What Is Time Preference?
Time preference refers to the relative value an individual places on receiving a good or experiencing a benefit at an earlier date compared to a later date. It is a fundamental concept within behavioral economics, influencing how individuals make decisions involving trade-offs between immediate gratification and future rewards. People generally exhibit a positive time preference, meaning they prefer to receive benefits sooner rather than later, and prefer to incur costs later rather than sooner. This inherent inclination shapes everything from daily spending habits to long-term investment decisions and financial planning.
A higher time preference indicates a stronger desire for immediate satisfaction, leading an individual to discount future outcomes more heavily. Conversely, a lower time preference suggests greater patience and a willingness to wait for larger, later rewards, often associated with concepts like delayed gratification. This preference is a crucial determinant in understanding individual and collective economic behavior.
History and Origin
The concept of time preference has deep roots in economic thought, evolving through the contributions of several prominent economists. Early economists like Eugen von Böhm-Bawerk, a leading figure of the Austrian School of economics, extensively discussed the idea that people value present goods more highly than future goods of the same kind. Böhm-Bawerk posited that this "positive time-preference" is a key reason why interest rates are positive; people are willing to pay interest to gain access to resources now, and require interest as compensation for delaying gratification.
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Later, American economist Irving Fisher elaborated significantly on time preference in his seminal work, "The Theory of Interest." Fisher established time preference as a subjective element, varying among individuals based on their unique circumstances, such as income levels, expectations, and foresight. He formalized the idea that individuals' utility functions influence their trade-off between present and future consumption, thereby linking time preference directly to the determination of interest rates and the time value of money. 3His framework laid much of the groundwork for modern understanding of intertemporal choice.
Key Takeaways
- Time preference describes the human tendency to value immediate rewards more highly than identical rewards received in the future.
- It is a core concept in behavioral economics, influencing decisions related to spending, savings, and investment.
- A higher time preference indicates a stronger inclination for immediate gratification and a greater discounting of future outcomes.
- Conversely, a lower time preference reflects greater patience and a willingness to wait for potentially larger future benefits.
- Time preference helps explain why people might engage in behaviors like borrowing at high interest or undersaving for retirement.
Interpreting Time Preference
Time preference is typically interpreted as a reflection of an individual's "impatience" or their subjective discount rate for future utility. A high time preference means that an individual places a significant discount on future benefits. For example, someone with a high time preference might choose to spend a windfall immediately rather than invest it for long-term growth. This strong preference for the present means that future benefits must be substantially larger to be considered equally appealing.
Conversely, a low time preference indicates a person is more patient and less inclined to heavily discount future rewards. Such an individual might be more willing to forgo current consumption in favor of saving for retirement or making long-term investments that yield returns far into the future. While time preference is a personal characteristic, it can be influenced by factors such as perceived future uncertainty, wealth, age, and education.
Hypothetical Example
Consider two individuals, Alex and Ben, who both receive an unexpected bonus of $1,000.
Alex (High Time Preference): Alex sees the $1,000 bonus and immediately thinks about a new gadget or a weekend trip. He values the immediate enjoyment and satisfaction of these purchases very highly. If offered a choice between $1,000 today or $1,200 in one year, Alex might still choose the $1,000 today because the additional $200 in a year does not sufficiently compensate him for the opportunity cost of delaying his gratification. His focus is on present utility.
Ben (Low Time Preference): Ben, on the other hand, considers long-term goals. He thinks about contributing to his retirement fund or making a down payment on a house. If offered the same choice between $1,000 today or $1,200 in one year, Ben would likely choose the $1,200 in one year. The prospect of a larger future sum outweighs the desire for immediate spending because his time preference leads him to value future gains more highly. He exhibits greater patience and a willingness to defer immediate benefits for greater future returns.
This example illustrates how varying degrees of time preference can lead to different financial choices, even when faced with identical monetary amounts.
Practical Applications
Time preference is a pervasive concept with significant implications across various domains:
- Personal Finance: It underlies decisions about savings versus consumption, retirement planning, and debt management. Individuals with high time preference may struggle with saving, opting instead for immediate gratification through spending or accumulating credit card debt.
