as a parameter in an individual's utility function which captures the trade off between consumption today and consumption in the future, and is thus exogenous and subjective. It is also the underlying determinant of the real rate of interest. The rate of return on investment is generally seen as return on capital, with the real rate of interest equal to the marginal product of capital at any point in time. Arbitrage, in turn, implies that the return on capital is equalized with the interest rate on financial assets (adjusting for factors such as inflation and risk). Consumers, who are facing a choice between consumption and saving, respond to the difference between the market interest rate and their own subjective rate of time preference ("impatience") and increase or decrease their current consumption according to this difference. This changes the amount of funds available for investment and capital accumulation, as in for example the Ramsey growth model.

In the long run steady state, consumption's share in a person's income is constant which pins down the rate of interest as equal to the rate of time preference, with the marginal product of capital adjusting to ensure this equality holds. It is important to note that in this view, it is not that people discount the future because they can receive positive interest rates on their savings. Rather, the causality goes in the opposite direction; interest rates must be positive in order to induce impatient individuals to forgo current consumptions in favor of future.

Austrian School views[edit]

In his book Capital and Interest, the Austrian economist Eugen von Böhm-Bawerk built upon the time-preference ideas of Carl Menger, insisting that there is always a difference in value between present goods and future goods of equal quality, quantity, and form. Furthermore, the value of future goods diminishes as the length of time necessary for their completion increases.

Böhm-Bawerk cited three reasons for this difference in value. First of all, in a growing economy, the supply of goods will always be larger in the future than it is in the present. Secondly, people have a tendency to underestimate their future needs due to carelessness and shortsightedness. Finally, entrepreneurs would rather initiate production with goods presently available, instead of waiting for future goods and delaying production.

By contrast, George Reisman says that time preference arises because of the possibility of being less able (say through injury or the effects of aging) or totally unable (through substantial incapacitation or death) to enjoy the use of goods in the future.[5] The further into the future someone considers, the less likely it is that this someone will be able to enjoy the goods as much as they can be enjoyed now. The root of time-preference in Reisman's view is an internal risk premium that is specific to the owner of the goods, in contrast to an external risk premium that is demanded when the owner invests them in a production process or lends them to another. He then points out that the scarcity of capital combined with the uncertainties he raises, means that time preference is unavoidable and hence a minimum rate of return on that capital (such as in interest and normal profit) is always going to be required by suppliers of capital.

In Human Action (chapter 18), Ludwig von Mises discusses time inconsistency: that sooner-occurring future intervals are valued more highly than later-occurring future intervals.[6] This observation has been observed in behavioral economics.[citation needed]

Temporal discounting[edit]

Temporal discounting (also known as delay discounting, time discounting)[7] is the tendency of people to discount rewards as they approach a temporal horizon in the future or the past (i.e., become so distant in time that they cease to be valuable or to have additive effects). To put it another way, it is a tendency to give greater value to rewards as they move away from their temporal horizons and towards the "now". For instance, a nicotine deprived smoker may highly value a cigarette available any time in the next 6 hours but assign little or no value to a cigarette available in 6 months.[8]

Regarding terminology, from Frederick et al (2002):

We distinguish time discounting from time preference. We use the term time discounting broadly to encompass any reason for caring less about a future consequence, including factors that diminish the expected utility generated by a future consequence, such as uncertainty or changing tastes. We use the term time preference to refer, more specifically, to the preference for immediate utility over delayed utility.

This term is used in intertemporal economics, intertemporal choice, neurobiology of reward and decision making, microeconomics and recently neuroeconomics.[9] Traditional models of economics assumed that the discounting function is exponential in time leading to a monotonic decrease in preference with increased time delay; however, more recent neuroeconomic models suggest a hyperbolic discount function which can address the phenomenon of preference reversal.[10]

Preference reversal[edit]

Offered a choice of $100 today and $100 in one month, individuals will most likely choose the $100 now. However, should the question change to having $100 today, or $1,000 in one month, individuals will most likely choose the $1,000 in one month. The $100 can be conceptualized as a Smaller Sooner Reward (SSR), and the $1,000 can be conceptualized as a Larger Later Reward (LLR). Researchers who study temporal discounting are interested in the point in time in which an individual changes their preference for the SSR to the LLR, or vice versa. For example, although an individual may prefer $1,000 in one month over $100 now, they may switch their preference to the $100 if the delay to the $1,000 is increased to 60 months (5 years). This means that this individual values $1,000 after a delay of 60 months less than $100 now. The trick is to find the point in time in which the individual values the LLR and the SSR as being equivalent. That is known as the indifference point[11].

Origin of differences in time preference across countries[edit]

Oded Galor and Omer Ozak explore the roots of observed differences in time preference across nations.[12] They establish that pre-industrial agricultural characteristics that were favorable to higher return to agricultural investment triggered a process of selection, adaptation, and learning that brought about a higher prevalence of long-term orientation. These agricultural characteristics are associated with contemporary economic and human behavior such as technological adoption, education, saving, and smoking.

See also[edit]

Notes[edit]

  1. ^ a b Frederick, Shane; Loewenstein, George; O’donoghue, Ted (2002). "Time Discounting and Time Preference: A Critical Review" (PDF). Journal of Economic Literature. 40 (2): 351–401.
  2. ^ Doyle, John R. (2013). "Survey of time preference, delay discounting models" (PDF). Judgment and Decision Making. 8 (2): 116–135.
  3. ^ Hofstede, Geert (2001). Culture's consequences: Comparing values, behaviors, institutions and organizations across nations. Sage publications.
  4. ^ Bayer, Y. M.; Osher, Y. (2018). "Time preference, executive functions, and ego-depletion: An exploratory study". Journal of Neuroscience, Psychology, and Economics. 11 (3): 127–134.
  5. ^ Reisman, George (1996). Capitalism: A Treatise on Economics (PDF). Ottawa: Jameson Books.
  6. ^ MISES, L. V. Human Action. A Treatise on Economics. Scholar's Edition. Alburn: Ludwig von Mises Institute, 1998. Pg. 480
  7. ^ Doyle, John R. (2013). "Survey of time preference, delay discounting models" (PDF). Judgment and Decision Making. 8 (2): 116–135. ISSN 1930-2975.
  8. ^ Bickel, W. K.; Odum, A. L.; Madden, G. J. (1999). "Impulsivity and cigarette smoking: delay discounting in current, never, and ex-smokers". Psychopharmacology. 146 (4): 447–454. doi:10.1007/PL00005490. ISSN 0033-3158.
  9. ^ Takahashi T., Hadzibeganovic T., Cannas S. A., Makino T., Fukui H., Kitayama S. (2009). "Cultural neuroeconomics of intertemporal choice". Neuro Endocrinol. Lett. 30 (2): 185–91. PMID 19675524.CS1 maint: uses authors parameter (link)
  10. ^ Green, Leonard; Myerson, Joel (2004). "A Discounting Framework for Choice With Delayed and Probabilistic Rewards". Psychological Bulletin. 130 (5): 769–792. doi:10.1037/0033-2909.130.5.769. ISSN 0033-2909. PMC 1382186.
  11. ^ Odum, Amy L. (2011). "Delay Discounting: I'm a k, You're a k". Journal of the Experimental Analysis of Behavior. 96 (3): 427–439. doi:10.1901/jeab.2011.96-423. ISSN 0022-5002. PMC 3213005. PMID 22084499.
  12. ^ Galor, Oded; Özak, Ömer (2016). "The Agricultural Origins of Time Preference". American Economic Review. 106 (10): 3064–3103.