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Time preference

From Wikipedia, the free encyclopedia

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]

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  • ✪ ⏳ Time Preference | Interest Rates
  • ✪ Prof. Hans-Hermann Hoppe on How He Nearly Got Fired from University for Wrongspeak
  • ✪ The Time Preference Theory of Interest and Its Critics | Jeffrey M. Herbener

Transcription

If people only had high time preference, we would probably still be in the Stone Age. Increases in production are only possible through saving and capital formation. Economic growth comes from people denying immediate consumption for themselves in favor of more consumption in the future. To correctly understand business cycles and where economic crises come from, we need to understand two concepts: time preference and interest rates. Time preference is the intensity of our desire to satisfy our wants now over satisfying our wants in the future. High time preference means that we want to satisfy our wants immediately. For instance, we see something in the store, something that we were dreaming about and we want it now, without waiting a single minute. Low time preference means that we are able to hold off on our consumption for now, in order to consume more in the future. For example: you want to go on vacation, but the only vacation you can afford right now is a small and short one. You decide to postpone your vacation so that you can have a better and longer one at a later date, after you have saved more. Another example: We want a decent life in retirement, so we decide to deny ourselves something now and invest the money, so that we may have more in the future. Let’s talk about how interest rates should work in the market economy. People save and spend their money, so they deposit and withdraw money from banks continually. In full reserve banking, banks would only be responsible for keeping people’s money safe for a fee or lending only the part that the customer would agree to lend. In fractional reserve banking, banks can lend a part of a depositor’s money and keep only fraction of it in reserves, hoping that not everyone would want to withdraw their money at once. In this scenario, banks can also offer their depositors interest on their deposit. Thanks to that, banks are able to collect the money in order to give other customers loans at interest. The difference between the earnings of the depositors and interest paid by the borrowers is the bank’s profit. Now look at the money like is any other good. What happens if a good is scarce? According to law of demand and supply, the price of the good increases, but where there is a lot of that product on the market, its price falls. So, if people have lower time preference, when the vaults are full, interest rates will fall. Think of it as a money on sale. When there is plenty of it, more people are able to get a loan from the banks. Falling interest rates is a very crucial bit of information for entrepreneurs. They see that people are saving their money now, so there is a lot of capital available and it is relatively cheap. They also know that the real resources for new projects are widely available, because people are not consuming them. What entrepreneurs usually decide to do in this case is to make longer term investments. As they increase their demands for the factors of production, the prices of capital goods start to increase. If interest rates were higher, those investments would not be profitable because the interest rate might exceed the return on investment. In the case of low interest rates, those investments are sensible and they provide a higher return than the interest rate. This way, entrepreneurs can prepare for greater future consumption since consumers have signalled this desire. After all, greater future consumption is the reason people save, and their lower time preference was reflected in the lower interest rate. Time preference can also go in the other direction, and savers could say: “Well, we have saved a nice amount of money, now we can live more comfortably by spending our savings”. And the entrepreneurs can answer: “That’s fantastic - we are ready - we have prepared for this by investing in projects that are just now finishing”. This mechanism contributes to balanced economic growth. Time preference and market interest rates are really important because they coordinate production in time. While people refrain from spending their funds immediately, those funds and the real resources are made available to producers and entrepreneurs. If people then increase their consumption, the arrangement of capital and production (also known as the capital structure) is capable of satisfying their desire to do so. Standards of living can grow because production is most effective when it is guided by this mechanism. If people’s time preferences switch from low to high, the money available for lending would become more scarce, and so interest rates would increase, encouraging depositors to save more and discouraging entrepreneurs from taking on long term investments. Therefore, interest rates should be dependent on people’s time preference, because only this way does it give important information about the availability of real resources in the economy. This way investments would be based on real savings and there would be no risk that there will not be enough resources to finish those investments. In the absence of artificial interest rates set by central banks, there are no boom/bust cycles, although fractional reserve banking could lead to some problems even then, which will be discussed in another film. Of course there could still be some bad investments or slowdowns in some industries, but there would be no economy-wide or systemic malinvestments. Market interest rates give entrepreneurs all the information they need regarding the general availability of resources for production today. Artificially low or high interest rates give them the wrong information about the availability of saved resources. In the next episode we’ll see why we have business cycles today and where these spectacular crises come from. If you don’t want to miss our next videos, subscribe on YouTube and like our page on Facebook. You can find the links in the video description below.

Contents

Examples

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

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

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

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

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

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

Notes

  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.


This page was last edited on 17 April 2019, at 06:40
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