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Time Preference Confirmed

March 11, 2005

Among the critics of Austrian economics none is so close, yet so far, from being an Austrian as Bryan Caplan. In his latest effort to discredit Austrian Economics Bryan has taken on the idea of time preference. According to Bryan the idea that interest rates and intertemporal consumption decisions depend upon time preference is wrong. All one need to explain this is the notion of diminishing marginal utility, not time preference.

In Austrian theory, scarcity forces individuals to economize. As Menger (1871 p94-6) put it- "[when] requirements are larger than the available quantity [of a good] men endeavor to make a choice between their more important needs and needs that they will leave unsatisfied to obtain the greatest possible result with a given quantity of the good or given result with the smallest quantity."

In order to economize, we must make judgments of value concerning how to use limited resources to best satisfy our demands (ibid p122). This requires us to order and grade different goods for the present or near future, and for the satisfaction of needs of a more distant time period (ibid p155). What are Bryan's specific examples?

"If you are stuck on an island with two bananas for two days, a perfectly patient person would still want to eat one banana per day. Even though he disvalues hunger today and hunger tomorrow equally, eating one banana today assuages his hunger more effectively than saving that banana for tomorrow." True, but note that this stranded individual is making a judgment of value concerning consumption of two time periods. A judgment that two time periods are of equal value is still a judgment. Such judgment are based on what if not time preference?

"Imagine you are going to inherit $1,000,000 next year. According to the law of diminishing marginal utility, you would want to increase your consumption now when the marginal utility is high, and pay for it by cutting back your consumption in the future when the marginal utility is low. No time preference story need apply." Yes, of course. An economizing individual must allocate his income across all time periods. Since this income is limited, as are the number of time periods (for mortals) each individual must make an estimate of the expected marginal value of consumption in each time period.

If you expect that your income will increase by 1 million dollars in a year, then the fact that it is a finite amount and that you have a finite number of time periods to consume it implies that you must allocate it according to the expected marginal utility of spending it in each time period. One "increases their consumption now and pays for it by cutting back on consumption in the future" by making a judgment of value in each time period. This IS time preference. If the expected marginal utility of expenditures in some future time period is lower than in more immediate time periods, then we transfer income from the future to the present. How can this not represent a judgment of value between two time periods?

Bryan's error is that he sees diminishing marginal utility in each time period, but ignores the fact that to economize one must still calculate the marginal rate of substitution between time periods. Any comparison of the marginal utility of income spent between any two time periods absolutely requires an estimate of the value of income spent in those two time periods. Individuals may value future time periods more, less or the same (though a positive rate of time preference is common), but scarcity forces us to choose, and Bryan actually indicates that this is the case when he argues that people consider diminishing marginal utility in more and less distant time periods.

When teaching time preference to undergrads I often mention the movie Armageddon. When the key characters learn that the world is probably doomed, they go out to live it up- one even takes out a huge loan from a loan shark. This is just a movie, but the point is that marginal principles apply to time periods and are based on preferences for consumption between time periods- time preference. When one learns that their world is about to end, perhaps due to illness, they rush to do the things they had they had thought they would do in latter years. They revaluate future time periods according to a shift in the relevant constraint based on time preferences.

The only way we can escape the necessity of choosing between time periods is through immortality. One who is freed from the constrains of aging, disease, and injury would have an infinite number of time periods. Under these conditions there would be little worry about the exact marginal satisfaction of income spent in each time periods. After all, with an infinite number of time periods time would have no economic value. Mortality makes scarcity and choice in time inescapable. This requires judgments of value between time periods based on preferences. This is time preference. Thanks for this little reminder Bryan. As hard as you might try not to, you often end up thinking Austrian.

See also Mises on time Preference

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