Microfoundations of Discounting

Abstract

An important question in economics is how people choose between different payments in the future. The classical normative model predicts that a decision maker discounts a later payment relative to an earlier one by an exponential function of the time between them. Descriptive models use non-exponential functions to fit observed behavioral phenomena, such as preference reversal. Here we propose a model of discounting, consistent with standard axioms of choice, in which decision makers maximize the growth rate of their wealth. Four specifications of the model produce four forms of discounting -no discounting, exponential, hyperbolic, and a hybrid of exponential and hyperbolic -two of which predict preference reversal. Our model requires no assumption of behavioral bias or payment risk.

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