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 nonexponential 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 discounting, hyperbolic discounting, and a hybrid of exponential and hyperbolic discounting-two of which predict preference reversal. Our model requires no assumption of behavioral bias or payment risk.