Time preference

By:

James Knight

James is a lead editor for Invezz, where he covers topics from across the financial world, from the stock… read more.

Updated: Aug 20, 2021

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A person’s preference for current as opposed to future consumption. Suppose we asked someone the following question: ‘If you were to give me £1 today, in exchange for a promise to pay you a sum of money in one year’s time, what would that sum of money have to be to compensate you for the loss of the current consumption?’ We stipulate that the sum of money is certain to be paid, and that there is no inflation. We mean by the word ‘compensate’ that we wish to leave the individual feeling just as prosperous as he would had he not surrendered the £1. His answer will then tell us the degree of his time preference. If, for example, our individual replied: ‘One pound and twenty-five pence’, then he is showing a preference for current as opposed to future consumption: £1 now is worth more than £1in the future, and in fact it is worth 25 per cent more, since he requires £1,25 more than the amount he is giving up to make him feel as prosperous. On the other hand, if he had answered ‘£1’, then he is clearly indifferent between consumption now as compared to the future, since he would feel equally well off consuming £1 in the future or £1 now. Finally, if he had said ‘seventy-five pence’, then he is showing a preference for future as opposed to current consumption, since £0,75 worth of consumption in one year’s time is worth as much to him as £1 of consumption now. We can make this idea more precise by defining the ‘rate of time preference’, which is a kind of subjective rate of interest. Let us take the two numbers in our time preference experiment, namely the £1 given up now and the sum required to be paid in compensation. Taking the ratio of the latter to the former in each example given above, we can write:

(a) £1,25 / £1 = (1 + 0,25)

(b) £1 / £1 = 1

(c) £0,75/ £1 = (1 – 0,25)

We now define in these three examples the consumer’s rate of time preference as the number, in the form of an interest rate, which expresses the individual’s relative evaluation of future and current consumption. In the first case, the individual required to be paid 25 per cent more than he gave up to compensate him for postponing consumption. In the second case, nothing extra had to be paid. In the third case, 25 per cent less had to be paid. So, 25 per cent, 0 and – 25 per cent respectively are the rates of time preference in the three cases. Clearly, the larger the value of this subjective interest rate, the more highly is current consumption valued relative to future consumption. An individual’s rate of time preference will depend to a large extent on his tastes and personality, which in turn could depend, inter alia, on his age and social situation. In addition, it will depend on the total amount of income he currently has and the amount he expects in the future. One might expect, for example, that an individual who expected his income to double in the near future would have a high rate of time preference – a pound’s worth of consumption now is more valuable to him than it will be later; conversely, if he expects a falling income, then he will tend to have a low or even negative rate of time preference – consumption later will have a high value relative to consumption now. Generally, we can say that the higher current relative to future income is, the lower will be the rate of time preference, while the lower current relative to future income is, the higher will be the rate of time preference. Note also that although in the example used above a time period of one year was chosen, a rate of time preference can be defined for any time period.

The concept of time preference plays an important part in the theories of capital, of saving, and hence of the rate of interest. The nature of its role can be suggested by the following propositions: an individual will postpone consumption and lend on the capital market as long as the rate of interest exceeds his rate of time preference. If his rate of time preference increases as the quantity lent increases, then his total saving is determined by equality between the rate of interest and his rate of time preference. If firms invest up to the point at which the rate of return on investment is equal to the rate of interest, then, in equilibrium, the rate of time preference will equal the rate of return on investment.

Reference: The Penguin Dictionary of Economics, 3rd edt.