Microfoundations of Discounting

TL;DR

This paper introduces a wealth-growth maximization model that explains various discounting behaviors, including exponential and hyperbolic, without assuming behavioral biases or payment risks.

Contribution

It presents a unified model of discounting based on wealth growth maximization, deriving multiple discounting forms consistent with choice axioms.

Findings

Four discounting forms: no discounting, exponential, hyperbolic, hybrid

Two forms predict preference reversal

Model aligns with standard choice axioms

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.