- Investing and Capital Budgeting: In corporate finance, time preference influences the discount rate used in valuing projects. Companies implicitly consider time preference when evaluating whether a project's future cash flows are worth the initial investment. Investors also incorporate their time preferences into their required rates of return.
- Public Policy: Governments and central banks consider time preference when designing policies related to taxation, social security, and environmental regulations. Policies like automatic enrollment in retirement plans or "nudge" strategies are often designed to counteract high time preference and encourage long-term beneficial behaviors. Research highlights how an individual's level of patience, or rate of time preference, directly impacts their trade-off between current and future consumption, influencing everything from health behaviors to energy use and financial outcomes.
2* Consumer Behavior: Understanding consumer time preferences helps businesses tailor marketing strategies, pricing models, and product offerings. For instance, instant rebate programs cater to a higher time preference, while long-term loyalty programs appeal to a lower one.
Limitations and Criticisms
While time preference is a powerful explanatory tool, it faces certain limitations and criticisms, particularly from the field of behavioral economics.
One major critique is that human time preferences are not always "time-consistent." Traditional economic models often assume that an individual's discount rate remains constant over time. However, empirical evidence, particularly studies on "hyperbolic discounting," suggests that people tend to discount the near future more steeply than the distant future. This means that preferences can "reverse" over time; an individual might prefer a smaller, immediate reward over a larger, slightly delayed one, but then prefer a larger, much-later reward over a slightly earlier, smaller one, when both options are far in the future. This "present bias" can lead to irrational decision-making, such as procrastination or a lack of long-term savings, as individuals make choices today that their future selves might regret.
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Furthermore, external factors like inflation, uncertainty, and specific framing of choices can significantly influence perceived time preference, sometimes leading to deviations from purely rational choices. Some criticisms also point to the difficulty of accurately measuring an individual's true time preference, as it can vary based on the context and magnitude of the rewards involved.
Time Preference vs. Discount Rate
While closely related and often used interchangeably in casual discussion, "time preference" and "discount rate" represent distinct concepts within finance and economics.
Time preference is a psychological concept reflecting an individual's subjective valuation of immediate satisfaction over future satisfaction. It is an intrinsic aspect of human nature, representing a preference for the present. It describes why a future dollar is valued less than a present dollar.
The discount rate, in a financial context, is the rate used to calculate the present value of future cash flows. It is an objective, quantitative measure applied in financial calculations. While an individual's time preference will influence the personal discount rate they apply to their own decisions, the discount rate itself can also be determined by market interest rates, risk aversion, and the perceived opportunity cost of capital. It describes how much a future dollar is discounted.
In essence, time preference is the underlying behavioral trait, while the discount rate is the mathematical tool used to quantify the impact of that (and other) behavioral traits, as well as market realities, on financial valuations.
FAQs
Why do people have time preference?
People generally have a positive time preference due to several factors, including the uncertainty of the future (a bird in hand is worth two in the bush), impatience, and the desire for immediate gratification. A present good offers certain utility, whereas a future good carries the risk of not materializing or being less desirable later.
Can time preference change?
Yes, an individual's time preference can change over their lifetime or in response to different circumstances. Factors like age, wealth, health status, and life experiences can influence how much an individual values present versus future rewards. For example, a young person might have a higher time preference due to fewer immediate responsibilities, while an older individual might develop a lower time preference as they focus more on long-term financial planning and retirement.
How does time preference affect personal finance?
Time preference significantly impacts personal finance by influencing decisions on consumption versus savings. A high time preference can lead to impulsive spending, accumulating debt, and insufficient retirement savings. Conversely, a lower time preference promotes deferred gratification, allowing for greater wealth accumulation through disciplined saving and investing for the future value of money.
Is time preference always rational?
Not always. While traditional economic models assume rational time preference (constant discounting), behavioral economics highlights phenomena like hyperbolic discounting, where individuals exhibit inconsistent preferences over time. This can lead to choices that are not in their long-term best interest, such as delaying beneficial actions (e.g., exercise, saving) in favor of immediate pleasures.