Time preference


Time preference

In economics, time preference (or "discounting") pertains to how large a premium a consumer will place on enjoyment nearer in time over more remote enjoyment.

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 compared to the average, 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.

The time preference that an individual exhibits at any given moment is determined by both their personal preferences and external circumstances. Thus, if one "prefers" to save his money but cannot do so in the present, he is still considered to have a low time preference. 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 he had earlier in life) due to a higher income and to the fact that he has had more time to acquire durable commodities (such as a college education or a house).

The time preference theory of interest is an attempt to explain interest through the demand for accelerated satisfaction. This is particularly important in microeconomics.

In the neoclassical theory of interest due to Irving Fisher, the interest rate determines the relative price of present and future consumption. Time preference, in conjunction with relative levels of present and future consumption, determines the marginal rate of substitution between present and future consumption. These two rates must necessarily be equal, and this equilibrium is brought about by the relative prices of present and future consumption.

Neoclassical view

In Neoclassical economics the rate of time preference is usually taken as a parameter in an individual's utility function which captures the trade of 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

The Austrian School sees time as the root of uncertainty within economics.

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 [Reisman, pp55-56] . 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.

ee also

* Time value of money
* Discounting
* Discount function
* Intertemporal choice
* Dynamic inconsistency

Notes

References

Reisman, G, (1998) "", Jameson Books, Ottawa. ISBN 0-915463-73-3. [http://www.capitalism.net/Capitalism/CAPITALISM_Internet.pdf Full book is available online.]

Shane Frederick & George Loewenstein & Ted O'Donoghue, 2002. "Time Discounting and Time Preference: A Critical Review," Journal of Economic Literature, vol. 40(2), pages 351-401, June. [http://www.nyu.edu/econ/user/bisina/FredLoew.pdf A comprehensive review]


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