Time preferences

What Are Time Preferences?

Time preferences, a core concept in behavioral economics and classical economics, refer to the relative valuation an individual places on receiving a good or service at an earlier date compared to a later date. This preference reflects the inherent human tendency towards impatience, meaning people generally prefer immediate gratification over delayed rewards, even if the delayed reward is objectively larger. The degree of this preference varies significantly among individuals, influencing a wide array of financial and personal investment decisions, from saving habits to consumption choices.

History and Origin

The concept of time preferences has deep roots in economic thought, dating back to early classical economists who recognized that individuals place a greater value on present goods than future goods. This idea was formalized by economists like Eugen von Böhm-Bawerk in the late 19th century, who identified "time preference" as a fundamental factor explaining the existence of interest. Later, Irving Fisher's work on the "Theory of Interest" (1930) further developed the notion, linking time preference directly to an individual's marginal utility theory and income stream.

In more recent times, research by the Federal Reserve Bank of San Francisco has explored how this discounting of future outcomes impacts economic decisions across different demographics and over time. ⁴This modern perspective, often drawing from psychology, delves into the nuances of human behavior that classical economics might have overlooked, particularly the idea that individuals may not apply a consistent discount rate to future events.
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Key Takeaways

Time preferences reflect an individual's relative valuation of current rewards versus future rewards.
Individuals typically exhibit a preference for immediate gratification, often preferring smaller, sooner rewards over larger, later ones.
These preferences are a key component of behavioral economics and influence financial decisions like saving and investing.
The concept of hyperbolic discounting highlights that time preferences can be inconsistent, with a stronger preference for immediate rewards over short horizons.
Understanding time preferences is crucial for effective financial planning and policy-making.

Formula and Calculation

While time preference itself is a psychological and economic concept rather than a direct calculation, it is quantified through the discount factor or discount rate applied to future values. The present value (PV) of a future amount (FV) is calculated using a discount rate (r) over a period (n). A higher time preference implies a higher discount rate, meaning future amounts are valued less in today's terms.

The formula for the present value is:

$PV = \frac{FV}{(1 + r)^n}$

Where:

(PV) = Present Value
(FV) = Future Value
(r) = Discount rate (representing the time preference)
(n) = Number of periods until the future value is received

This formula demonstrates that as the discount rate (r) increases, the present value of a future value decreases, indicating a stronger preference for the present.

Interpreting Time Preferences

Interpreting time preferences involves understanding an individual's implicit or explicit trade-offs between receiving something now versus later. A person with a high time preference tends to be more impatience and will require a significantly larger future reward to forgo an immediate one. Conversely, someone with a low time preference exhibits greater delayed gratification, valuing future rewards more highly and being willing to wait for them.

In financial contexts, a high time preference might manifest as a lower propensity to save for retirement, a greater likelihood of taking on high-interest debt, or a preference for short-term gains over long-term growth. Conversely, a low time preference is often associated with disciplined saving, strategic investment decisions, and a long-term perspective. These preferences are closely tied to an individual's risk tolerance and overall financial well-being.

Hypothetical Example

Consider two individuals, Alex and Ben, each offered a choice:

Receive $1,000 today.
Receive $1,100 one year from now.

Alex, who has a high time preference, decides to take the $1,000 today, valuing immediate access to funds more than the extra $100 in a year. His implicit discount rate for that year is higher than 10%. He might choose to immediately use the money for consumption or a short-term need.

Ben, on the other hand, has a lower time preference. He chooses to wait for the $1,100, recognizing the additional $100 as a worthwhile return for waiting. His implicit discount rate is less than 10%. Ben sees the $100 difference as a form of opportunity cost for not waiting. This decision reflects his greater willingness to delay gratification for a larger future benefit.

Practical Applications

Time preferences play a critical role across various financial and economic domains:

Saving and Investment: Individuals with lower time preferences are more likely to save for retirement and make long-term investment decisions, accepting current sacrifice for greater future wealth. Conversely, higher time preferences can lead to under-saving and reliance on credit for immediate needs.
Borrowing and Lending: Time preferences influence the interest rates people are willing to pay for loans (reflecting a strong preference for current funds) and the rates they demand for lending (reflecting their patience).
Public Policy: Governments consider societal time preferences when designing long-term policies, such as environmental regulations, infrastructure projects, or pension reforms. A society's collective time preference influences how much present resources are allocated to addressing future challenges. Research from the Federal Reserve Board highlights the role of time preference in household finance decisions.
²* Marketing and Consumer Behavior: Businesses leverage consumers' time preferences by offering "buy now, pay later" schemes or emphasizing immediate benefits to encourage consumption.

Limitations and Criticisms

While fundamental, the traditional model of time preferences, which assumes a constant discount rate, faces several criticisms, primarily from the field of behavioral economics:

Inconsistency (Hyperbolic Discounting): A major critique is that human time preferences are often dynamically inconsistent. People tend to discount immediate future events more heavily than distant future events. This phenomenon, known as hyperbolic discounting, means that while an individual might plan to save for retirement next year, when next year arrives, the preference shifts towards immediate consumption again. ¹This inconsistency can lead to procrastination and sub-optimal long-term outcomes.
Context Dependence: Time preferences can be influenced by factors like emotional state, framing of the choice, and perceived urgency, rather than being a stable trait.
Lack of Formulaic Precision: Time preferences are complex psychological constructs not always easily captured by a simple mathematical formula, as they involve subjective valuations and often deviate from rational economic models.

These limitations underscore the importance of understanding the behavioral aspects of decision-making beyond purely rational models.

Time Preferences vs. Time Value of Money

While related, time preferences and the time value of money are distinct concepts.

Time preferences are a psychological and economic concept describing an individual's subjective inclination to prefer goods or services sooner rather than later. It is a behavioral trait reflecting inherent impatience or a desire for delayed gratification. It explains why money has a time value for an individual.

In contrast, the time value of money is a financial principle stating that a sum of money is worth more now than the same sum will be at a future date due to its potential earning capacity. It's a mathematical calculation that quantifies the difference in value between money received today and money received in the future, given a specific rate of return (e.g., interest rates). It explains how to calculate the difference in value.

The confusion arises because time preferences contribute to the existence of the time value of money, as the collective preference for immediate over future consumption drives positive interest rates and the discount rate used in calculations.

FAQs

Q: Why do people generally prefer money now rather than later?
A: This preference stems from a combination of factors, including uncertainty about the future, the immediate utility or enjoyment derived from current consumption, and the opportunity to invest or earn returns on money received sooner.

Q: Can time preferences change over a person's life?
A: Yes, time preferences can evolve due to life experiences, financial stability, education, and age. For instance, younger individuals might exhibit higher time preferences, while older individuals, especially those focused on retirement, might have lower time preferences and a greater emphasis on saving.

Q: How do time preferences affect personal finance?
A: Time preferences significantly impact personal finance. A strong preference for immediate gratification (high time preference) can lead to insufficient saving, increased debt, and impulsive spending. Conversely, a lower time preference encourages prudent financial planning, long-term investment decisions, and greater financial security.

Q: Is there a "right" time preference?
A: There isn't a universally "right" time preference. The optimal time preference depends on individual circumstances, life goals, and market conditions. However, extreme time preferences (e.g., an overwhelming preference for the present to the detriment of future well-being) can lead to poor financial outcomes.