Academic journal article Economic Inquiry

A Theory of Time Preference

Academic journal article Economic Inquiry

A Theory of Time Preference

Article excerpt

GRANT A. TAYLOR [*]

This article proposes that people generally prefer present consumption to future consumption because their expected utility from consumption (eventually) falls as their mental and physical abilities (eventually) decline with age. Moreover; contrary to the ubiquitous intertemporal formulation with a constant rate of time preference and contrary to three recent theories of time preference that predict decreasing discounting as people age, this article asserts that discounting increases over the life cycle. This hypothesis is supported by data from the Panel Study of Income Dynamics as well as evidence from numerous previous studies. (JEL D91)

1. INTRODUCTION

Despite the almost universal assumption of time preference in models of intertemporal choice, an adequate explanation of why people discount the future has not been provided. [1] Olsen and Bailey (1981) make a convincing case for positive time preference by contradiction (i.e., without time preference models of intertemporal choice do not yield predictions consistent with observed behavior), but they do not explain why individuals would rationally discount the future. [2] Three recent studies have attempted to provide the explanation. Rogers (1994) argues that societies that discount the future (at a rate of about 2%) will be the long-run survivors in an evolutionary fitness situation. [3] Posner (1995) argues that discounting occurs because individuals have "multiple selves," that is, "people are weighting their present consumption far more heavily than their future consumption... [because] the present self and the future self are, in some meaningful sense, separate persons" (92). Becker and Mulligan (1997) argue that discounting occurs because of a rational "defective recognition of future utilities" (730). But, as will be shown, these three theories are inconsistent with empirical evidence on consumption over the life cycle in at least one important aspect.

This article constructs and empirically supports a new theory of time preference. The hypothesis is that people do not have an intrinsic preference for present consumption relative to future consumption. Instead, the instantaneous utility function (also known as the felicity function) is expected to vary with age, just as people's physical and mental abilities vary with age. In other words, the ability to enjoy consumption eventually deteriorates over the life cycle along with other abilities. This life-cycle view of the expected utility function causes people to rationally devalue consumption in periods of low expected felicity, that is, discount future consumption. Perhaps this is what is meant by the cliche "don't wait until you are too old to enjoy it." Moreover, this causes individuals' implicit discount rates to vary systematically with age. [4] In fact, this provides the testable implication of the theory. The standard specification of intertemporal preferences holds the discount rate constant over th e life cycle. [5]

To be more precise, in the early stage of the life cycle the capacity to enjoy consumption may be expected to rise. Hence a young individual's discount rate may be negative. Figure 1 illustrates this possibility with a hypothetical adult life-cycle marginal felicity function for a given level of consumption, [U.sub.C](C, a) (C denotes consumption and a denotes age), and its corresponding discount rate function, [rho](a). The vast majority of wealth is held by older people, that is, those in the declining stage of their abilities. Thus the preference for present consumption over future consumption appears to hold in the aggregate.

This view of intertemporal preferences may at first seem inconsistent with practically all dynamic analyses, which are based on the notion of stationary utility. On further consideration, however, the hypothesis is quite consistent with modern consumer theory. Since Becker (1965) it has been widely accepted that households derive utility from commodities that are produced with market goods combined with household time and skills (i. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.